Sunday, December 29, 2013
U.S. Economic Outlook for 2014
- Preconditions are in place for much stronger economic expansion in 2014. After nearly five years of modest growth, the US economy appears ready to gain some momentum.
- The problems and imbalances that developed during the housing bubble nearly a decade ago have largely been corrected. Households have significantly reduced their debt burdens. The banking system is well-capitalized and highly liquid. The financial health of nonfinancial businesses is strong. The main missing ingredient for stronger growth is confidence.
- The biggest risk for this calendar year is fiscal policy.
After nearly five years of modest growth, the US economy appears ready to gain some momentum in 2014. Most Gross Domestic Product (GDP) components should accelerate and contribute positively to growth. On December 20th the Bureau of Economic Analysis (BEA) released the revised Q3 2013 GDP with a positive real 4.1% growth rate.
This was up from a gain of 2.5% in the second quarter. The jump came, in part, from slower growth in imports and faster growth in state and local government spending. But the acceleration this quarter was dominated by faster inventory accumulation and is, therefore, a negative for the outlook in the next few quarters. Residential investment is strongly leading, while the largest drag is a decline in government spending, especially for federal defense. Consumer spending is increasing at about the same pace as overall GDP. Forward-looking indicators are mixed; rapid inventory accumulation is a drag, but expectations for faster consumer spending and continued advances in residential investment are still positives. Hence, the outlook for faster growth next year remains intact.
Preconditions are in place for much stronger economic expansion in 2014. Evidence of this underlying strength is clearest in the job market. Payroll gains have accelerated to around 200,000 net new jobs per month and are increasingly broad-based across industries and pay levels. The problems and imbalances that developed during the housing bubble nearly a decade ago have largely been corrected. Households have significantly reduced their debt burdens. The banking system is well-capitalized and highly liquid. The financial health of nonfinancial businesses is strong
The main missing ingredient for stronger growth is confidence. The nightmare of the Great Recession weighs heavily on the collective psyche, and political brinkmanship and policy uncertainty have been hard to bear. But sentiment has improved with the budget deal and apparent reduction in brinkmanship in Washington. Investors are especially upbeat, as stock prices continue to hit record highs. With the reduction in fiscal drag and release of pent-up demand, 2014 could be a breakout year for the economy.
The biggest risk for this calendar year is fiscal policy, specifically politicians’ continued failure to act in a timely manner and instead bringing our economy to edge of the next “cliff” scenario. The political agreement that ended the government shutdown only suspended the debt ceiling until February 7. If there is no debt ceiling agreement by that date, the US economy can face roadblocks that are now all too unfortunately similar, weighing on both consumer and business confidence. Given that 2014 is an election year, we doubt we’ll see a repeat of the fiscal drama we have seen, as the political cost could be too high. Nonetheless, the risk of fallout remains.
Another risk is rising interest rates. If the speed of the Federal Reserve’s tapering of its Quantitative Easing program is more aggressive than the market anticipates, the backup in yields could be concerning. In an environment of rising yields, interest rate-sensitive sectors, such as housing and autos, could suffer. Despite these risks, we remain relatively optimistic about the US economic outlook in 2014.
Bottom Line: Berkshire Money Management (BMM) projects 2.8% real growth in 2014, with slower gains in the first several months of the year and acceleration later on. This would be the fastest pace since 2005, supported by steady income and employment growth, favorable credit conditions, and improving manufacturing and services activity. This growth expectation is well above the 2.3% average annual growth during the current expansion. This projection is right in line with the Survey of Professional Forecasters, but at the low end of the Federal Reserve’s central tendency forecast of 2.9% to 3.1%.
- Inflation is expected to increase moderately in 2014 due mostly to stronger economic growth. Given that there is still excess capacity in the economy, the upward pressure should be minimal.
- The risks to a larger than expected inflation rate are coincident to improving aggregate demand.
