Key Points

  • Despite a volatile start to the year, we remain optimistic about equities. However, a correction of some magnitude is a possibility and equity investors should be prepared to weather the storm. We are in the heart of earnings season, which should again be better than soft expectations, and economic data continues to indicate stronger growth last quarter and into 2014.
  • Janet Yellen has been confirmed as the next Chairman of the Federal Reserve and the already-announced tapering of quantitative easing (QE) is scheduled to begin this month. Monetary policy remains quite accommodative and could be for quite some time given low inflation and continued employment concerns. Congress returns to work without the real threat of a government shutdown, but still needing to get a deal done on the debt ceiling.
  • Our outlook for Chinese equities is improving, despite the likely continued slowing of economic growth. Europe continues to show signs of improvement, although additional monetary stimulus is likely needed; while Japan is about to endure sales tax hikes that could damage the already fragile consumer.

After five years of moving from crisis to crisis, 2013 was less volatile and the near-term forecast is for continued smoother skies. The U.S. government is unlikely to be shut down, the Fed's QE tapering has begun, the European debt crisis has eased substantially, banks have repaired their balance sheets, and even tensions in the Middle East have come off the boil. There remain risks, but the drama associated with many of these events has noticeably declined. But, does that mean smooth sailing for stocks?

Not necessarily. We still remain optimistic that 2014 will end up being a positive one for equities, and history backs this up, as gains such as we saw in 2013 (more than 25%) are usually followed by decent advances the following year. However, we often comment how equities like to climb a "Wall of Worry" as evidenced by last year's steady and strong advance, despite some drama that could have derailed stocks. But the strong market returns have softened that worry and complacency could be a near-term hurdle for stocks. Investor surveys are indicating that sentiment has become a bit frothy and we are watching for more clear danger signs if gains continue. We can't forecast or time corrections any better than others; while last year taught investors about waiting on the sidelines for one to occur. We also know from history, that although midterm election years have often brought nasty corrections, they were also typically followed by robust returns over the subsequent couple of years. We do believe if a correction unfolds early in the year, it's more likely a buying opportunity than a sinister sign for the year and beyond.

Improvements continue

We would likely view a decent sized pullback as a relatively healthy pause in an ongoing secular bull market and would caution against trying to time around it. Our optimism is rooted in several key themes, including: an improving U.S. economy, a likely healthy earnings season, a still-extremely accommodative Fed, reduced fiscal drag, stabilizing global economic growth, and outsized corporate cash balances that we believe will feed into better capital spending this year.

With less drama, but more complacency, earnings season may take on added importance, especially forward-looking guidance by corporate leaders. Heading into fourth quarter earnings reporting season, expectations were relatively muted and it wouldn't be a surprise to see lowered estimates beaten at a higher-than-average rate. Given how much valuation has expanded over the past two years, earnings will likely have to shoulder more of the market's heavy-lifting this year.

Economic growth may be gaining some traction after years of "new normal," sub-par growth The Institute for Supply Management's (ISM) Manufacturing Index posted a solid 57 reading for December, continuing the string of strong readings. Its employment component rose to 56.5, the highest reading since June 2011, while new orders were impressive at 64.2. We pay special attention to this last reading as it has tended to have a high correlation with both capital spending (as you can see in the chart below) and bottom-line earnings growth.

Orders indicate further growth

Source: FactSet, ISM, U.S. Census Bureau. As of Jan. 9, 2014.

These trends, as well as the very strong trade numbers recently reported, are great supports for our manufacturing renaissance thesis. In fact, the better trade data led many economists to boost their fourth quarter U.S. gross domestic product (GDP) estimates by as much as one full percentage point. You can read more about this thesis in our Investing Idea: U.S. Manufacturing and Energy Revival-Finding Opportunities.

