2013 Review and Outlook

Amy MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

2013 was a stellar year for U.S. equities, the best since 1997. Despite major concerns relating to the Federal Reserve (tapering of asset purchases, new Chairperson) and Washington (sequestration, government shutdown, debt ceiling), as well as issues like Cyprus and Syria, the U.S. equity markets steadily rallied throughout the year, failing to experience a pullback of more than 6%.

Source: Strategas Research Partners, LLC

In the U.S. markets, strong gains were experienced across all market capitalizations and styles, with each gaining at least 32% for the year. Small caps outperformed large caps and growth led value. Yield-oriented equities, like telecoms and utilities, generally lagged as they were impacted by the taper trade. The strongest performing sectors—consumer discretionary, healthcare and industrials—all gained more than 40%. Correlations across stocks continued to decline, which is a positive development for active managers.

YenDeveloped international markets produced solid gains for the year, but lagged the U.S. markets. Japan was the top performing country, gaining 52% in local terms; however, the gains translated to 27% in U.S. dollar terms due to a weaker yen. Performance in European markets was generally strong, led by Ireland, Germany and Spain.  Australia and Canada meaningfully lagged, delivering only mid-single-digit gains.

Concerns over the impact of Fed tapering and slowing economic growth weighed on emerging economies in 2013, and their equity markets significantly lagged that of developed economies. The group’s loss of -2.2% was exacerbated due to weaker currencies, especially in Brazil, Indonesia, Turkey and India. Emerging market small cap companies were able to eke out a gain of just over 1%, while less efficient frontier markets gained 4.5%.

Fixed income posted its first loss since 1999, with the Barclays Aggregate Index experiencing a decline of -2%. The yield on the 10-year U.S. Treasury began rising in May, and moved significantly higher after then Federal Reserve Chairman Bernanke signaled in his testimony to Congress that tapering of asset purchases could happen sooner than anticipated. The 10-year yield hit 3% but then declined again after the Fed decided not to begin tapering in September. It climbed steadily higher in November and December, ending the year at 3.04%—126 basis points above where it began the year.

TIPS were the worst performing fixed income sector for the year, declining more than -8%, as inflation remained low and TIPS have a longer-than-average duration. On the other hand, high-yield credit had a solid year, gaining more than 7%. Across the credit spectrum, lower quality outperformed.

Magnotta_Client_Newsletter_1.7.13_5We believe that the bias is for interest rates to move higher, but it will likely come in fits and starts. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome. Despite rising rates, fixed income still plays a role in portfolios, as a hedge to equity-oriented assets if we see weaker economic growth or major macro risks. Our fixed income positioning in portfolios, which includes an emphasis on yield advantaged, shorter duration and low volatility absolute return strategies, is designed to successfully navigate a rising interest rate environment.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we begin 2014, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: Even with tapering beginning in January, short-term interest rates should remain near zero until 2015. In addition, the European Central Bank stands ready to provide support, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been slow and steady, but momentum has picked up (+4.1% annualized growth in 3Q). The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S., growth has not been very robust but is still positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged more than 200,000 and the unemployment rate has fallen to 7%.
  • Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. is running below the Fed’s target.
  • Increase in household net worth: Household net worth rose to a new high in the third quarter, helped by both financial and real estate assets. Rising net worth is a positive for consumer confidence and future consumption.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash that could be reinvested, returned to shareholders, or used for acquisitions. Corporate profits remain at high levels and margins have been resilient.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows over the last three months while fixed income funds have experienced significant outflows, a reversal of the pattern of the last five years. Continued inflows would provide further support to the equity markets.
  • Some movement on fiscal policy: After serving as a major uncertainty over the last few years, there seems to be some movement in Washington. Fiscal drag will not have a major impact on growth next year. All parties in Washington were able to agree on a two year budget agreement, averting another government shutdown in January. However, the debt ceiling still needs to be addressed.

However, risks facing the economy and markets remain including:

  • Fed Tapering: The Fed will begin reducing the amount of their asset purchases in January, and if they taper an additional $10 billion at each meeting, QE should end in the fall. Risk assets have historically reacted negatively when monetary stimulus has been withdrawn; however, the economy appears to be on more solid footing.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery. Should mortgage rates move higher, it could jeopardize the recovery in the housing market.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal. The market has not experienced a correction in some time.

Risk assets should continue to perform if real growth continues to recover, even in a higher interest rate environment; however, we could see volatility as markets digest the slow withdrawal of stimulus by the Federal Reserve. Valuations have certainly moved higher, but are not overly rich relative to history. Markets rarely stop when they reach fair value. There are even pockets of attractive valuations, such as emerging markets. Momentum remains strong; the S&P 500 Index spent all of 2013 above its 200-day moving average. However, investor sentiment is elevated, which could provide ammunition for a short-term pull-back. A pull-back could be short-lived should demand for equities remain robust.

