2014 JANUARY13
2013 in Review
Equities
Global Economy
Fixed Income
2013INREVIEW
Global equities, as measured by the MSCI All Country World Index, were up 23.5% last year, and were led by U.S. and Japanese stocks. The S&P 500 rose 32.4%, while the Nikkei Index climbed an astonishing 59% (though only 30.4% in dollar terms, as the yen fell). European stocks showed new signs of life – rising 20.9% – as investors’ severe pessimism regarding the eurozone abated. Emerging market stocks were the laggard last year, with the MSCI Emerging Markets Index falling 2.4%, as investors bet that rising interest rates in the U.S. would make emerging market assets less competitive in the global contest for capital. Consistent with the dour mood toward emerging markets, the U.S. dollar rose last year, with the Dow Jones Dollar Index up 6%.
This steady and consistent rise in global stocks (barring emerging markets) in 2013 was contrasted with extreme tumult in the bond market. Interest rates rose
dramatically last year, with the yield on the 10-year Treasury rising from 1.76% at the start of the year to 3.03% by year-end. The Barclays Aggregate Bond Index fell 2% last year, its first fall in 14 years. All of this came in response to announcements that the Federal Reserve would slow down bond purchases, beginning in 2014. Reported inflation, as well as inflation expectations, have remained very low, and the increase in interest rates mainly reflects an increase in the real interest rate. It’s important to note that even with last year’s interest rate increase, rates are still quite low by historical standards. We believe rates will continue to rise in 2014 as economic growth picks up, employment improves, and the Fed slowly but surely ends quantitative easing. That said, rates are likely to remain low on the short end of the yield curve, as the Fed is promising to keep the fed funds rate near zero into 2015. U.S. stocks are fully valued, and there are better opportunities in the emerging markets and in Europe.
EQUITIES
U.S.-based stocks had a great 2013 and led global equity markets. Some of that was due to increased earnings as the domestic economy improved, but much of the gain was due to an increase in valuation
Equity
multiples, as investors discounted expected earnings at a lower rate. The S&P 500 rose 32.4% (dividends included) in 2013 but reported earnings in the year were up only 6%. The S&P 500’s price-to-earnings ratio
Returns 2013 S&P500
using trailing earnings was 17.4 at the end of December, up from 14.2 the year before, and the highest level since 2009. Both the Nikkei and the FTSE Developed Europe index saw an expansion of multiples last year as well. Meanwhile, the MSCI Emerging Market Index saw its P/E ratio fall from 12.6 to 11.8. In short, the underperformance of emerging markets last year was due more to investor perceptions and discounting than actual earnings growth realized.
Looking at forward price to earnings ratios (using market expectations of 2014 earnings), the discount applied to emerging market stocks is also very high relative to domestic stocks. The MSCI Emerging Market Index is trading at 10.3 times forward earnings, compared to 15.5 for the S&P 500, 13.6 for the FTSE Developed Europe Index, and 20.6 for the Nikkei. Earnings could be hurt in 2014 if the Fed ends up roiling emerging economies, but that possibility is more than factored into current prices.
Market sentiment is strongly against emerging markets, but their long-term positives are
numerous: good demographics, growing middle classes, decent macroeconomic policies (generally), and continued strong economic growth. U.S. stocks, on the other hand, are fully valued. Japanese stocks also look frothy, after having
a tremendous run in 2013. Europe is more attractive than either the U.S. or Japan, as depressed earnings are set to increase significantly as economic growth picks up.
GLOBALECONOMY
The U.S. economy continues to recover. The unemployment rate has fallen steadily since 2009 and is now at 6.7%. The underemployment rate (which includes part-time workers and those that would like to work but have stopped looking) has fallen to 13%, which is still very high but marks an improvement from 17% in early 2010. Housing starts are up, as the housing market continues to recover, and consumer confidence rose in late 2013. U.S. GDP growth was 2.0% in 2013, and we’re forecasting an improvement to 3.0% in 2014.
Underemployment Rate
United States
The eurozone suffered a mild recession in 2013, and we expect growth to increase to 1.0% in 2014. The dark days of 2011 – when a breakup of the currency bloc appeared possible – are definitely behind us, and Europe is on its way to recovery. The bond market has already come to this realization, and Spanish bonds are trading at spreads not seen in three years. Yields on Italian and Greek bonds (which also spiked in 2011) are down as well. Most of the easy money in European debt has already been made, but there is still good potential in European equities. The FTSE Developed Europe Index is trading as 13.6 times 2014 earnings, a 12% discount to the S&P 500.
