The 3 Major Stories in the Global Economy for the Year
Now that 2013 is behind us, let's take a look at the events that shaped markets last year. 2013 was the year that investors finally became confident in the economic recovery and poured their enthusiasm into equities.
Despite significant continued volatility, stocks soared to new heights, giving the S&P 500 its best year since 1997. For the year, the S&P rose 29.6%, the Dow gained 26.5%, and the MSCI EAFE (developed international) advanced 19.4%.
Here are the 3 major stories from 2013 we believe will continue to impact 2014:
When Diversification “Fails”…but why it still works
Devin Cassels from SEI Investments recent published a commentary discussing the over exuberance in the use of the S&P 500 as a yard stick. A unique aspect of the S&P 500 Index is that many investors consider it to be a barometer of financial market performance. This trend has emerged for two main reasons: (1) the ease of focusing on a single number, and (2) the media’s tendency to publicize the S&P 500 as a proxy for overall financial market performance. While these forces make this trend understandable, they can also create confusion for investors when portfolio returns deviate from those of U.S. large-cap stocks. In environments like 2013, a natural question tends to arise—if investors understand the S&P 500 Index and often compare their portfolios to that proxy, why don’t investment professionals simply provide their clients with portfolios that contain large allocations to U.S. stocks and track very closely to the well-known index?
The simple answer is that, while U.S. large-cap stocks do act as an important allocation, they are also subject to fluctuations in performance just like other asset classes. For this reason, it is important that portfolios contain other exposures that can moderate the investment experience—with an aim on consistency, rather than out-performance.
US Government Shutdown & Continued Divided Government
Political gridlock in Washington was another source of market volatility in 2013. After resolving the Fiscal Cliff on New Year’s Day, legislators were still unable to agree on a deficit-reduction plan. This forced the federal government to the “sequestration” budget cuts designed to significantly reduce the budget over the next 10 years.
This was followed much later in the year with a disagreement over the federal budget which ultimately caused a 16-day shutdown. Generally, investors stayed calm and markets rose sharply in the period immediately following the budget deal. Some estimates put the cost of the shutdown at $2 billion in lost productivity plus the cost of ripple effects across the economy.
Fortunately, a bipartisan budget deal reached in December promises to alleviate a new round of sequestration cuts and stabilizing government funding through late 2015.
The Economist published a recent article commenting that “insurgent” political parties are on the rise in Europe—in addition to the “tea party” in the US—noting that they could carry more power than “at any time since the second world war.” Though US politicians will still have to tackle raising the Treasury debt ceiling in early 2014, we expect to avoid another showdown. Political division could be seen and heard in other parts of the world—with the effects felt in the global economy.
The Federal Reserve: Inflation, Taper, & Interest Rates
The Bureau of Labor Statistics published their calculation of consumer price index (seen by many as a general measure of inflation) through the end of November at 1.2% for the previous 12 months. This is much lower than historical inflation numbers—and it has been for about the last year. One of the main concerns over the Federal Reserve’s bond buying program (termed quantitative easing or QE) was that it could trigger higher inflation over time due to more currency being put into circulation. As the Fed begins to gradually wind down QE, the big questions is how will inflation react?
In balance with QE taper is the question of how the Fed will adjust interest rates going forward. With interest rates still at near 30-year lows, bond values could suffer as rates head upward.
Current Fed chairman Ben Bernanke will be stepping down at the end of January and the Senate has confirmed Janet Yellen, the current vice chair, as his successor. It is expected that she will continue many of his policies. A recent contribution in Forbes magazine comments however that Yellen believes in “printing money to drive down unemployment.” If this continues as the main economic ammo for the Fed, we may in fact see higher inflation on the horizon—which could also in turn influence how quickly interest rates rise.
Looking ahead, we're optimistic about 2014. Even if stocks slow their pace of growth, we think there's still upside potential if the U.S. economy continues to gain steam and Q4 corporate earnings reports are positive. While a pullback is always possible as investors consolidate their positions, long term economic trends are still heading in the right direction. Although it's impossible to predict market trajectories with accuracy, we're always on the lookout for both dangers and opportunities for our clients, and we look forward to supporting you in the year ahead!
