Fourth Quarter 2013 Key Takeaways –
We find ourselves with a more sanguine big-picture view, at least over the nearer-term, than we have had in some time. U.S. and global economic fundamentals gradually improved over the past year across a number of dimensions, and seem poised for continued improvement or at least stability in 2014.
It was a very strong year for U.S. stocks, fueled in large part by the Federal Reserve’s ongoing support and by improvement in the economic outlook. While developed international stocks also generated strong gains, emerging markets asset classes were strikingly negative as investors reacted to softer economic growth and potential changes in U.S. monetary policy.
Interest rates rose considerably over the course of 2013, as the yield on the 10-year Treasury jumped from 1.8% to just over 3.0% by year-end. As a result, core investment-grade bonds fell 2%, their worst calendar-year return since 1994.
Despite underweight the year’s highest-returning asset class in mid year, our diversified portfolios delivered strong returns, buoyed by the performance of our active stock and bond managers. As we look back on our portfolios’ performance, we view it as a year in which our investment discipline, manager selection, portfolio management, and risk management processes were critical, as each of these played an important role in determining our portfolio allocations.
While it strikes us that the underpinnings of our economy are getting stronger, we also see that most asset classes are priced near or at their fair value, and stock market sentiment in the United States is optimistic for the first time in years. Furthermore, the risks related to excessive global debt, subpar growth, and unprecedented government policy that we have worried about since the aftermath of the 2008 financial crisis still remain largely unresolved. Investment fat-pitch opportunities are few and far between and this is not the time for most investors to be at the plate swinging aggressively.
Our portfolio positioning therefore needs to balance these longer-term concerns with the high degree of uncertainty, and by implication, unusually wide range of potential outcomes. This is why diversification—owning a variety of asset classes, strategies, and managers that should perform reasonably well across a wide range of possible scenarios—is an important part of our investment discipline in addition to our conviction-driven investment approach.
We don’t know the timing, but we are confident better investment opportunities will arise (corrections will happen) over the next few years. If so, our “dry powder” in the form of lower-risk investments in fixed-income and alternative strategies will be a major benefit to the portfolios instead of the drag on returns they were in 2013. We will continue to apply our discipline in order to capitalize on compelling return opportunities when they arise, but always with a strong focus on the risks to which our portfolios may be exposed, understanding that not all risks will ultimately come to pass.
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Fourth Quarter 2013 Investment Commentary
The Improving Macro Picture
As we come to the end of 2013, we find ourselves with a more sanguine big-picture view, at least over the nearer term, than we have had in some time. U.S. and global economic fundamentals gradually improved over the past year across a number of dimensions, and seem poised for continued improvement or at least stability in 2014. Regarding investment sentiment, it seems that it is widely accepted that we are genuinely in a bull market (It has been many months since we have heard that this is a cyclical Bull rally in a secular Bear market). Because of this change of sentiment, we have seen a flow of funds towards U.S. and Developed Equities increase in the second half of 2013. 
Unfortunately, the risks related to excessive global debt, subpar growth, and unprecedented government policy that we have worried about since the aftermath of the 2008 financial crisis still remain largely unresolved. But before we revisit our concerns, let’s quickly run through some of the key positives.
- At the broadest level, the growth rate for the global economy (which the International Monetary Fund estimates at 2.9% for 2013) improved in spots over the year and seems set to increase at least modestly next year. On a year-over-year basis, the U.S. economy grew at a real (i.e., inflation-adjusted) rate of around 2% in 2013 (through the third quarter), Europe finally emerged from recession, and the United Kingdom (2.6%) and Japan (2.1%) also generated modest but positive growth. Emerging-markets’ growth was disappointing overall in 2013, but they should benefit from improved export demand in developed markets next year.
- The U.S. housing market continues to improve. For example, the S&P/Case-Shiller Home Price Index was up 11% from a year earlier, and CoreLogic reports the percentage of homeowners who owe more than their homes are worth fell to 13% (as of the third quarter) compared to 22% a year ago. Along with the surging U.S. stock market, the strengthening housing market boosted household net worth to new highs.
- The U.S. labor market continues to gradually improve. Nonfarm payrolls (the net new jobs created in the economy each month) averaged a solid rate of nearly 200,000 per month during 2013 (although that is still below the pace of job growth during a typical economic recovery), and the unemployment rate dropped to 7% in November. Of course, as we and others have pointed out, much of the decline in the unemployment rate has been driven by a drop in the labor participation rate to 30-year lows.
- An improved debt and credit picture bodes well for consumer spending. The household debt/income ratio, a measure of the willingness and ability of consumers to increase their borrow-ing, has dropped 20% from its peak in 2007, and is now back where it was in 2003 and in line with its long-term historical trend. Meanwhile, household debt service and financial obligations ratios re-main at historically low levels thanks to extraordinarily low interest rates engineered by the Federal Reserve, along with modest income growth. Furthermore, credit conditions (i.e., credit availability and cost), as measured by a variety of indicators, also continue to improve and remain relatively loose.
- Inflation in the United States (and globally) is low and remains well-contained due to subpar growth and significant slack (excess capacity) in the economy.
- Related to the inflation picture, developed country central banks are likely to remain highly accommodative at least over the next year or two in terms of holding short-term interest rates at extremely low levels, and in some cases also providing additional liquidity via quantitative easing bond purchases.