Based on the Consumer Price Index (CPI), year-to-date numbers have inflation for 2013 coming in at 1.2%. BMM expects a modest uptick in inflation pressure, moving CPI closer to 1.7% for 2014. This is somewhat below the two percent consensus, per the latest Survey of Professional Forecasters. The higher consensus is a risk should there be a larger than expected sustained pickup in wage inflation and/or supply shortages. Neither of these risks to higher inflation are considered a significant risk to the overall economy.
Our outlook for higher inflation is based on an expectation of stronger economic growth (the unemployment rate remains in a downward trajectory), an increase in average hourly earnings (wage pressures have emerged for skilled workers), and a firming of energy and commodity prices.
The US economy has been growing at or below trend for the better part of the current expansion. We expect economic growth to accelerate moderately in 2014. Firmer aggregate demand should provide support for consumer prices. But given that there is still excess capacity in the economy, the upward pressure should be minimal.
After a three-year delay, average hourly earnings are finally picking up, in line with the decline in the unemployment rate. Wage pressures have begun to emerge in several industries, including manufacturing, transportation, information, and logging. These four industries account for about eighteen percent of private nonfarm payrolls, so their combined impact on overall wage growth can have impact. Information in the Federal Reserve’s “Beige Book”, as well as other reports, indicates a shortage of skilled labor in high-tech, engineering, accounting, and high-level manufacturing and construction trades. This shortage contributes to the upward pressure on wage earnings, and thus inflation.
The risks to more inflation than BMM expects are 1) that wage growth is stronger than expected, and 2) inventory shortages pull price. Based on December 20th’s Gross Domestic Product (GDP) report (which was a booming 4.1%), inventories picked up enough in the third quarter of 2013 to temper our inflation expectations relative to the consensus. (If inventories have already risen, then less production is required to satisfy an increase in demand.) Still, we acknowledge that commitment lead times, an indicator of the demand/supply dynamic, has trended upward over the last few years. Commitment lead times typically rise when there is either excess demand or supply shortages. The outcome of either (or both) can be higher inflation.
Despite the low cost of holding inventories (due to low interest rates), businesses are keeping their inventories largely in line with demand, as suggested by the low inventory-to-sales ratio. So what has been happening, for example, is that a retailer will accept a longer delivery time instead of stocking the shelves. This is indicative of business uncertainty about future demand. If demand strengthens next year, as BMM expects, then the current longer delivery times could lead to supply shortages and higher costs, thus pushing inflation higher.
Bottom Line: BMM expects a modest uptick in inflation pressure, moving CPI closer to 1.7% for 2014. Our outlook for higher inflation is based on an expectation of stronger economic growth (the unemployment rate remains in a downward trajectory), an increase in average hourly earnings (wage pressures have emerged for skilled workers).
Global Market Outlook for 2014
- BMM expects global growth to be better in 2014 than in 2013.
- Many of the major threats from prior years have abated.
The bottom line for 2014 global growth is that Berkshire Money Management expects it to be better in 2014 than 2013. While there continues to be several risks to the outlook, many of the major threats from prior years, such as the European sovereign debt crisis and the global financial crisis, have abated.
The world’s largest developed economies, the U.S., the Eurozone, and Japan, all of which will likely expand next year, will play a major role in shaping the global economic outlook. China, to a lesser extent, will also drive global growth due to its relatively faster growth rate.
We anticipate 2014 to be a good year for the U.S., making it a major driver of global growth. After five years of modest growth, we expect the economy to gain some momentum. The Eurozone economy climbed out of recession this year after two years of stagnation. It will continue to grow next year, no longer being a drag on the global economy. Japan’s “Abenomics” (the economic policies of Japans’ Prime Minister, Shinzo Abe) helped fuel a cyclical recovery, and growth will likely continue next year, even if at a slower rate. China’s growth rate will remain stable, but given the economy’s sheer size and fast growth rate, China may contribute to even more global growth in 2014 than 2013.
Bottom Line: BMM expects global growth to be better in 2014 than in 2013. While there continues to be several risks to the outlook, many of the major threats from prior years, such as European sovereign debt crisis and the global financial crisis, have abated.
