2014 Outlook: Accelerating economy and normalizing markets

TIMOTHY HOPPER, PH.D., CHIEF ECONOMIST
DANIEL MORRIS, CFA, GLOBAL INVESTMENT STRATEGIST

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December 23, 2013

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2014 Macroeconomic Outlook

In 2014, the U.S. economy should finally move toward “escape velocity” — a sustained economic recovery that no longer requires the support of the Fed’s extraordinary monetary stimulus but instead is propelled by higher consumer demand, robust employment gains, increasing private investment and continued strength in the housing market. On December 18, the Fed took an initial step towards winding down its intervention when it announced that it will “taper” its monthly bond purchases by $10 billion a month (making it roughly $75 billion) beginning in January.

Article Highlights

  • The U.S. economy should accelerate evenly throughout the year. We forecast average GDP growth of 2.8% and annualized growth approaching 3.5% by year end.
  • Interest rates will move moderately higher, with the 10-year Treasury yield reaching 3.45% by December.
  • Despite rising interest rates, the bull market in U.S. stocks should continue.
  • Reasonable valuations, earnings growth, and the global economic recovery will create opportunities in the U.S. and abroad.

With these factors in mind, we project that the U.S. economy will grow 2.8% in 2014, with this expansion occurring roughly evenly throughout the year. The global economy will also gather speed next year, growing 3.7% on average. Of the major economic regions of the world, we expect the eurozone to expand by 0.7% and China by 7.7%, which will help drive U.S. exports. In China, the new administration’s effort to liberalize the economy bodes particularly well for the U.S.

But U.S. economic performance in 2014 will be determined primarily by consumer spending. A number of factors suggest people are ready to shop:

  • shrinking ratios of debt to disposable income
  • increasing household wealth
  • sales growth in durable goods and autos
  • rising housing prices
  • a return to revolving credit spending.

Income growth — while tepid at best — has nonetheless been rising faster than credit expansion, leaving consumers with the ability to incur more debt.

Equally important is the continued improvement in the labor market. In 2014, the economy should generate consistent monthly jobs gains of 200,000 or more, especially in the second half of the year. By the end of 2014, we expect 2.45 million new jobs to be created, with the unemployment rate dropping to 6.5%.

On the political front, significant discord in Washington has been a drag on the recovery. But with the recent bipartisan budget agreement in Washington, the crippling gridlock of the past few years appears to be easing. We believe there will be agreements in early 2014 to extend the government’s spending authority and raise the debt limit. We further think these solutions will last through the next election cycle, enabling the economy to expand relatively unencumbered.

The major economic risk in 2014 is a rise in interest rates tied to tapering that will begin in January. Tempering this risk, however, is the Fed’s assurances that short-term interest rates will stay low even after the tapering begins. So while the end of extremely easy monetary policy is on the horizon, a low-rate environment will prevail for another 18 or more months.

2014 Capital Markets Outlook

Global equity markets racked up another year of double-digit gains in 2013, bringing a total return of about 150% since the lows of March 2009.1 Given the magnitude of these returns and the length of the rally, some question whether stocks can continue to climb. However, we believe that a combination of reasonable valuations, steady earnings growth, and the continuing cyclical recovery of the global economy will lead to sustained, albeit modest, returns ahead. While all equities are at risk due to Fed tapering, the likely reversal of investor fund flows back to the U.S. means that U.S. equities should prove more resilient.

U.S markets

We expect U.S. equities across all market-capitalization sizes to continue outperforming their international counterparts. U.S. large-cap valuations are only slightly higher than those in other developed markets, and corporations here are far more adept at improving earnings in a low-growth environment.

Fixed income, however, will be more challenged. Yields are set to rise not just because the Fed will begin to taper quantitative easing (QE) asset purchases in January, but also thanks to improving economic growth. We expect the yield on the 10-year U.S. Treasury to rise throughout 2014 and hit 3.45% by the end of the year. As was the case last year, some of the riskier parts of the market, such as high yield, may outperform.

Meanwhile, commercial real estate investment is well-positioned to benefit from the stronger economic growth expected in 2014. We expect the national economy to drive NCREIF National Property Index returns roughly in line with the benchmark’s historical long-term average of 9.1%.

European markets

Europe will see a cyclical recovery as the region continues to emerge from its recession. The region’s multinational corporations remain attractive to investors because these companies are not entirely bound by the country in which they are domiciled. On average, valuations across Europe are slightly better than in the U.S., but below the surface they vary widely by country.

On the fixed-income side, Europe’s high-yield debt market currently offers yields that are well below historical norms but are still generous compared to investment-grade benchmarks. With yields near fair value, however, price appreciation in 2014 will likely be limited.

Emerging markets

In the short term, rising interest rates in the U.S. could hurt emerging markets since investors will feel less need to take on these countries’ currency and political risks. Over the longer term, however, we believe emerging markets offer compelling opportunities. In particular, countries in Asia are trading at P/E multiples 20% below their average since 1987.

As for fixed income, an increase in emerging-market debt yields during 2013 restored some value to the market. Spreads of 300-400 basis points on U.S. dollar debt are well above what investors received prior to the financial crisis.

Finding a new path forward

More than six years after the onset of the global financial crisis, investors still face a challenging and unusual financial market landscape. But with the global economic recovery gaining speed, the intelligent investor can find opportunities in equity, fixed-income, and real estate markets.

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