Macro

Positioning for the 2013 Stretch Run

October 14th, 2013 | By Nick Sargen

With investment results now in for the third quarter, the odds are 2013 will go down as an exceptional year for the stock market and a poor year for the bond market: Year-to-date returns stand at nearly 20% for the S&P500 Index and minus 1.9% for the Barclays Aggregate Index. During the third quarter, financial markets greeted the Federal Reserve's announcement that it would delay tapering its quantitative easing (QE) program favorably. The stock market set a record high in mid-September and went on to post a 5.2% quarterly return, while the bond market rallied on the news and ended the quarter on a positive note.

Looking ahead to the balance of this year and into 2014, investors confront two key issues: (1) Are bond yields likely to move higher; or will they stabilize? and (2) Will the stock market continue its remarkable upward ascent; or will it consolidate?

Our take is that the odds favor the stock market consolidating following outsized returns, while bond yields are likely to stabilize in the fourth quarter before resuming their upward trajectory next year. This view reflects our assessment that the U.S. economy and corporate profits are not likely to accelerate materially in the fourth quarter. The outlook for 2014 is brighter, as conditions abroad are beginning to improve and "fiscal drag" is expected to lessen. The looming battle over the debt ceiling, however, leaves the outlook uncertain and could cause the Fed to postpone tapering until next year.


U.S. Economy: Waiting for a Pick-up

At the beginning of this year, we anticipated the U.S. economy would get off to a slow start owing to the impact of an increase in payroll taxes and higher income taxes for the wealthy, as well as the effect of sequestration in curbing federal spending. Collectively, they are estimated to have pared overall growth by about 1.5 percentage points. We looked for the economy to gain traction in the second half of the year as the impact of "fiscal drag" lessened. Finally, we thought there was a good chance the economy could post 3% real growth in 2014 for the first time since the Financial Crisis.

Based on the evidence thus far, the economy appears to have withstood the effects of fiscal drag in the first half. However, it is not yet clear that the pace of activity is accelerating in the second half, as incoming data have been mixed. In the consumer area, for example, auto sales have been strong, but retail spending has been soft. Housing continues to recover, but starts have slowed from the first half pace, and the outlook is more uncertain owing to the rise in mortgage rates during the spring-summer. For their part, businesses have been cautious in hiring and expanding plant and equipment, although orders for capital goods have improved somewhat. Corporate profits continue to be solid, but growth has slowed considerably over the past year.

One clear positive is that conditions abroad are improving: Global manufacturing activity has picked up this year following a slump in 2012, when the global economy posted its weakest growth since the Financial Crisis. This partly reflects the emergence of Europe from recession, as well as improved conditions in Japan, China and the Pacific Rim. If this trend continues, a significant obstacle to U.S. growth will have lessened. It is too early to tell how much momentum is building, as recovery in Europe is likely to be very gradual and there is considerable uncertainty about a handful of emerging economies including Brazil, India, Indonesia, South Africa and Turkey that are experiencing significant slowdown and, in some instances, capital flight.

We continue to believe the U.S. economy will post stronger growth next year, mainly because the effects of fiscal drag are set to diminish. But we are less certain it will attain an overall pace of 3%, which many observers would view as a sign the economy is normalizing. A looming risk is the deliberations over the federal debt ceiling and the 2014 budget, where the outcome at this time is highly uncertain.


Will Fiscal Follies Impact the Markets?

Throughout much of this year, investors have largely ignored the effects of fiscal policy changes. The implementation of sequestration earlier this year, for example, was a sideshow for the markets despite all the headlines it grabbed. Similarly, the recent partial shutdown in federal government operations has had little market impact thus far. The principal reason is investors view what is happening in Washington, D.C. as political theatrics and assume a deal will be struck before too long.

By and large, we share this sentiment, as previous instances of government shutdowns had only very small effects on the economy and markets. Nonetheless, we are compelled to consider what would happen if the shutdown is not resolved by October 17, when the Treasury Department has indicated it will be left with only $30 billion in cash. By month's end there would not be enough cash to pay out Social Security benefits, Medicare reimbursements, payments for the military and veterans or to service its debt.

Our assumption is that the politicians will reach an agreement to "kick the can down the road" before then, as the consequences of not servicing the debt or meeting critical obligations would be profound. That said, we also recognize the markets may have to erupt at some point to catch the attention of the political leaders. Therefore, we cannot rule out a replay of the fireworks that unfolded in August of 2011, when the markets sent a strong signal to the politicians.


Fed Tapering: A Matter of Time

By comparison, investors this year have been riveted on forthcoming monetary policy changes since May-June, when Fed officials openly discussed the prospect for tapering the quantitative easing program. Chairman Bernanke indicated that the intent was to wind down the program of monthly bond purchases of $85 billion by mid-2014 assuming the economy and jobs picture continued to improve. This discussion caught bondholders off guard, and the Treasury yield curve rose by more than a full percentage, while spreads versus Treasuries for corporate bonds and mortgage backed securities widened considerably.

Just when market participants thought the Fed was ready to pull the trigger in mid-September, the Fed once again surprised investors by announcing it would delay tapering until it had a clearer read the economy was improving and uncertainties over the deferral debt ceiling were resolved. Since then, ten year Treasury yields have fallen by about 30-40 basis points from their highs.

In light of the confusion over Fed policy, our take is that investors should focus on economic developments as a guide to the direction of bond yields. Until the debt ceiling issue is settled, it is unlikely that yields will rise materially, and they could continue to drift lower. Thereafter, we would expect yields to settle into trading ranges. Looking into 2014, we would expect bond yields to resume their ascent if the economy gains traction. By then, the Federal Reserve will likely have embarked on its program to scale back QE.


Portfolio Positioning

Prior to the September FOMC meeting, we altered our investment strategy for balanced portfolios in institutional accounts by paring back our overweight position in equities from 10% to 5%. Our reasoning was the stock market was fairly valued, corporate profit growth had slowed and we thought the Fed would begin to taper QE this year. Following the Fed meeting we are maintaining our stock-bond allocations on grounds it is only a matter of time before the Fed acts and bond yields will likely resume their upward trajectory as the economy gains traction.

One change we have made is in fixed income portfolios, where we have increased our allocation to investment-grade corporate bonds to establish a moderate overweight position. Our logic is the Fed's latest decision will reinforce the perception that it is in no hurry to raise interest rates and will likely wait until 2015 to do so.