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2014 Outlook: The Way Forward

January 2014

Leo Grohowski

Chief Investment Officer, BNY Mellon Wealth Management

What's Ahead for the Markets and Investors' Portfolios?

As 2014 gets underway with heightened volatility, it is a good time to reflect on what investors might expect for the economy and the markets. We had our share of uncertainties in 2013 around the unwinding of the Federal Reserve's (Fed's) stimulus policy, the U.S. debt ceiling crisis and geopolitical unrest. These and other issues caused periods of market volatility. Yet most global equity markets remained resilient, with several indices — including those in the U.S. — hitting record highs. Meanwhile, the anticipated move to higher interest rates from historically low levels caused short-term turbulence in the fixed income market, prompting investors to readjust their expectations for this asset class. Looking ahead, we remain optimistic about an acceleration in global growth and believe the environment is full of opportunities to consider — as well as some challenges to navigate.

Global Growth to Pick Up Speed

Our assessment is that the global recovery is fundamentally stronger than most investors may think, with GDP growth projected to improve in most developed markets (as illustrated in Exhibit 1 on the following page). There is growing evidence that the U.S. economy is gaining momentum, propelled by fewer fiscal drags, a housing recovery that remains intact and continuing gains in employment. In fact, the Fed recently acknowledged the improving economic conditions by continuing to taper its extraordinary monetary stimulus, now down to $65 billion a month. We expect that the Fed won't begin to increase short-term interest rates until mid-2015, given that unemployment and inflation are below levels that can cause the Fed to become more restrictive. The unemployment rate was 6.7% in December, while the Consumer Price Index (CPI) is running comfortably below 2%.

Europe has moved out of recession and has clearly bounced off the bottom, with a central bank committed to "do whatever it takes" to support the region's economy. Fearing that inflation well below its target could undermine growth, the European Central Bank recently lowered the rate at which it lends to banks. Yet high unemployment and the need for banking reform will remain obstacles that will likely contribute to lackluster growth as the region continues its recovery.

Within emerging markets, the projected slowdown in growth outlined in Exhibit 1 has garnered a fair amount of attention. Although growth trends among Brazil, Russia, India and China are expected to be more divergent than in the past, the pace is still faster than those in the developed markets. Moreover, China has avoided its feared hard landing, but attention will now turn to potential policy reforms aimed at shifting China's economy from export-led to more consumer-oriented economy.

Overall, an improving global economy, muted inflationary pressures in most countries, and accommodative monetary policy in developed markets should continue to be supportive of risk assets.

Exhibit 1 // Global Growth Expected to Improve

Real Gross Domestic Product (GDP)

Exhibit 1 // Global Growth Expected to Improve

As of January 2014. Source: International Monetary Fund

Equities Have Room to Run

The broad U.S. stock market finished 2013 strong with the S&P 500 Index posting its biggest percentage gain since 1997. While recent gains are a point of concern for some investors who wonder how high the markets can go, we believe current valuation levels remain reasonable, given the context of improving economic growth and benign inflation. Even modestly higher interest rates are a positive for equities as long as the primary driver is a strengthening economy rather than an uptick in inflation, and the latter appears unlikely.

We have been positive on U.S. large capitalization companies for some time and continue to believe they offer upside potential. U.S. balance sheets are strong and dividend payout ratios have the potential to improve. Furthermore, cash-rich companies should increasingly deploy capital back into their businesses, which should fuel economic and earnings growth.

U.S. corporate earnings remain steady, with room for improvement in 2014. While U.S. equities are higher than a year ago, they remain attractive compared to bonds or cash. We are forecasting a range in S&P 500 earnings of $115-$120 in 2014, which translates to a 6-10% rate of growth. We think an improvement in global economic activity will help fuel demand and drive solid profit growth. Of course, given the strong performance of U.S. equities over the past few years and positive investor sentiment, we are not surprised by the uptick in market volatility early this year. We expect that any retrenchment will be temporary, however, due to significant levels of cash equivalents on the sidelines, and still reasonable valuations.

With the recovery strengthening we expect that defensive sectors, such as utilities and telecommunications, will continue to lag more cyclical sectors, such as technology, industrials, energy and financials. U.S. multinational firms with global exposure to recovering Europe and higher growth emerging markets should offer upside potential. We also favor companies well positioned to capitalize on new sources of energy, and companies that can take advantage of the manufacturing resurgence in the U.S.

International Equities Offer Potentially Attractive Entry Points

U.S. stocks account for just under half of the world's market opportunities.1 Thus, it is important to consider international markets when diversifying. As illustrated in Exhibit 2, valuations of both developed international and emerging markets are well below their historic averages. This may provide an attractive entry point for investors who can withstand potential near-term volatility caused by either slowing growth or currency-related issues. Selectivity will be important, however, and requires a proven, bottom-up approach to identify those companies and sectors with the most attractive fundamentals and longterm potential.

