Evaluating ISG's Ten for 13
December 10, 2013
By most measures, 2013 has been an exceptional year for U.S. equity markets, with the S&P 500’s 27% year-to-date return (through December 13) far exceeding the most bullish Wall Street predictions. Nevertheless, not all asset classes fared as well. In this edition of Strategic Spotlight, we review the recent performance of various asset classes and the accuracy of our economic and market expectations from a year ago
Economy and Rates Have Driven Markets
Arguably, the two main forces behind returns have been improving growth expectations and rising U.S. interest rates. After declining to record lows last year, rates rose on the prospects of Federal Reserve "tapering" and improving global growth. This negatively affected many fixed income assets (see display), with only high yield bonds generating positive returns as their distributions and spread compression offset price declines from rate increases. For the most part, assets with higher durations have suffered the biggest losses.
Within equities, the United States has led international and emerging markets as improving economic data and a decline in macro uncertainty have pushed valuations higher. U.S. small caps have done particularly well, gaining 32%. By sector, domestically focused areas such as Consumer Discretionary and Health Care have outperformed while more expensive, income-generating sectors like Utilities and Telecoms were hampered by the mid-year interest rate rises. International equities have also done reasonably well, with the return of growth in Europe and optimism about "Abenomics" in Japan. Although showing improvement more recently, emerging markets equities suffered from concerns over China’s growth path and, in some markets, commodity price declines.
Diverging Paths for Stocks and Bonds
Source: FactSet, as of December 13, 2013
Evaluating the Ten for ‘13
Consistent with our view that 2013 would be a year of improving global growth and sustained monetary stimulus, six of our 10 expectations have essentially panned out, three have had mixed results, and one was flat wrong. We provide a brief review below:
1. U.S. Fiscal Blues Amid Broadening Growth ✓
We expected retrenchment in government spending and tax increases to hold back the economy early in the year, but believed that growth would accelerate in the second half. So far, that has been the case. Economic growth has increased every quarter, while unemployment has declined from 7.8% to 7.0%. Even though U.S. growth will likely end above the 1.5%–2.0% range that we anticipated, our growth expectations for the most part have been correct.
2. A Bargain—But Far From Grand ✓
As we anticipated, the U.S. Congress did not deliver on a "grand bargain" to address the nation’s long-term deficit and growth problems. We also believed that the debt ceiling would be raised and that automatic "sequestration" spending cuts would be replaced by a negotiated budget. Although we were right on the first count, we were off on timing of the second—the budget deal currently in progress amends sequestration but the changes would not be initiated until 2014.
3. Europe: Reconcilable Differences ✓
As expected, Europe exited recession and returned to growth in 2013 as core countries led the recovery. Also, we did not expect elections in Italy and Germany to be game changers; with voters expressing their desire that the eurozone remain intact, we were correct to downplay the risk of those events.
4. Monetary Easing Sustained ✓
We initially believed that the world’s central banks would sustain loose monetary policy after large-scale actions in 2012. At mid-year, we argued that the U.S. Federal Reserve would maintain quantitative easing, as fiscal consolidation and benign inflation remained in place. Both expectations were correct, along with our view as to the positive impact that easy monetary policy would have on risk assets.
5. Souring on "Safe Haven" Assets ✓
In 2012, interest rates dropped to unprecedented levels, driven by central banks’ unconventional policies and what we considered excessive risk aversion. With real yields at negative levels, however, the situation appeared untenable, and in fact rates have increased this year with improvement in economic growth. We were right about the reversal and also its negative impact on fixed income investments.
6. Chinese Growth Reignites Amid Gradual Reforms ✓ / x
In late 2012, various indicators pointed to an imminent acceleration of growth in China. However, the upturn was short-lived and growth is trending closer to 7.5% than the 8% we were expecting. But we were right that structural reforms would be gradual following the leadership transition in 2012.
7. Emerging Markets: Buy Small, Buy Local ✓ / x
We believed emerging markets equities would continue their acceleration from late 2012, particularly fueling gains in smaller companies focused on domestic consumption as opposed to large, state-owned financial and commodity producers. While sectors such as Consumer Discretionary, Consumer Staples and Health Care have vastly outperformed Energy, Materials and Financials within the MSCI Emerging Markets Index, smaller-cap names have taken the larger hit. So, in all, results were mixed.
8. U.S. Equities Stay Positive ✓
We expected U.S. stocks to provide decent returns as valuations remained attractive relative to historical values and also other asset classes, particularly bonds. We expected that corporate activity (e.g., buybacks and dividends) would attract buyers and provide a support to the market. While earnings expectations have waned over the course of the year, multiple expansion has driven returns, as we also anticipated.
9. Commodity Prices Stay in Check ✓ / x
We predicted that commodity prices would remain under pressure as increased supply offset rising cyclical demand. This would prove particularly true for energy, as U.S. production of oil and gas skyrocketed during the year. However, while we were right that commodity prices would be challenged, we did not anticipate such a large negative return (-9.3% year-to-date as of December 13, 2013).
10. Cyclicals to Lead x
In 2012, among the best performing U.S. equity sectors were Financials, Consumer Discretionary and Health Care. It appears that these sectors are on pace to repeat the feat in 2013, which is a somewhat unusual repetition. We had preferred the cheaper global cyclicals such as Energy, Information Technology and Industrials. Of these, only Industrials have outperformed the overall S&P 500 Index (year-to-date as of December 13, 2013).
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