Investment Review and Outlook

Winter 2014

Last year was a very strong one 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 in-vestment-grade bonds fell 2%, their worst calendar-year return since 1994.

Our clients’ diversified portfolios delivered strong returns. Our investment discipline, bond manager selection, portfolio management, and risk management processes were critical.

Diversification—owning a variety of asset classes and strategies expected to perform well across a wide range of possible scenarios—is an important part of our investment discipline.

 

Investment Review and Outlook 

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.

Benchmark Funds	Q4 2013	12 Months Ending 12/31/2013
U.S. Large Cap Vanguard 500 Index Fund	+10.5%	+32.2%
U.S. Large Cap Value iShares Russell 1000 Value Index	+9.9%	+32.2%
U.S. Small Cap iShares Russell 2000 Index	+8.7%	+38.9%
U.S. Small Cap Value iShares Russell 2000 Value Index	+9.2%	+34.3%
International Vanguard Total International Stock Index Fund	+4.8%	+15.0%
Emerging Markets Vanguard MSCI Emerging Markets ETF	+1.6%	-5.0%
U.S. REITs Vanguard REIT ETF	-0.7%	+2.4%
Investment-Grade Bonds iShares Core Total U.S. Bond Market ETF	-0.2%	-2.1%

Positive Economic Considerations

Below are the key positives in the current economic environment.

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 during 2013, and seems set to increase at least modestly this year. On a year-over-year basis, the U.S. economy grew at an inflation-adjusted rate of approximately 2% in 2013 (through the third quarter), Europe finally emerged from recession, and the United Kingdom and Japan 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% compared to 22% a year ago. 

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. The unemployment rate dropped to 7% in November. 

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 borrowing, 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 remain at historically low levels thanks to extraordinarily low interest rates engineered by the Federal  Reserve, along with modest income growth.

Inflation in the United States and globally is low and remains well-contained due to subpar growth and significant excess capacity in the economy.

Related to the inflation picture, developed country central banks are likely to remain highly accommodative to 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, and with the recent bipartisan two-year budget agreement, the drag on GDP growth from fiscal policy tightening will be reduced in 2014. The two-year budget deal also greatly reduces the threat of another government shutdown during that span.

While there are many macro positives that should not be ignored, it is important to remember that just because economic fundamentals are improving doesn’t necessarily imply we will see a strong year for the stock market. Valuations, earnings growth, interest rates, and overall investor sentiment/ psychology are likely to be much more important drivers of market returns. The stock market is a discounting mechanism, and we believe it already incorporates positives such as stronger economic fundamentals.

Negative Economic Considerations

There remains 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 increasing 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 quantitative easing 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.

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.

Risks in the financial system related to China’s debt/infrastructure spending bubble remain.

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.

Our Positioning and Outlook

Our analysis continues to show that investment-grade bonds are likely to provide low single-digit annualized returns over the next five years. Therefore, we have replaced a significant portion of our core bond exposure with flexible and short-term fixed-income funds that have more latitude to generate higher returns and navigate a challenging interest-rate environment.

The degree by which U.S. stocks outperformed emerging-markets stocks 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. stocks.

Parting Thoughts

Looking ahead to 2014 and beyond, it appears that the economy is getting stronger. However, stock market sentiment in the United States is reaching optimistic extremes, suggesting vulnerability to a pullback. With hugely accommodative monetary policies still in place against a backdrop of tame inflation and gradually improving global growth, stocks could continue to climb. As always, we believe patience and a long-term perspective are critical.