European Outlook for 2014
- European equities, in general, are not overvalued. The multiples have simply bounced back to normal levels, and now the rally requires a heavier dose of earnings growth to justify the continuation of the rally.
- European companies do not need gangbuster 2014 revenue growth to deliver decent earnings growth; BMM expects decent earnings growth and thus a continuation of the European equity rally.
- Healthy 2014 market growth could be stacked in the second-half of 2014, as the rally of 2012 and 2013 requires some digestion, and the first-half of 2014 requires some earnings reality.
Equity markets have celebrated the end of the European recession with great exuberance. The incredible rally of the past year-and-a-half has been fueled heavily by price multiple expansion, leaving investors to expect either a violent correction, or a sudden improvement in the earning and economic outlook. European equities, in general, are not overvalued. The multiples have simply bounced back to normal levels, and now the rally requires a heavier dose of earnings growth. BMM believes this will happen.
Basic statistics on numbers of days without a correction confirm that the European rally is overstretched. As of the end of 2013, it has been 136 days without a five-percent correction (using the MSCI Europe Index), the longest stretch in the last five years. Investors who missed the rally in 2013 have been awaiting a correction to participate, which may mute (on a relative basis) any 2014 correction.
The first phase of this rally is quite understandable – an oversold market, firming economic growth, and the “whatever it takes” declaration from the President of the European Central Bank, Mario Draghi, regarding the ECB acting as the lender of last resort for the Eurozone. The last phase has been a bit more difficult to justify. Investors have continued to give this rally the benefit of the doubt as the markets continued to appreciate even as growth estimates were taken down. Thus the entirety of the rally has been propelled in large part by price multiple expansion.
European equities are now about fairly valued from a historical perspective. Investors will demand to see some earnings growth to justify price increases at these valuations. We believe there will be some. European profit margins appear to be bottoming at six percent. European margins may not catch up with US margins (about ten percent), but the gap between the two regions have never been this high, suggesting that some convergence should take place.
Margins are predominantly driven by the economic cycle. Margin expansion is usually strongest in the early stage of a recovery, as commodity prices and wage pressures remain depressed. We expect a 2004-to-2007-like scenario, when European companies slowly emerged from a deep slump and even very weak three-percent sales growth in 2004 led to double-digit earnings growth. In other words, European companies do not need a gangbuster 2014 to deliver decent earnings growth.
An admittedly complicated theory (and thus easy to debate), is that given European stocks remain among the cheapest of developed economies, stock market returns could approach double-digits in 2014. The International Monetary Fund (IMF) expects growth of 1% in Europe, which would translate into real top line growth of 2% for European large caps. A 2004-like multiplier of three would lead to 6% earnings growth. Dividends would add another three percent to total returns. And with a pick-up in stock buybacks, the fundamentally justified return of European stocks could reach double-digits.
However, this market growth could be stacked in the second-half of 2014, as the thrills of 2012 and 2013 require some digestion, and the first-half of 2014 requires some earnings reality.
Bottom Line: Equity markets have celebrated the end of the European recession with great exuberance. The incredible rally of the past year-and-a-half has been fueled heavily by price multiple expansion, leaving investors to expect either a violent correction, or a sudden improvement in the earning and economic outlook. BMM expects earnings improvement, but market growth could be stacked in the second-half of 2014, as the thrills of 2012 and 2013 require some digestion, and the first-half of 2014 requires some earnings reality.
2014 Sector & Industry Outlook
- The rewards and risks for the year ahead will be largely dependent on fiscal and monetary policy, the outcomes of which can lead to sector leadership ranging from modestly cyclical to defensive.
- Our sector allocations will be guided by our macroeconomic expectations for 2014, which include moderately higher interest rates, a market decline, and an orientation toward growth stocks. These influences are also likely to vary their importance at different times throughout the year.
