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11 Jun

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Investment Outlook 2014: Optimism Resurfaces in Spite of Challenges

June 11, 2014 | By |

2013 will be remembered for two significant events: one of the best U.S. stock market returns in 10 years and the worst U.S. fixed income market return in 10 years.

Despite fears of a fiscal cliff, government shutdown and a war in Syria, U.S. stocks turned in a year of stellar returns. With a spike in interest rates in June, when Federal Reserve Chairman Ben Bernanke hinted at a tapering of federal bond buying, bonds suffered losses, with long government bonds and treasury inflation protected bonds incurring the largest losses.

Looking ahead to 2014, expectations include a continued healing process for economic growth in developed countries and more volatility in emerging economies. With more permanence in tax regulations, advisers are more confident in making multiyear projections, incorporating tax bracket management that weighs ordinary income, capital gains, phase-outs of personal exemptions and itemized deductions and net investment income.

Global Recovery Dominates the Investment Outlook

Developed economies are slowly pulling out of global recession. The United States appears to be in the middle of an economic expansion in which gross domestic product growth rates are finally starting to emerge from sub-par 2-percent rates for the past four years to an estimated 2.5 to 3.5 percent rate for the next few years. With the transition to Janet Yellen as chairman of the Federal Reserve, we may see policies that keep low interest rates in place for several more years. As the Fed revises forward guidance, there is speculation that even if we hit the 6.5-percent target for unemployment, we may continue current easy monetary policies.

Europe, although still in recession, is slowly improving. The Euro is still intact, and a sluggish recovery is in process, perhaps growing at 0.75 to 1.5 percent. Challenges remain, with tensions between the northern and southern countries and high debt burdens. Japan’s economy is benefiting from Abenomics’ shock therapy of deflationary policies and is expected to continue to improve, although concerns remain about longer-term outcomes.

Emerging markets took a mid-year hit as Bernanke speculated on future government tapering. Although China’s growth is slowing, expectations are that it will grow at a more modest pace of 6 to 7.5 percent in future years due to declining demographics and other factors. Keep an eye on India as it taps Raghuram Rajan, professor at University of Chicago and a former chief economist at the International Monetary Fund, to run the Reserve Bank of India for the next three years. Although the TIMPs – Turkey, Indonesia, Mexico and Philippines – were projected to outperform the BRICs – Brazil, Russia, India and China – that was not the case over the past year.

Shifting U.S. Equity Allocation Higher

The global economy is healing as it emerges from a worldwide recession. Although developing countries are still projected to grow at modest rates, the U.S. economy may offer the best risk-adjusted returns. As the U.S. stock market flirts with new market highs, could it go even higher? It could, if you look at current market valuations (price/earnings), corporate cash on balance sheets and low interest and inflation rates. But that doesn’t mean you should expect another year with near 30-percent returns. A more realistic outlook for U.S. stocks is in the 7-percent to 9-percent (nominal) range. Dividend yields are about 2 percent now, with expectations for earnings growth in the 5- to 7-percent range. Global equities may trend slightly higher in the 8- to 10-percent (nominal) range, but with significantly higher volatility.

Fixed income returns will likely be much more muted. Cash and ultra-short fixed income may fail to keep up with inflation over the long term. Inflation is approximately 1.5 to 2 percent now and is expected to increase to around 3 to 4 percent over the next year or so. We may be looking at fixed income returns of 2.5 to 3.5 percent (nominal) over the next 10 years. The 10-year Treasury bond is frequently cited as a reference point for fixed income returns. In May 2013, the 10-year Treasury rate was 1.6 percent. By September, rates were 2.98 percent, or an increase of 86 percent. Looking forward, 10-year treasury rates are projected to reach 3.5 to 4.5 percent by the end of 2014, where they should level off for a while.

As advisers, we need to educate our clients about the role of fixed income in portfolios. Even with projected low returns, fixed income adds an element of risk management that volatile stocks can’t provide. It may also mean that we need to encourage our clients to reevaluate the asset allocation of their portfolios if they reduced their stock allocation after the shock of the 2008 market downturn. We may also want to reevaluate the mix of stocks and bonds in retirement portfolios in light of a new study by Kitces and Pfau about rising equity glidepaths in retirement.

Setting Expectations Is Key

2013 saw big increases in consumer spending on cars and houses. While interest rates crept up from earlier lows, rates continue to be attractive relative to historical levels. 2014 may continue these trends.
We’ve seen big gains in technology stocks in 2013. Three of the five top holdings in U.S. stock index funds are technology stocks (Apple, Google and Microsoft). Twitter’s IPO had none of the problems Facebook had in 2012. Innovation has been, and will continue to be, one of our greatest advantages, but have we reached an inflection point in which valuations are too pricy?

In a very short time, we’ve witnessed the U.S. rise in energy production with expectations that we may take the global lead from Russia and Saudi Arabia in the next year. For now, energy stocks remain undervalued. There are many challenges ahead to convert that production surplus to profits as a world energy supplier. We’re also seeing an increased interest in other types of energy consumption; just look at the 275-percent increase in Tesla stock in 2013 despite setbacks in safety concerns. Many other auto manufacturers are aggressively pursuing electronic car options for the near term.

Bankruptcy in Detroit opens up many future challenges. The fact that the motor city can reduce public pensions may have a ripple effect. Illinois recently enacted legislation to reduce public pension benefits in an attempt to address budget imbalances. No doubt there will be a contested legal battle on these topics. While investors may continue to steer clear of Puerto Rican bonds, municipals offer a tax-efficient way of reducing net investment income for many high net worth investors trying to manage the net investment income tax.

Ben Bernanke will leave the Federal Reserve with a parting gesture of a $10 billion cut per month in the quantitative easing bond buying program. Janet Yellen will need to set expectations as she assumes the reigns early in 2014.

Bob Shiller, the recent recipient of the Nobel Prize in economics, thinks everyone should have a good adviser who can talk investors out of potentially disastrous financial decisions. Shiller, who won the Noble Prize for his work in market psychology, equates finding a good financial adviser with finding a good medical adviser. Both are critical. There is no doubt that investing in 2014 will be filled with potential opportunities for both success and failure. Our role is to help our clients make the most of the opportunities while avoiding as many pitfalls as possible.

Author: Sue Stevens, CPA/PFS, CFP®, CFA, MBA, is CEO and founder of Stevens Wealth Management in the Chicago area. She has held positions as director of Financial Planning at Morningstar, led Participant Education at The Vanguard Group and served on the board of Arthur Andersen Financial Advisers. Sue is the author of two award-winning books on financial planning. Contact her at sue@stevenswealth.com.