Exhibit 2 // Global Equities Remain Attractively Valued

U.S.vs. Developed International and Emerging Markets Market Valuation (P/E)

Exhibit 2 // Global Equities Remain Attractively Valued

Dashed lines: 1996-2012 mean. Solid lines: P/E ratios are trailing 12 months and are as of 12/31/13.

Source: Bloomberg

The Road to Normalized Rates

The transition back to 'normal' interest rates from multi-decade low levels is causing some pain for fixed income investors as many fixed income sectors delivered modest or negative total returns last year. Yields are expected to continue to rise as the Fed begins to taper, and the economy strengthens. We do not expect the steep and rapid climb in interest rates we witnessed last year, but a gradual rise. The 10-year Treasury note likely will range between 2.5% and 3.75%, and end the year near 3.375%. Even a small increase in rates can erode the value of bonds, however. Thus, investors should reassess their fixed income strategies and portfolio allocations.

Diversification will play an important role in minimizing a portfolio's sensitivity to rising rates. We continue to caution investors on longer dated government bonds and advocate a core fixed income allocation complemented by higher yielding fixed income sectors, as well as the incorporation of floating rate strategies. Investment grade corporate and high yield bonds still offer attractive yields, but the opportunity for appreciation is expected to be more muted in 2014. We also see value in sectors that have experienced greater dislocations, such as municipal bonds. An active management approach that employs thorough due diligence and timely strategy adjustments, as well as thoughtful management of risk, will be critical in helping position portfolios for a gradually rising rate environment.

Heightened Volatility and Risk Mitigation

What concerns us? Risks are prevalent in any market, even though we see fewer potential 'black swan' events than a year ago that could derail the global recovery. Markets have been resilient in their ability to digest global tensions and refocus on the fundamentals, though we may see more volatility throughout 2014. Against this backdrop, we continue to believe that risk mitigation is an important consideration given this environment of constant economic change in both developed and developing markets. Whether these changes relate to monetary and fiscal policy, global growth trends or geopolitical dynamics, investors will need a different perspective and potentially different strategies to ensure they are well prepared for what lies ahead.

To that end, there are potential risks we are monitoring. Although U.S. lawmakers passed a bipartisan budget that will avoid the possibility of a government shutdown for two years, debt ceiling negotiations will reemerge in early 2014. Also, midterm elections in the U.S. and several important elections around the world could result in unanticipated policy shifts. While the Fed has removed some uncertainty with its decision in December to begin tapering its bond-buying program, any potential misstep in unwinding its quantitative easing, or an earlier change to its monetary policy, could create a headwind. Geopolitical unrest in the Middle East or parts of Asia could be another factor to resurface and negatively impact the pace of growth.

A well-diversified portfolio will usually serve investors well in the face of market roadblocks. In addition, one of the ways we can mitigate risk is through the use of alternatives, or lower correlated strategies. These strategies can provide downside protection and enhanced diversification. For example, managed futures solutions allow the flexibility to capitalize on any trend, such as rising rates, across a wide variety of investments to provide a diversified source of return. In addition, long/short equity hedge funds can offer a source of downside protection in periods of increased volatility. For qualified investors, private real estate and private equity can offer further diversification and opportunities for appreciation over a long time horizon.

The Way Forward in 2014

We enter the year with expectations for stronger global growth, largely accommodative central banks and normalizing interest rates. This environment should be positive for stocks, but not without some fits and starts along the way. As investors learned from 2013, markets can prove resilient in the face of headwinds and grind higher, but it is difficult to time the market. Thus, investors should stay disciplined to their investment strategy.

Moving forward, diversification, due diligence and bottom-up, fundamental analysis will prove valuable in an environment where strong fundamentals are rewarded and market volatility is increasing. Equally important is an ability to thoughtfully take advantage of changing market conditions and proactively plan for market headwinds. A combination of these strategies, along with a long-term perspective, should continue to help investors navigate this environment and reach their goals.

 

1 Based on U.S. market cap weight in the MSCI ACWI index as of 12/31/13.

This material is provided for illustrative/educational purposes only. This material is not intended to constitute investment or financial advice. Effort has been made to ensure that the material presented herein is accurate at the time of publication. However, this material is not intended to be a full and exhaustive explanation of all of the investment or financial options available. The information discussed herein may not be applicable to or appropriate for every investor and should be used only after consultation with professionals who have reviewed your specific situation.

BNY Mellon Wealth Management conducts business through various operating subsidiaries of The Bank of New York Mellon Corporation.

© 2014 The Bank of New York Mellon Corporation. All rights reserved.

01/2014