- The U.S. federal budget deficit has come down sharply over the past year due to economic growth, tax increases, sequestration spending cuts and one-time contributions from Fannie Mae and Freddie Mac. The two-year budget deal also greatly reduces the threat of another government shutdown during that span. However, another political fight over the debt ceiling remains a possibility later in the first quarter of 2014, and the need for a credible medium- to longer-term plan for government deficit and debt reduction remains.
While there are many macro positives that should not be ignored, it is important to remember that just be-cause economic fundamentals are improving doesn’t necessarily imply a strong year for the stock market. Valuations, earnings growth, interest rates, and overall investor sentiment/psychology (to name a few) are likely to be much more important drivers of market returns. The stock market is a discounting mechanism, so presumably it already incorporates positives like stronger economic fundamentals as this evidence comes out. There also remain significant macro risks and uncertainties that continue to influence our investment outlook and portfolio positioning as we look out over the next five years:
- Wage growth and income growth in the United States remain subpar, although both have been in-creasing since late 2012. Weak income growth implies that consumer spending is likely to be subdued even as consumer deleveraging becomes less of a headwind. With consumption accounting for roughly 70% of U.S. GDP, this suggests a continued drag on economic growth absent a significant increase in consumer borrowing or reduced saving.
Overall U.S. debt levels remain very high and the projected growth in government debt and entitlement spending relative to GDP is still too high to be sustainable over the very long term.- Fed monetary policy is still far from normal and, although the QE taper has begun, there remains a great deal of uncertainty as to how the Fed will exit from its zero fed-funds rate policy and unwind its huge balance sheet without causing an economic or market shock. We think it’s more likely than not that the Fed will err on the side of tightening monetary policy (raising rates) too late rather than too early, and that inflation will become an issue for the financial markets, which would be a negative for both stocks and bonds. But, given the Fed’s policy pronouncements as well as their unpleasant experience with the market’s reaction to last summer’s “taper talk,” we’d put a low probability on the Fed tapering or tightening too aggressively. But policy errors in either direction are certainly possible.
- Despite exiting recession in 2013, the Eurozone economy remains very weak, with structural imbalances between creditor and debtor countries that are still far from resolved. There remains a meaningful risk of deflation and a debt crisis stemming from the weaker peripheral countries. The banking system is undercapitalized and still in need of a credible region-wide banking union backstop. Meanwhile, eurozone unemployment climbed to more than 12% in 2013 and is at much higher levels in the periphery, causing social unrest with the potential to spiral into a more serious crisis.
- Risks in the financial system related to China’s debt/infrastructure spending bubble remain. While it is encouraging to see China’s new leadership acknowledging and addressing the economy’s cyclical and structural imbalances, it is no guarantee they can successfully manage them without a major disruption.
- Japan is the world’s third largest economy, so the success or failure of “Abenomics” (prime minister Shinzō Abe’s wide-ranging plan for reinvigorating Japan’s economy) is a wild card that will have important global economic and market implications. We don’t have a high-conviction opinion as to its ultimate outcome—just recognition that it’s another manifestation of an unbalanced and weak global economy, and the extremely aggressive and unconventional policies that are being undertaken to try to turn things around.
Our Positioning and Outlook
The biggest contributor to our 2013 performance was the simple fact that the majority of our portfolios had their largest allocation to U.S. Equity/Stock markets. U.S. Stocks outperformed every other asset class by such a significant margin that the decision alone ended up being the most important allocation decision.
Our actively managed stock funds were also significant positive contributors to performance in 2013. While we can never predict how our active managers will perform from one year to the next, we do intensive and ongoing qualitative due diligence to gain a high level of confidence in their ability to outperform over the longer term.
The primary headwind to performance was the inverse of the above…any allocation to anything other them US equities ultimately detracted from performance. Our exposure to emerging-markets stocks and emerging-markets local-currency bonds detracted the most.
The degree by which U.S. stocks outperformed emerging-markets stocks and emerging-markets local-currency bonds in 2013 was unusual. We believe it was largely an overreaction to shorter-term factors and is not justified by longer-term fundamentals or valuations. Over the next five years, we believe that emerging-markets stocks are likely to generate better returns than U.S. stock across most scenarios. Therefore, we are maintaining our emerging-markets’ stock exposure.
We are also maintaining our position in emerging-markets local-currency bonds in our balanced portfolio strategies because we expect mid-to high-single-digit returns from this asset class over the next five years. These bonds also provide some insurance against a decline in the U.S. dollar.
Our alternative investment strategies met their strategic risk/return objectives in 2013, which is to outper-form core bonds with lower downside risk and volatility than stocks and low correlation to stocks and bonds. The risk management benefits of owning alternative investments were evidenced last year by their strong outperformance during the few brief periods when stocks declined meaningfully. While full-year returns were no match for the 25%-plus returns from stocks, we continue to believe our alternative strategies can generate returns at least comparable to portfolio of stocks and bonds over our tactical investment horizon, but with much less risk.
Parting Thoughts
Looking ahead to 2014 and beyond, it appears that the economy is getting stronger. Even though most as-set classes we would say are currently fully priced, we still do not think economic consensus has moved to-wards a full acceptance of the strength of the U.S. economy or the potential for a rapid rebound in Europe. We keep in mind that it has now been almost 30 months since we have had a 10% or more correction in the U.S. Stock market. The timing of corrections is something we cannot predict and with hugely accommodative monetary policies still in place against a backdrop of tame inflation and gradually improving global growth, stocks could continue to climb for a number of months. In this environment, we believe patience and a long-term perspective are especially critical.
We appreciate your confidence and trust, and share our best wishes for a happy, healthy, and prosperous new year.
Sincerely,
Jon Houk, CFP®