However, the employment picture continues to be muddled and the recent cold snap throughout much of the country may impact numbers negatively for a couple of months—including the December reading. Last month, a lower-than-expected 74,000 jobs were added, and while the unemployment rate dropped to 6.7%, that should be taken with a grain of salt as the labor force participation rate fell to the lowest level since 1978. We believe last month's weaker job growth is highly weather-related. The Bureau of Labor Statistics noted that December had the second highest December reading in history for workers with a job but not working during the period due to weather. This suggests that, like after other historical weather-impacted months, subsequent revisions are likely to be sharply higher. Most other indicators of employment trends have much more favorable.

One area of modest economic concern is the housing market. After a stellar rebound over the past couple of years, housing gains have started to moderate, as they should given recent strong gains in sales and prices. But we are watching closely the impact of higher mortgage rates.

New leadership, same path

Jobs and housing have been areas of focus for the Federal Reserve. Although soon under new leadership, with Janet Yellen recently confirmed as the next Chairman, Fed policy is unlikely to veer far from its currently-set course. A tapering of QE begins this month, with a scaling back of monthly purchases from $85 billion to $75 billion. Although the market expects a steady reduction in QE of about $10 billion at each meeting this year; obviously an outsized move by the economy (or inflation) in either direction, could cause the Fed to adjust their policy. That said, we expect monetary policy to remain quite accommodative throughout 2014. Our fixed income strategy team expects the 10-year Treasury yield to creep up to 3.5% this year; with upside risk to 3.75% if growth accelerates further.

Fed's balance sheet continues to expand

Source: FactSet, Federal Reserve. As of Jan. 9, 2014.

For those that may be disappointed that drama is in decline, never fear, Congress is coming back to work! The threat of a government shutdown is largely off the table with the budget agreement reached late last year, but that doesn't mean there won't be plenty of fireworks in this Congressional election year. The debt ceiling still has to be dealt with and the Affordable Care Act will continue to be scrutinized after the website launch debacle and early indications that fewer-than-expected young and healthy people are signing up. If the signups remain lopsided in favor of the infirm and away from the young and healthy, assumptions about the cost curve and efficacy of the program will likely have to be rethought. Additionally, tax reform will continue to be hotly debated, with prospective corporate changes gaining momentum as the U.S. becomes less tax-competitive with much of the rest of the world as they reduce their corporate tax rates.

Europe: despite fragile recovery, many positives

The reduced threat of a break up of the euro thawed economic growth in Europe and helped boost stocks globally in 2013. Europe's economic recovery appears likely to continue in 2014 according to leading economic indicators.

Europe's recovery is expected to continue

Source: FactSet, OECD. As of Jan. 14, 2014.

In fact, Europe has had a string of good news in recent weeks:

  • Ireland exited its bailout program and returned to capital markets for funding. Demand at its first bond auction after the exit was roughly 14 billion euros, and the country sold 3.75 billion euros worth of 10-year bonds at the lowest borrowing costs in nearly a decade.
  • Portugal's government tested capital markets ahead of its expected June bailout exit, by selling 3.25 billion euros in five-year bonds with an average yield of 4.66%.
  • Spain had several successful bond auctions, including a five-year bond sale at the lowest yield since Bloomberg started compiling the data in 2005. Spain's economy grew at its fastest pace in nearly six years in the fourth quarter of 2013, and there are signs unemployment in Spain has peaked.
  • The eurozone unemployment rate has stabilized at 12.1% for eight months through November; although difficulties remain—Italy's unemployment rate hit 12.7% in November, the highest in at least 36 years.
  • The decline in peripheral government bond interest rates lowers borrowing costs of governments, banks, corporations and individuals in those countries.

However, the recovery remains "fragile," yet to become self-reinforcing to the upside.

There are three main factors that we believe are needed for a self-sustaining recovery: domestic demand kicking in, lending turning around, and the European Central Bank (ECB) providing more stimulus.