U.S. Housing Starts
GDP growth in the emerging markets, despite some notable lagging countries, remains good. China grew 7.8% in 2013 and should achieve a similar number in
2014. Indonesia’s GDP growth has slowed but was still 5.6% last year, and is likely to be 4.0-5.0% next year, in spite of market jitters over the effect of Fed tapering on its capital account. Latin America has slowed, largely as a result of falling commodity prices, but investment-grade countries Colombia and Chile grew 4.5% and 4.7% last year, respectively. Both countries should achieve similar results this year. The region’s laggard has been Brazil, with growth at a very
Yield on 10-year bond
Germany Spread Spain
disappointing 2.2%. Even there, though, there are signs of life with growth picking up in the fourth quarter.
Brandon Fitzpatrick
FIXEDINCOME
The fixed income markets declined again in December as the Federal Reserve initiated the long anticipated “tapering” of its Quantitative Easing (QE3) bond buying program from $85 billion to $75 billion per month. Although this was a very modest reduction, the Fed also stated that it may completely terminate QE3 by year -end 2014 if economic conditions are sufficiently strong. Treasury benchmark yields have surged since the Fed started publicly discussing tapering in May (see Exhibit 1). The
volatility seen in 2013 in the Treasury market was historic and was caused mainly by speculation about tapering, supplemented by spectacle in Washington as politicians clashed over the debt ceiling and budget deficit.
Exhibit 1: U.S. Treasury Rates (%)
Exhibit 2: Federal Reserve’s Balance Sheet (in trillions)
As a result of the increase in intermediate and long term rates, the bond market suffered its first annual loss in 14 years, as measured by the Barclays U.S. Aggregate Index. 30-year U.S. Treasury bonds returned a negative 15.0% in 2013, while the 10-year bond was off 7.8%. The Barclays U.S. Aggregate index declined 2.02%, while the U.S. Mortgage Back Securities (MBS) and Intermediate U.S. Government
indices were off 1.41% and 1.25%, respectively. The DBF Short and Intermediate portfolios generated returns of negative 0.14% and negative 1.69%, respectively, in 2013.
Since the financial crisis and Great Recession that started in 2008, the Federal Reserve has been actively supporting the bond market with the goal of stimulating the housing sector and the general
Exhibit 3: Total Return of U.S. Treasury Securities
Exhibit 4: Divergence of Treasury yield and change in Consumer Price Index (CPI)
economy. As a result, the Fed’s balance sheet has soared from less than $1 trillion in 2007 to $4 trillion by 2013. This emergency action by the Fed may well have averted a major financial/economic collapse, but has also injected significant distortions in the financial markets, as can be seen in the sharp increase in the volatility of fixed income prices since 2008 (Exhibit 3).
Fixed income markets and inflation (and inflationary expectations) are normally highly correlated; i.e., as inflation declines yields decline and bonds appreciate. In 2013, however, the opposite occurred as yields soared in an environment of declining inflation (Exhibit 4). This divergence of nominal bond yields from inflation is clearly an effect of the Fed’s “unwinding” of its extraordinary monetary stimulus.
We believe that these atypical effects of tapering will be reversed as the Fed terminates QE3 by the end of 2014. If U.S. economic growth continues to strengthen, as we expect, yields may continue to increase but only if inflationary pressures build. If inflationary pressures remain subdued, the fixed income markets will improve.
We anticipate that a modest increase in inflationary expectations (resulting from a stronger economy) will result in the 10-year US treasury yield increasing to the 3.25 – 3.75% range in 2014. Additionally, we expect short term rates to increase modestly in 2014. As a result, we expect DBF Short duration portfolios to perform relatively well in 2014 as portfolio cash flows are reinvested in a rising yield environment.
DBF Intermediate duration portfolios are positioned to “cushion” the effects of moderately rising yields in early 2014. During the next 2 – 3 years we expect DBF Intermediate duration portfolios to generate 2.5 – 4.0% annualized returns. Prabhab Banskota
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