Economic And Market Review And Outlook, January 2014

As was the case throughout most of 2013, the fourth quarter featured a strong U.S. equity market and a slightly weaker fixed income market. Foreign stocks were mixed, with developed markets higher while emerging markets dipped slightly. Many issues that worried investors were resolved positively during the autumn.

Janet Yellen, the favorite of the financial markets, was nominated and confirmed after the New Year as the new Federal Reserve Board Chairwoman. She is considered even more dovish than predecessor Ben Bernanke and, even though tapering of QE (Quantitative Easing) stimulus began recently, the Yellen Fed is likely to use forward guidance and keep short term interest rates low through next year. Also, the uncertainty of when tapering would begin is now past and most economists expect an exit to QE by the end of the year.

Finally, in a rare display of bipartisanship, the President and Congress managed to reach an agreement to keep the government running and to raise the debt ceiling. Although no permanent solution was reached, current indications are that lawmakers will continue to “kick the can down the road” and extend funding periodically, as needed. Politicians from both parties are realizing budgetary scare tactics and bluster may cost them votes at the next election and have moved on to other issues, such as the minimum wage or the ACA (Affordable Care Act).

The domestic economy was a little stronger than expected in the last half of 2013, though the recovery continues to grow at a subpar level compared to previous post-World War II expansions. Real GDP growth improved to a 4.1% rate in Q3 and is forecasted to be 2.5-3.0% for Q4, due to better performance in manufacturing, employment and trade . However, economic growth may slow a little in the first quarter due to an inventory unwind and weaker consumer spending, partially caused by harsh weather experienced throughout much of the country. However, the rest of the year should see at least a moderate pick-up in activity caused by diminishing headwinds from the expiration of the Bush tax cuts early last year. Additionally, if oil prices remain at currently depressed levels, consumer spending and manufacturing should get a boost.

Foreign markets continued to diverge, with developed countries such as Japan, the United Kingdom, and some northern European economies, such as Germany, improving.   Yet, many emerging nations, including Brazil, Russia, Turkey and Indonesia, struggle to maintain growth rates of the last decade. We believe this dichotomy will last as long as the emerging countries fail to enact structural economic and financial reforms. In particular, most export oriented growth models are now obsolete and will have to be radically changed.

With short term interest rates locked at low levels by the Fed, 10 year U.S. Treasury bond yields should trade between 2.50-3.00% before resuming their upward creep toward a 3.25-3.50% trading range in the spring. The yield curve, probably the best predictor of the economy, is nowhere near recession territory, as it remains very steep. Municipal bonds should recover from a difficult 2013, as tax loss selling ends and bargain hunters look for good value. In particular, Puerto Rico paper has begun to stabilize, with the commonwealth cutting its teachers’ pension liabilities, and it will be testing the markets with new bond offerings in the next few weeks. Nonetheless, its economy is not out of the woods yet and we will continue to monitor the situation closely.

As mentioned in our last report, U.S. equities are in a secular or multiyear bull market, though a repeat of last year’s run is unlikely and a giveback of some of the gains is possible in the first half of the year. Nevertheless, we remain positive and would add to positions on price weakness, especially in selected technology, financial, industrial and healthcare stocks. There remain few attractive investment alternatives to equities . At about 16 times forward earnings, the market is fairly valued and far from bubble territory. And, as the legendary investor Leon Cooperman has said, “Bull markets end as a result of excesses rather than in terms of duration. “