Berkshire Money Management does not make predictions and then lock them away. The global economy is too fluid, and too unpredictable, to treat predictions as constant. But BMM finds it a good exercise to consider the possibilities and the probabilities to assess the likelihood of relative rewards and risks.
The rewards and risks for the year ahead will be largely dependent on fiscal and monetary policy, the outcomes of which can lead to sector leadership ranging from modestly cyclical to defensive. So rather than relying on a forecast, BMM prefers to have a strategy for dealing with the market’s potential fluctuations and influences. We must maintain a flexible mindset.
Our sector allocations will be guided by our macroeconomic expectations for 2014, which include moderately higher interest rates, a market decline, and an orientation toward growth stocks. These influences are also likely to vary their importance at different times throughout the year.
Regarding moderately higher interest rates, BMM will not look at just absolute levels, but relative levels. Specifically, our outlook of higher interest rates will focus on the yield curve as measured by the difference between the 10-year and the 3-month Treasury rate. BMM expects that spread to continue to widen over the year as the market continues to expect further tapering. In recent years, a steepening yield curve has added favorable tailwinds to sectors such as Financials, Energy, Materials, and Industrials; and negative headwinds to defensive sectors like Consumer Staples, Health Care, Utilities, and Telecom.
While higher interest rates will likely occur in line with improving economic conditions, rising interest rates (along with other factors) is often a precursor to significant market tops. Navigating a top of any real significance will require an adjustment to BMM’s investment consideration of the importance of momentum. Price momentum is a wonderful factor for locking onto major trends, and is often where big money can be made. However, momentum can also fail miserably at major market turning points. If the factors line up to suggest we may be approaching a significant market peak, BMM will look to decrease our reliance on momentum and adjust toward lower-beta and dividend-paying sectors, with reasonable valuations likely to be given added emphasis.
Going into 2014, we have a heavier Growth-tilt than we had going into 2013. Growth tends to perform well when earnings growth is weak, and Growth stocks trade at a premium as investors seek out companies with better growth. The Information Technology and Health Care sectors tend to benefit from this.
Bottom Line: Fed tapering (and its effect on the yield curve), the potential for a significant stock market decline, and a bias toward Growth sectors are the key macroeconomic influences to focus on in 2014. The expected result is a three phase approach to navigating 2014. The first phase BMM will rely upon momentum, favor Growth, and expect a widening yield curve. The second phase will focus less on momentum and more on lower-beta selections and dividend-payers with reasonable valuations. And the third phase will be mostly determined by the magnitude of the decline, but we would expect to lean toward higher-beta names with mean reversion possibilities.
Market Risks and Rewards for 2014
The list of good news for 2014 outweighs the list of bad news for 2014.
- Monetary policy remains accommodative in the vast majority of markets around the world.
- Economic growth is gaining momentum globally, while inflation remains subdued.
- Earnings growth continues to trend upwards.
- U.S. and international mutual fund flows have been rising on a 13-week basis, now averaging $9.5 billion a week (the most since 2007).
- Evidence continues to point toward the existence of a new secular bull market. For example, a hundred years of Dow Jones Industrial Average data shows that 2013 has had the most record highs since 1996 (50, as of 12/26/13). Only seven years have had as many, all occurring within secular bull markets.
The bad news, however, is meaningful:
- Assured by the economic and earnings trends and inspired by the stock market performance, investors are likely to continue their buying into early January. The risk to this bullish outlook is that investors get more used to good news, they will become more vulnerable to the inevitable disappointments and negative surprises. Signs of complacency are already evident in many stock market indicators.
To be clear, any 2014 correction – no matter the size – would be cyclical in nature and not upset the longer-term secular bullish outlook. While the rising tide of optimism could lead to short-term pain in the form of reaching a cyclical top, more broadly these are the animal spirits required to satisfy longer-term needs. The current sentiment, especially outside of the stock market (ex. Employment, valuations, consumer surveys) is far from the exuberance that we experienced around previous secular tops, such as in 2000.
