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LOOKING AHEAD: Return of risk to color 2014 market sentiment

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By Barry B. Burr, Crain News Service

CHICAGO (Jan. 6, 2014) — Renewed risk appetite will contribute to driving a stronger U.S. economy in 2014, while the U.S. equity market will be challenged to meet the level of actuarial return assumptions for 2014, according to economic and market strategists.

For the rest of the developed markets, growth in economies and markets will accelerate this year, although strategists disagree on the extent.

The ranges of top strategists' forecasts for 2014 were: a total return of the S&P 500 from zero to 10 percent, and the MSCI EAFE Index, from 6 percent to 12 percent (this is a stock market index designed to measure the equity market performance of developed markets outside of the U.S. and Canada); the 10-year Treasury yield at year-end 2014 ranging from 2- 4 percent; and a real U.S. GDP from 1.8 percent to 3.5 percent.

"The U.S. is the centerpoint of the next phase of this global recovery," said Markus Schomer, managing director, chief economist, PineBridge Investments L.L.C., New York.

Eric Lascelles, chief economist, RBC Global Asset Management Inc., Montreal, lists renewed risk appetite as a key element underpinning prospects for U.S. economic and market growth in the new year.

Risk appetite—willingness by corporations to hire and invest, and by investors to allocate to risk-seeking assets—"went from what I would characterize as a risk-reduction mode at the start...(of 2013) to a more risk-neutral attitude over most of the (rest of the) year," Mr. Lascelles said.

Now risk appetite is picking up to a level not seen since before 2008, he said.

"That revival of risk appetite, you can think of almost like animal spirits:" something "that is needed for economic growth but that hard to put your figure on," Mr. Lascelles said.

Overall, Mr. Lascelles said, "We see developed economies accelerating." That strengthening "applies certainly to the U.S., the U.K., Japan and also the eurozone."

James Paulsen, chief investment strategist, Wells Capital Management, Minneapolis, said, "We have a global synchronization as never before (in the economies of) the U.S., Europe and Japan."

For the U.S. market, "fiscal austerity will bite much less fiercely (in 2014)...and that adds a full (percentage) point to (economic) growth," Mr. Lascelles said. The fiscal cliff and resulting sequestration of federal funds cut almost two percentage points in growth in 2013, he estimated.

A stronger housing market is a key driver to growth, he said.

"Even with a higher (interest) rate environment, we can still observe quite healthy housing gains" for 2014, Mr. Lascelles said.

"My conviction is we will see further gains in U.S. housing (prices). Housing is still very cheap (and) mortgage payments are still very low relative to incomes."

Mr. Schomer expressed similar views: "I think the housing market globally is not a concern anymore but a major driver of growth."

"Another big part of the U.S. story is the end of household deleveraging," Mr. Lascelles said. "For several years after the crisis, households quite wisely reduced their debt levels in response to the hit to their assets and perhaps diminished employment prospects." But that deleveraging is ending, he said.

Equities forecast

Messrs. Lascelles and Schomer view U.S. equities as the best asset class for 2014.

Mr. Lascelles, who doesn't disclose a specific number, forecast the S&P 500 total return, including dividends reinvested, will be in the high single digits, while the MSCI EAFE total return will be in the mid- to high single digits.

He expects the U.S. gross domestic product to reach a real, or inflation adjusted, 2.75 percent in 2014, up from less than 2 percent in 2013.

"Markets go up 20 percent in a modest (economic) growth" in 2013. "So why am I forecasting half the (equity) growth" in an improving economic outlook? Mr. Lascelles said.

"Stocks went up so much because risk appetite rose, not because of earnings soaring. Stocks are now fairly valued. Stocks will have to rise on their own merits" in 2014, Mr. Lascelles said.

Mr. Schomer said he is "still quite bullish on the (U.S.) equity market," although he added, "clearly the growth rates we saw (in 2013) will not be repeated because we won't get anymore" quantitative easing.

Ticking off the top reasons for his optimism, Mr. Schomer said, "Profit growth is very strong, markets are not overvalued, monetary policy will be accommodative and interest rates will remain low to support (equity) valuation. So we still have a couple more years of very decent equity market growth ahead before we get overbought."

He projects the total return of the S&P 500 will be between 8 percent and 10 percent.

For the rest of the developed world, the MSCI EAFE index will have a total return between 6 percent and 8 percent, Mr. Schomer predicted.

Edward F. Keon, managing director and portfolio manager, Quantitative Management Associates L.L.C., Newark, N.J., forecasts U.S. and European equities will be the best asset classes in 2014.

"My expectation for (economic) growth will be better-than-consensus expectations" propelling the stock markets, Mr. Keon said.

A. Gary Shilling, president of A. Gary Shilling & Co., Springfield, N.J., forecasts a continued weak economy of 2 percent real GDP growth. The S&P 500 will be positive, Mr. Shilling said, although he didn't give a number.

A weak economy will temper corporate profits, Mr. Shilling said: "It's not an economically driven (equity) market."

The best asset classes will be long Japanese stocks and short the yen, because of its weakening against the dollar, he said.

Mr. Shilling is upbeat about Treasuries, predicting the 10-year Treasury rate will fall to 2 percent by the end of 2014.

The biggest risk investors will face is a shock, whether economic or geopolitical, Mr. Shilling said, "something that will force equity investors into an agonizing reappraisal and to realize equities have been supported by the largesse of the Fed and profit margins of unsustainable levels."

