Outlook for 2014: the dawn of reality or infinite QE?

Positives

• A reduction of long term energy costs driven by natural gas is underway and will bring significant long term benefits. Fracking, entirely driven by private sector initiative, is now starting to transform the United States, despite federal policy, into an exporter of energy. This will partially re-route global petro$ capital flows... well, to us... and have an impact on related geostrategic matters. Imagine that. Take a look at Exxon’s annual Energy Outlook here.

• The bankruptcies of Detroit, Stockton, and others yet to come, are starting to induce a greater awareness of financial & economic reality. We also see as a signal event the recent vote of the International Association of Machinists & Aerospace Workers District 751 (IAM) to accept Boeing’s contract. A key part of the deal was a transformation from defined pension benefit plans to defined contributions styled akin to a 401K. A different outcome of the vote would have seen Boeing move to South Carolina and precipitated a crisis for Seattle, the state and the IAM. We see more reality creeping into contractual behavior & the assumption of risk. Sight of the gallows sharpens the mind: this is necessary, will spread, and is a long term positive trend.

• While domestic economic growth is still too low, it is positive, increasing, and seemingly sustainable. We look for ~ 2% real GDP in 2014 and hope we turn out to have been a bit pessimistic.

• Political paralysis may stop some of the bleeding induced by bad policy. We sense a growing perception that government is too big and doesn’t do things well. We also sense that the electorate and particularly young people, are learning the hard way about legislated generational theft. More political failures, and we do expect more, will create a growing awareness that results actually count, that there is a growing need to assess cost, effectiveness, and quality of all our important national initiatives: fiscal, monetary, tax, regulatory, defense, and educational policy issues, and, last but not least, quality of leadership.

Negatives

• The US has a crisis of ineffective & unethical leadership. Abroad we see an erosion of our credibility, strength & leadership, while at home we face bitter divisions of seemingly all descriptions, inflamed by our leaders for political purpose. A divided citizenry watches the paralysis and quietly growing Constitutional and cultural crises. The failure of education, corruption of leadership, and the advent of the welfare/dependency state as a preferred permanent political outcome by our leadership has put the heart of America, the American Creed at risk. If not turned around, this trend will define the end of the country... think of a different kind of Supreme Court, one with Romulus Augustus and Maximilien de Robespierre deliberating while the mob chants “You didn’t build that!” The mob could win.

• We anticipate continuing softness in the labor market. Low labor force participation will make consumers and corporations cautious. The measured unemployment rate may improve but the labor market participation will only marginally improve.This is bigger than the usual short term cyclical issue. A whole generation of young Americans are at risk of being left behind in the job market... courtesy of misguided policy... and that loss is an age based demographic and permanent. It is not: “Take a ticket and move to the back, please.” It’s: “Get off the bus.”

• State, municipal, and federal finances are in the main unsustainable and demonstrably so. Kyle Bass presents the dark side here. Our national perspective on debt discussions must be changed to always include funded & unfunded liabilities. The topic must be constantly brought to public attention. The politicians will fight tooth and nail to prevent it: that’s their vig.  They know if you can’t see the problem, you can’t solve it. Improved disclosure & enforcement is absolutely necessary.

• Regulatory & tax uncertainty will continue to depress employment, corporate capital expenditures, investment & innovation. It is lowering our standard of living.

Neutral

• A slow & steady increase in interest rates will be benign or beneficial for the equity markets.

• Inflation will be neutralized by the significant slack in the economy, but the fuse which ignites inflation, unprecedented excess reserves on deposit at the Fed, has gotten much shorter. If the knots all hold it should be benign for the balance of 2014... bear in mind, that means low, not high economic growth. We anticipate the Fed is going to increase its scale of manipulation... uhh, we mean intervention... beyond the interest rate curve to include the (global?) repo market to directly manage excess banking reserves and money supply. We are unclear what makes them think the repo market will be stable absent the all-in-check book of the American taxpayer? Merely putting the pea under a different shell. John Cochrane has suggested that maybe the old rules don’t work in this economic, structural, and regulatory construct: the Fed should listen.

• Valuations: we’re agnostic on equity valuations. Yes, they’re getting high, but not prohibitively so. We’ve been selling into to bull market to rebalance back to target for most of this year, and anticipate doing so when appropriate this year. It’s a matter of risk management.

Implications for 2014: short and simple

In 2013 we were primarily in short duration and selling equities into the bull market to rebalance back to target. We anticipate the same trend this year, although we expect much smaller absolute gains for equities in 2014, perhaps in the 4-6% range (but we don’t know, and we know we don’t know). We could be forgoing some upside, but our sense is that we’re due for a correction, and 2014 could deliver one. This kind of equity run doesn’t go forever.

Again, we focus on risk. We got the returns accorded by our allocations. Our strategy for 2014 will again be to rebalance back to target periodically, and we will be prepared to buy to target if a correction comes.

Below are the equities markets over the last 2 years (price only,  US equities/VTI in blue,  and non-US equities/VEU in red):

If you expand the timeframe the run in equities gets even more impressive. Again, the issue of risk management looms large in our thinking.

Interest rates will hopefully rise in a measured and steady manner if an improving economy increases demand for money, and if so, it will be beneficial for equity markets. This was the case for 2013 where as you can see below. The 10 year rates had a pretty dramatic move with no adverse impact on equities. If you were holding duration, well, our sympathies. Fortunately, neither we nor our clients were, nor will we for a while. We suspect there is more to go here, but we stipulate we don’t forecast interest rates.

There are just too many moving parts. Again, our focus is on risk management, and we are prepared to pay the opportunity cost of not buying mid to long duration until we have better clarity. We might reconsider if or when the 10 year hits ~4%. Frailty, thy name is Fed, currency wars, and leverage.

10 year Treasury yields over the past year:

We continue to like short duration and investment grade credit spreads which have narrowed but remain attractive.

Overall there are some powerful long term forces at work. On balance we tend to think the Positives will carry the day, or rather the year. We do expect some kind of correction, but it seems for now we have a semi-stable equilibrium. The question is how long it will last. Our concern is that we have a lot of pressures deriving from monetary and fiscal issues that without sensible & timely resolution will stress markets and social structures.  

So, for 2014 we keep our expectations modest, but positively so, and our risk budgets tight.  

Comments

[hb]

" That leaves net exports, which for various reasons also are likely to contribute little to growth next year. Adding up all these categories of spending yields a forecast for GDP growth of just a little above 2 percent — not much different from what we've seen for the last three years.... The pickup in growth late last year is certainly a welcome development, and it may well be a harbinger of stronger growth ahead. But experience with similar growth spurts in the recent past suggests that it is too soon to make that call. My suspicion is that we will see growth subside this year to closer to 2 percent, about the rate we've seen since the Great Recession" - Jeff Lacker Feb 4 2014

http://www.richmondfed.org/press_room/speeches/president_jeff_lacker/2014/lacker_speech_20140204.cfm

[hb]

Volkswagen's Union Defeat

http://online.wsj.com/news/articles/SB10001424052702304315004579385332756856374?mod=WSJ_Opinion_AboveLEFTTop