Because any correction would be cyclical in nature, Berkshire Money Management will consider making minimal – if any – adjustments in investment portfolios. Of course, if we identify indicators that concern us of, say, a twenty-percent drop (such as stretched valuations, or rapidly deteriorating breadth) then we will be required to take defensive action. If that is to occur, the next logical question might be, “when?”
While the high optimism and low volatility are consistent with a bull market that is in its late stages, we wouldn’t rush to the exits with the tape indicators still as positive as they are. If an ongoing advance occurs with lingering complacency, receding volatility, worsening valuations, narrowing leadership, and increasingly prevalent divergences, then a better selling opportunity will arise, most likely by the second quarter of 2014 when seasonal and cyclical influences turn negative in markets around the world.
In the first quarter of 2014, equities will be entering the fifth year of the long-term uptrend that started in 2009. The rate of return since then has been similar to market returns following the secular bear market bottoms of 1921, 1942, and 1982. While BMM is somewhat comforted that the market is exhibiting behavior that had previously been consistent with a new era for allocation (stocks over bonds), it is apparent that globally investors are not as optimistic as we are. It may be months off, but by the time the markets see a global scope of record highs and equity fund inflows, it is quite possible that sentiment and valuation indicators will be warning that optimism is excessive, leaving the market vulnerable to a cyclical top. Just as had occurred around this time into the bull markets of 1921, 1942, and 1982, around the same time the retail investor capitulates and buys into the market, equities could be poised for a drop again.
The amounts of the previously mentioned drops from a cyclical top were in the twenty percent range, so they were meaningful. When would the current bull start to look overextended? Again, historical tendencies offer guidance. As of the close of 2013, this cyclical bull has run 813 calendar days since the 2011 bottom. That is longer than the historical median of 655 days, and in February it will surpass the median for cyclical bulls occurring within secular bulls (870 days).
Of course, bull markets do not die of old age – they die of excesses. So while a sizable downdraft next year is “due” and consistent with the U.S.’s mid-term year of the “presidential cycle”, the timing of such a move downward is difficult. Though at thirteen months of trading above its 200-day moving average, it is concerning how easy it could be to prognosticate that the timing would simply be “soon.”
So if not a death by old age, then what excesses might kill the bull market? Given the extremely low probability of an excess-led recession in 2014, there will likely be no one killer as much as an excess number of “mild” excesses. Elevated earnings expectations, expanding valuation multiples, excessive optimism, and rising interest rates could all occur simultaneously, leaving the market vulnerable to a disappointing reality. The expectation from BMM is that this gang-up approach of market killers will be powerful as a group, but none will be so meaningful by themselves that a new secular bear market will begin. Downside damage will be limited, and quick, as investors – even with declining portfolio values – refocus on the resilience of the global economy. This will launch a new cyclical advance, and revive the secular uptrend. From start to finish, a moderate gain is expected for most global markets. The risk and the reward for the stock market will not be beginning to end, but rather during the year. The risk during 2014 will be a 10-20% correction. The reward for 2014, from start to finish, (with the luck of ending on a high note on a one specific calendar date, New Year’s Eve) may be as generous as ten percent (more than the long-term annual return of the stock market, so quite a generous return for stock market investors who understand reality). But absent an outlier of the year ending on a high note on a specific calendar date, the returns for the global market likely will see low-to-mid single-digit return rates.
Throughout the year BMM will keep in mind that even as the cyclical stock market, and maybe the economic cycle, deteriorates, the secular outlook is very likely to remain bullish. While the cyclical bull market may die from the excesses created by greed and over-optimism, market conditions are still relatively early in recovering from the fear and pessimism extremes experienced five years ago. In 2014, improving confidence and the associated rising retail-investor equity inflows and other signs of greed and optimism will be a contrarian warning for the year – for the short-term. But these same attitude adjustments will ultimately have positive implications for the rest of the decade. The return of risk appetite in business, consumers, and investor activity stands to support the next phase of the secular bull market in equities.