Exports have been the primary driver of the eurozone recovery; while domestic demand, such as investment and consumption, has been weak. With global growth potentially improving further in 2014, this could benefit exports. Combined with business confidence on the mend since late-2012, we expect capital spending to eventually recover. Due to deleveraging by banks and corporations, lending has been weak, falling by another 3.8% in November, and has likely hindered growth. Positively, the European Central Bank's (ECB's) October quarterly survey showed banks eased credit standards for the first time since the fourth quarter of 2009; and banks indicated they expect loan demand to increase over the coming months.

However, the longer economic growth remains sluggish, the risk that prices, and therefore profits, begin to fall. This could become self-reinforcing on the downside. Given the ECB's forecast for inflation in 2015 of just 1.3%; well below the ECB's target of close to, but below 2% target; we believe the ECB likely needs to provide more accommodation. This will be no easy task—meaningful action is likely to require changing the stance of German policymakers.

While the next stage of performance for European stocks may be more difficult, we remain positive due to the continued economic recovery, the potential for lending to improve, and the possibility that earnings accelerate. The consensus estimate for the MSCI Europe ex-UK Index if for a gain of 14.5% for the next year, up from the -4.1% over the trailing 12 months, according to Ned Davis Research. Profit margins are still below levels before the global financial crisis; unlike in the United States, where profit margins are at multi-decade highs. If the economic recovery continues, profit growth could outpace revenue growth, as the utilization of factories and productivity of workers increases in tandem with output growth.

Japan in a wait-and-see mode

The Bank of Japan's (BoJ's) QE program propelled economic growth, which improved in 2013, but will likely moderate in 2014. The outlook of the Bloomberg consensus of economists is for Japan's growth to slow from 1.7% to 1.6% in 2014; with quarterly volatility driven by changing spending patterns by consumers. Japanese consumer spending is facing the hurdles of a sales tax hike that begins in April; and inflation on the rise due to the weak yen pressuring import prices for food and energy. While Prime Minister Abe is calling for wage increases, we believe businesses are likely to wait until they have better certainty on demand.

Investors are likely to adopt a wait-and-see attitude toward Japanese stocks as many believe the BoJ will need to increase its asset purchase plan; but the BoJ could wait until after the sales tax impact can be measured. Meanwhile, structural reform momentum appears to have waned.

China—near term economic risks but improved stock outlook

China's economic growth outlook remains to the downside in our opinion, continuing our narrative of "slower growth is the new normal in China." In fact, heading into the Chinese New Year at the end of January, it's possible another cash crunch hits its economy. Demand for cash typically rises during this time, when businesses close and holiday spending rises. The timing of the Chinese New Year also tends to create distortions in economic data, which could obscure economic trends. As a result, 'Chinese growth concerns may come to the fore again.

However, we believe small changes in the absolute level of growth are less important than the quality of growth. In late 2013, the Chinese government outlined an ambitious reform plan in the "Third Plenum" in an attempt to overhaul its economy. The conditions in China are ripe for reform, and there has already been notable progress on 23 of the 60 concrete tasks identified in the plan. The top reforms we view favorably include financial system, local government budgets, rural land rights, and hukou (household registration) reforms, as detailed in our article.

Investors have shunned Chinese stocks

Source: Morningstar. As of November 30, 2013.

China could be entering the next phase of growth that is more sustainable as a result of these reforms; and we are upgrading the Chinese stock market to a positive view, large caps in particular. Valuations and investor sentiment on Chinese stocks are depressed and could rise—higher-quality growth typically commands a higher valuation. However, we still have a neutral view on the overall emerging market equity universe due to structural issues for many countries. We will be writing more about this and other issues in articles at www.schwab.com/oninternational.

So what?

We remain optimistic on stocks for 2014, but there will likely be bumps in the road. Investor sentiment is elevated, complacency seems to be building, and the valuation story is less compelling. But waiting for a correction can be quite detrimental to portfolio performance, evidenced by last year. QE tapering will likely continue at a very modest pace and U.S. interest rates will likely drift higher throughout the year. We remain positive on Europe and our outlook toward China is improving, while we are in at wait-and-see sort of mode with Japan.

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