Market Perspectives - January 2014
Outlook 2014 : Are we in the eye of the storm?
The economyBy Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist Another year of sub-trend growth is what the global economy delivered in 2013. Whether they lived in America, Asia, or anywhere else, people seemed nostalgic for the faster growth of the distant past. But for the majority of the world, material progress has been made in economic and financial conditions, and that bodes well for future growth.
Better growth in 2014 than in 2013Except for China and some other emerging economies, we think the world will see accelerating growth in 2014. All of this will likely be in a context of low inflation. In some areas, like Venezuela, Argentina, and India, inflation is a concern. In others, like the U.S. and the eurozone, inflation that is too low is a concern. To reconcile these divergent experiences, we think we’ll have to see some significant foreign exchange rate adjustments, with the dollar and the euro likely weakening relative to some emerging markets currencies, strengthening against others, and creating an interesting environment for security selection for emerging markets investors.
Possible debt and currency crisis talkAbrupt adjustments in exchange rates could cause political instability in the countries that are affected and could renew rumors of currency crises or debt crises. But we don’t think the situation will reach crisis proportions. The rumors of crisis may not be good for Venezuela or Argentina, which are already experiencing shortages of staples such as toilet paper and have a history of debt and currency crises. In India, 2014 is an election year, and the country also has a competent new head to the central bank. The anticorruption parties look poised to win, and with competent management of the money supply, India should fare well. Regionally, we prefer to limit our exposure to South American securities.
Positive political reforms in emerging marketsMexico is implementing important reforms that should benefit the country’s growth and finances. Late in 2013, the Mexican constitution was changed to open up the important oil market to competition. While anything underground (like oil) still belongs to the government, foreign investment in extracting those resources will be allowed. So instead of relying on state-run monopolies, which can be rife with corruption and inefficiencies, Mexico is opening resource extraction up for competitive bidding. As a result, government finances should be strengthened, while oil output increases more efficiently. The primary beneficiaries, from an investing perspective, could be U.S. firms that are already operating in Mexico in a limited way or are primed to enter it.
Other reforms are ahead in Mexico, which makes us optimistic about the economic growth trajectory of our neighbor. Although this could lead to a stronger peso, we’d temper anyone’s enthusiasm about investing in Mexico by pointing out that the changes could primarily benefit the U.S. and firms that are not currently in this market.
China and Japan are continuing to feud over islands in the East China Sea, an issue that has South Korea concerned. China has similar disputes with other countries over other islands, suggesting that it may need to learn how to play nice with its neighbors if it wants to assume a bigger role on the global stage. While these disputes with China will be important to watch, we don’t think the hot tempers will escalate to action.
With the reform framework announced in November 2013 coming out of the Third Plenum, China looks like it will continue its slowing march of development. The foreign policy developments are the biggest unknowns in that region, especially with the increasingly erratic actions out of North Korea. The assassination of Kim Jong Un’s uncle was a surprise and shows a belligerent streak in the young dictator. Because China is a common destination for many North Korean refugees, it may need as many friends as it can get in the region to keep North Korea from becoming a disordered, failed state.
On the election calendar, some important 2014 elections for the emerging markets are in May for India and South Africa, July for Indonesia, and October for Brazil. We are most interested in the voting in India, which looks to be moving away from its entrenched system of cronyism and corruption and toward a more open government—one focused more on broad development than on enriching only the powerful elites. If that trend continues, it could turn India into the China of the next 10 years.
U.S. politics move from a liability to an assetStarting with New Year’s Day 2013, U.S. politics seemed to cause periodic conniptions in the market. The year started with the fiscal cliff and began October with a partial government shutdown. The year ended on a higher note, with a two-year budget deal. This late-in-the-year deal has created hope that 2014 could be a year of détente—or at least relative peace.
2014 is a midterm election year, with one-third of the Senate and the entire House up for election. While the midterm elections in the U.S. are likely to be interesting and important, the campaigning and results might not move the markets. Because the president will continue in office, the balance of power won’t shift significantly, even if the Republicans retain control of the House (which is likely) and take the Senate (which is possible, but not highly likely). The late 2013 budget deal at least takes away the possibility of a partial government shutdown. It’s also unlikely that we’ll see another debt ceiling debacle, as the early October 2013 polling showed that the public doesn’t appreciate technical and possibly exhausting political theater. Image is everything in elections, and we think that neither party will want to tarnish its own image so close to Election Day. We expect a lot of talk about reforms but little action until after November.