Wells Capital's Mr. Paulsen is glum about U.S. equities. The accelerating economy will create investor anxiety fearing rising inflation and unsustainable growth, said Mr. Paulsen.

He forecasts a bullish 3.5 percent real GDP, but a flat to 2.5 percent total return on the S&P 500.

Increased "confidence and better balance sheets...will help bring out the "animal spirits' in corporations," bolstering the GDP, Mr. Paulsen said. "The year (2014) is going to start with (investment optimism in) accelerating economic growth and end up with panic of the (Federal Reserve) overheating growth."

The S&P 500 might run up above 2,000 in the first half and then fear of inflation will create a sell-off, Mr. Paulsen said.

"I don't think the bull market is over—it is just talking a pause" in 2014, Mr. Paulsen said.

Other developed equity markets, Europe and Japan, will outpace the U.S. market, and the emerging markets will perform best of all, for dollar-based investors, because of a weakening dollar, Mr. Paulsen said.

There won't be "an inflation problem but a fear of inflation," Mr. Paulsen said. That anxiety can be enough to trip up the equity market, he said. "The financial market doesn't have to have a problem for there to be a problem" in perception and potentially damage the market.

In emerging markets, Mr. Schomer is optimistic. "As the U.S grows faster, exports revive. The emerging markets are posed for a big catch-up" after underperforming in recent years.

Yet Mr. Lascelles worried about weakening global export trade and unresolved credit excesses in China and other emerging markets that will slow their economics and dampen their investment markets.

Emerging markets in 2014 "are not likely to return to the growth rates we've grown accustomed to over the last decade," he said.

Optimistic outlook

A CFA Institute Global Market Sentiment Survey of members found they generally embrace an upbeat view for 2014.

The survey, released in December, found 71 percent of 6,561 members responding identified equities as the asset class likely to perform best in 2014, up from 50 percent in 2013.

Some 26 percent of respondents rated the U.S. equity market likely to perform best globally, while 10 percent predicted the equities in China would perform best and 6 percent each rated as tops equities in Japan and Germany.

Overall for the U.S. economy, Mr. Schomer said, "We're at a point where business investment is poised for a pickup after a number of years of moderate demand-led growth but very little supply growth," Mr. Schomer said. "Businesses have a lot of catching up to do in terms of investment, which will then spur hiring and...higher demand growth around the world."

Monetary policy—a major driver of the U.S. economy and markets—will have little change in 2014, Mr. Schomer said, even as tapering begins. For a while, monetary policy will still be extremely accommodative, Mr. Schomer said. "It will take three or four years before we get to a point before monetary policy becomes a small headwind to economic growth." In the meantime, "there will be abundant liquidity. Interest rates will be low; financing will be cheap.

"That's the story not just in the U.S., but around the world," he said.

Mr. Lascelles said the Fed "seems to be at great pains to emphasize this (taper) does not mean the end of stimulus."

If 10-year Treasury bonds push much beyond 3 percent and threaten 4 percent, "there is reason to think a move of that magnitude would not be sustainable" and the Fed would intervene to mitigate the "harsh impact on the economy" and bring yields down, "which is what they did in September when yields were close to 3 percent and then they got them back to 2.5 percent," Mr. Lascelles said.

Fixed-income views

Fixed income, particularly Treasury and other sovereign debt, is seen as the worst major asset class for 2014.

"Long bonds will get killed," Mr. Paulsen said, saying their return will be negative.

"Sovereign bonds in general probably won't do well," Mr. Schomer said. "Everywhere bond yields have been depressed by either (quantitative easing)...or by overflowing effects of QE."

"It's not so easy anymore to (allocate) to fixed income when interest rates are rising," Mr. Schomer said. Investors, instead, are moving more to real estate and other inflation-protected assets.

Investment-grade corporate and high-yield bonds provide some protection against rising interest rates because of their relatively higher coupons. In addition, "default rates are at extremely low levels," he said.

The 10-year Treasury rate will rise to 3.25 percent by the end of 2014, Mr. Schomer predicts.

Mr. Lascelles calls for underweighting exposure to government bonds and overweighting credit, including high-yield bonds, in 2014. "One reason is the sovereign fiscal positions have deteriorated and the corporate fiscal positions have improved," Mr. Lascelles said. "So there has been a relative shift in the risk between the asset classes. The other reason is corporate default rates are low and as the economy improves ... they should stay low. Similarly when you look at corporate balance sheets, they are rock solid right now."

Cloud sighting

What could go wrong with an optimistic outlook?

"The biggest investment risk in 2014 is politics," Mr. Schomer said. "It's the uncertainty. The ideology doesn't matter, because we've seen investment growth whether it's...high or low taxation. As long as there is certainty about the investment environment, business will find a way to make money. But not providing the certainty right now; that's the biggest impediment" to growth prospects.

For Mr. Lascelles, the biggest risk is U.S. "political dysfunction."

Globally, the biggest risk includes Europe, which "is still not on firm ground," and China, where credit excesses pose a threat to growth.

"Our judgment is those risks are...sufficiently manageable," Mr. Lascelles said. "We would still rather be in risk-seeking mode, overweight in equities and underweight on bonds.

"For someone who disagrees with that assessment, they would be less keen on risky assets and would be more inclining toward gold and cash and government bonds," he said.

"Unfortunately, you cannot have both. You can't be perfectly protected from risk while simultaneously capitalizing on gains. That is the basic nature of the market," Mr. Lascelles said.

This report appeared in Crain's Pensions & Investments magazine, a Chicago-based sister publication of Tire Business.

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