Asset Class Outlook

Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Asset Class ReturnsAsset Class Returns

Monthly Market and Economic Outlook: November 2013

MagnottaAmy Magnotta, CFA, Senior Investment Manager, Brinker Capital

The impressive run for global equities continued in October. While U.S. and developed international markets have gained more than 25% and 20% respectively so far this year, emerging markets equities, fixed income, and commodities have lagged. Emerging markets have eked out a gain of less than 1%, but fixed income and commodities have posted negative year-to-date returns (through 10/31). While interest rates were relatively unchanged in October, the 10-year Treasury is still 100 basis points higher than where it began the year.

After the Fed decided not to begin tapering asset purchases at their September meeting, seeking greater clarity on economic growth and a waning of fiscal policy uncertainty, attention turned to Washington. A short-term deal was signed into law on October 17, funding the government until mid-January 2014 and suspending the debt ceiling until February 2014. With the prospects of a grand bargain slim, we expect continued headline risk coming out of Washington.

The Fed will again face the decision to taper asset purchases at their December meeting, and we expect volatility in risk assets and interest rates to surround this decision, just as we experienced in the second quarter.  More recent economic data has surprised to the upside, including a +2.8% GDP growth rate and better-than-expected gains in payrolls. Despite their decision to reduce or end asset purchases, the Fed has signaled that short-term rates will be on hold for some time. Rising longer-term interest rates in the context of stronger economic growth and low inflation is a satisfactory outcome.

11.12.13_Magnotta_MarketOutlook_1However, we continue to view a rapid rise in interest rates as one of the biggest threats to the economic recovery.  The recovery in the housing market, in both activity and prices, has been a positive contributor to growth this year.  Stable, and potentially rising, home prices help to boost consumer confidence and net worth, which impacts consumer spending in other areas of the economy.  Should mortgage rates move high enough to stall the housing market recovery, it would be a negative for economic growth.

We continue to approach our macro view as a balance between headwinds and tailwinds. We believe the scale remains tipped in favor of tailwinds as we approach the end of the year, with a number of factors supporting the economy and markets.

  • Monetary policy remains accommodative: The Fed remains accommodative (even with the eventual end of asset purchases, short-term interest rates are likely to remain near-zero until 2015), the ECB has provided additional support through a rate cut, and the Bank of Japan has embraced an aggressive monetary easing program in an attempt to boost growth and inflation.
  • Global growth strengthening: U.S. economic growth has been sluggish, but steady. The manufacturing and service PMIs remain solidly in expansion territory. Outside of the U.S. growth has not been very robust, but it is positive.
  • Labor market progress: The recovery in the labor market has been slow, but stable. Monthly payroll gains have averaged 201,000[1] over the last three months.
  • Inflation tame: With the CPI increasing only +1.2% over the last 12 months, inflation in the U.S. has been running below the Fed’s target level.
  • Equity fund flows turn positive: Equity mutual funds have experienced inflows of $24 billion over the last three weeks, compared to outflows of -$12 billion for fixed income funds.[2] Continued inflows would provide further support to the equity markets.
  • Housing market improvement: The improvement in home prices, typically a consumer’s largest asset, boosts net worth, and as a result, consumer confidence.  However, another move higher in mortgage rates could jeopardize the recovery.
  • U.S. companies remain in solid shape: U.S. companies have solid balance sheets flush with cash that could be reinvested or returned to shareholders. Corporate profits remain at high levels and margins have been resilient.

However, risks facing the economy and markets remain, including:

  • 11.12.13_Magnotta_MarketOutlook_2Fed mismanages exit: The Fed will soon have to face the decision of when to scale back asset purchases, which could prompt further volatility in asset prices and interest rates. If the economy has not yet reached escape velocity when the Fed begins to scale back its asset purchases, risk assets could react negatively as they have in the past when monetary stimulus has been withdrawn.  If the Fed does begin to slow asset purchases, it will be in the context of an improving economy.
  • Significantly higher interest rates: Rates moving significantly higher from current levels could stifle the economic recovery.
  • Sentiment elevated: Investor sentiment is elevated, which typically serves as a contrarian signal.
  • Fiscal policy uncertainty: Washington continues to kick the can down the road, delaying further debt ceiling and budget negotiations to early 2014.

Risk assets should continue to perform if real growth continues to recover even in a higher interest rate environment; however, we expect continued volatility in the near term, especially as we await the Fed’s decision on the fate of QE. Equity market valuations remain reasonable; however, sentiment is elevated. Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.

Some areas of opportunity currently include:

  • Global Equity: large cap growth, dividend growers, Japan, frontier markets, international microcap
  • Fixed Income: MBS, global high yield credit, short duration
  • Absolute Return: closed-end funds, relative value, long/short credit
  • Real Assets: MLPs, company specific opportunities
  • Private Equity: company specific opportunities

Asset Class Returns

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