A more silent risk, if only because it is a long-term risk, is that bonds will no longer offer the generous returns that investors have become accustomed to. Investors who were allocated “conservatively” over the last two, ten, even twenty years into bonds and bond mutual funds recognized not only income, but also appreciation. Interest rates on bonds will go higher over the years to come, and prices will drift lower, forcing bond allocation into lower-quality bond products and eventually into equity. For those who require a less volatile portfolio and the possibility of keeping up with the rate of inflation, bond allocations will require taking credit risk.
Bottom Line: Based on duration alone, the stock market is “due” a significant correction. But bull markets do not die of old age, they die of excesses. Given the extremely low probability of an excess-led recession in 2014, there will likely be no one killer as much as an excess number of “mild” excesses. The expectation from BMM is that this gang-up approach of market killers will be powerful as a group, but none will be so meaningful by themselves that a new secular bear market will begin.
The risk and the reward for the stock market will not be beginning-to-end, but rather during the year. The risk during 2014 will be a 10-20% correction. The reward for 2014, from start to finish, may be as generous as ten percent.
2014 in 2014?
- The potential exists in 2014 for the biggest correction since 2011.
- When a cyclical bear does occur, it will likely be a shallow bear (in terms of magnitude and duration) unless economic conditions deteriorate significantly.
As painful as the financial crisis was, it sowed the seeds for one of the biggest stock market rallies on record. Not only were stocks oversold, but the aftermath of the crisis altered government, corporate, and investor behaviors to the benefit of equities. Still, the potential exists in 2014 for the biggest correction since 2011. As long as the economy avoids a recession (as BMM believes it will), the odds of a severe bear market remain low.
Expecting the market rally to continue at its current pace requires assumptions on price-to-earnings ratios, economic growth, and profit margins that many – including BMM – would describe as aggressive. Reasonable and low price multiples enabled the market to withstand slow earnings growth, but now the market is fairly valued. A repeat of 2013 would likely require more economic acceleration in 2014 than we are forecasting. And a continuation of the rally would require an expectation of profit margins wider than S&P 500 companies’ already near record high of 8.6%.
The economy and the stock market move in cycles. That is not new news. The difficulty, of course, is determining where in that cycle investors have made their bets, and when that cycle might shift. Whether we are approaching the part of the cycle where a cyclical bear occurs or not may be a question of semantics. Fundamental conditions, macroeconomic backdrop, and cycle analysis suggest that we need to watch for a correction that all but the longest-term investors would want to be aware of. When a cyclical bear does occur, it will likely be a shallow bear unless economic conditions deteriorate significantly.
Assuming the S&P 500 ends the year at 1,825 points, the average reward for the possible iterations of where we are in the cycle is an 8.2% gain, or 1,974 points. And given that the cycle composite ends the year on a high, that average could serve as a year-end target. The most bullish scenario is a 10.3% gain, which would be a level of 2,014 points with a P/E ratio of 16.7 (right about where it is now) applied against a consensus earnings estimates of 120.63.
The average risk for the possible iterations of the cycle where we are in the cycle is a 13% decline, or 1,588 points on the S&P 500. The most bearish scenario is a twenty percent drop, down to 1,460 points.
These types of scenario analyses provide a framework, but our objective indicators will tell us whether and when the scenarios are actually playing out. Deteriorating breadth, rising interest rates, and worsening sentiment are potential drivers of a decline in the market. Berkshire Money Management has never attempted to make year-end targets. It’s an almost obligatory practice for financial firms, but it is useless in so much that getting it right not only depends on the luck of how the market closes on its last day of the year, but also because information changes. And as information changes, we need to change our mind. We need to change our considerations so as to best move client portfolios forward, but while maintaining our primary objective – preserving client capital.
Bottom Line: Expecting the market rally to continue at its current pace requires assumptions on price-to-earnings ratios, economic growth, and profit margins that many – including BMM – would describe as aggressive. While the market can end the year higher by as much as ten percent, in that same market a twenty percent correction could occur mid-year.