Monetary policy still a plusWith little chance for big budget reforms in the U.S., monetary policy is likely to stay accommodative. The Federal Reserve (Fed) is likely to follow a gradual approach to eliminating its asset purchase program. It’s also likely to keep the federal funds rate at zero throughout 2014. Some innovations we could see from the Fed would be a press conference after every FOMC meeting instead of every other meeting. The Fed may also introduce another policy rate besides the federal funds rate. The current target is the federal funds rate for short-term loans between commercial banks. In an era of money market accounts and other forms of short-term lending, something like the overnight repurchase rate may be a more appropriate target for the Fed. Targeting that rate requires that the Fed use counterparties to transactions outside of the typical primary dealer network the Fed has used—for example, using money market funds as counterparties. 2014 could be the year we see this monumental change, which could help monetary policy become a more potent force. Ironically, this increase in influence would come while the Fed tries to wrap up its large-scale asset program, which some view as a way for the Fed to start withdrawing from the markets.
While the Fed has been on the cutting edge of monetary policy, the European Central Bank (ECB) seems to be having a fashion crisis, not having a thing to wear. It can’t use QE the way other central banks do because it risks creating a political mess no matter which country’s bonds it buys. It has also driven its policy rate to near zero. Longer-term cheap financing for banks doesn’t seem to help because banks just repay the loans, as experienced with the long-term refinancing operations the ECB tried earlier. It may try a program like the one in the U.K., where the Bank of England provided low-cost financing to banks, provided the banks made mortgage loans, but with a focus on business loans. The results would likely be middling, just like the results in the U.K. were. Alas, the ECB is probably stuck with trying to persuade people that it is serious about keeping the eurozone together, interest rates low, and inflation not too low or too high. That means the euro is likely to stay about where it is relative to the dollar.
While monetary policy is impotent in the eurozone, it won’t stop the economies from advancing. Granted, the bar is set pretty low, so it doesn’t take much to create growth, but the strengthening coalition in Italy, the divisive—but functional—coalition in Germany, and a light election calendar in 2014 promises stability and the likelihood of continued slow growth.
The Bank of Japan is probably going to have a tough time getting the yen to weaken more against the dollar. The weak yen has increased the cost of imports, especially food and energy, and with a politically active and elderly population living on fixed incomes, that could be a political disaster. In April, the value-added tax is increasing. We could see a flurry of consumption activity in the first quarter, as people stock up before the tax increases. The rest of the year could suffer a slight hangover from the early-year binge.
Profit outlook is positiveProfit margins for U.S. businesses have spent the past four years in excess of 8%. The average, going back to 1977, is 6.49%. Since the end of 2010, naysayers have been preaching a message of profit margin contraction, stock market declines, and credit market losses. Maybe the naysayers will eventually be proven right, but we don’t think that will happen in 2014.
First, there’s no law that says profit margins must return to any particular level. Competitive forces tend to drive excess profits down, but markets are not perfectly competitive. The average operating profit margin for businesses in the S&P 500 Index from 1977 to 1993 was 5.29%. The average from 1994 to 2013 was 7.51%. As Chart 1 shows, the free trade agreements and globalization of business that accelerated in 1994 with the passage of the North American Free Trade Agreement have been a real boon to U.S. businesses.
Chart 1: Profit margins for U.S. businesses have risen well above
the 36-year average of 6.49%, and we believe they are likely sustainable
Operating profit margins in 2013 were 9.52%. That might not be sustainable, as squeezing labor costs and interest expenses can only go so far. We don’t think we’ll see materially higher labor costs or interest costs. Businesses are a lot less leveraged than they were in the past—debt as a percentage of assets for the S&P 500 Index peaked at just over 35% at the beginning of 2008 but now stand at just over 22%. Earnings before interest, taxes, depreciation, and amortization (EBITDA) was a healthy 10 times in 2007 but is now an even healthier 13 times. If return on equity starts to fall, businesses have the scope to lever up their balance sheets for a boost.
The obvious way to get a bigger profit is to go for volume: sales growth. Sales growth can come from the charging of higher prices, a growing economy, or the selling of products in new markets. While price competition is fierce enough that we shouldn’t expect it to drive sales higher, we could see somewhat stronger economic growth in 2014 compared with 2013. Also, while the trade deal coming out of the World Trade Organization’s Doha Round of talks (which took a decade to complete) was somewhat disappointing, it should help support global trade. So, we could see internationally facing businesses experiencing more rapid sales growth—and earnings growth—over the next few years.
Another way to bolster the bottom line is through improved efficiency. Since 2010, the increase in investment information processing equipment and intellectual property products has not resulted in a real boom, like the one we saw in investment in structures. Investments in productivity-enhancing technologies (making more with less labor or energy) can take years to show up in the data. In addition to increased investment in this type of technology, we could also see its fruits in continued high profit margins. Thanks to this increase, due in part to the investment in computers during the run-up to the year 2000, we probably had a change in the mean of profit margins, going from the low 5% range from 1977 to 1993 to the mid-7% range from 1994 to today. That’s the thing about means—they can change!
While there are certainly risks on the horizon, we don’t see that the markets are in the eye of a storm. We do see continued slow growth, to the tune of 3% real gross domestic product (GDP) in the U.S., with the unemployment rate coming down to 6.5%; low inflation—averaging 2% for the year; improved credit quality of businesses globally; and continued high profit margins. It should be a good year to take on some more risk.