Quick Market Update
What a Year!
January 3, 2014
Tracie McMillion, CFA®
Asset Allocation Strategist
Chris Haverland, CFA®
Asset Allocation Strategist
Investment Research Analyst
In this Quick Market Update:
Investors regain their confidence
Investors shifted away from “safe haven” assets such as U.S. Treasuries and gold in 2013.
In U.S. dollar terms, U.S. equities led global markets in 2013, while Japan led developed markets in local currency returns.
The U.S. Aggregate Bond index return was negative for only the third time since its inception in 1976.
Emerging markets and commodities struggled against higher interest rates and a strong U.S. dollar.
Hedge funds helped stabilize portfolio values as bond holdings declined.1
Global diversification may be especially important in the coming year as interest rates rise and global monetary policies diverge.
The biggest surprise in 2013 may have been the resiliency of equity investors, particularly U.S. equity investors. Cuts to the U.S. Federal budget, a government shutdown, and even the start of “tapering” had little impact on U.S. stock markets. Equity investors seemed to gain confidence with the passing of each of these trials. International investors cheered “Abenomics” in Japan, an improving economy in the U.K., and the gradual progress towards financial unification in the Eurozone. Meanwhile, emerging markets as a group slowed, and many of their economies faced challenges such as climbing inflation and a slump in commodities prices.
U.S. interest rates rose in anticipation of reduced bond-buying support (tapering) from the Federal Reserve (Fed), the result of a firming domestic economy. Higher interest rates proved positive for the U.S. dollar, but damaging to domestic bond indices. The Barclays U.S. Aggregate Bond Index posted a negative annual return for only the third time since its inception in 1976. International bond indices also declined as the U.S. dollar strengthened, while structural schisms were observed in emerging economies as the U.S. prepared to remove some liquidity from world markets.
Overall investors with balanced portfolios experienced healthy returns in 2013, and more aggressive investors likely outperformed those with greater bond exposure.
2013 Asset Class Performance
Source: FactSet and Bloomberg, as of 1/2/14
2013 Global capital markets highlights
The aggregate global equity market return was 23.4 percent in 2013. We began the year with an overweight to equities, and mid-year we instituted a higher strategic allocation to the asset group. Throughout the year, we did not back away from our commitment to higher equity allocations.
For U.S. investors, the U.S stock market was the best-performing asset class in 2013. U.S. small-cap stocks were the top performers, mid caps were second-best, and U.S. large caps came in third. It has been 33 years since this combination of U.S. stock indices has topped global equity performance lists.
In local-currency returns, the Japanese stock market had the most outstanding performance among developed markets, up 59.3 percent for the year.
Eurozone equity markets performed very well for the year with most markets returning in excess of 25 percent.
Emerging markets ended the year in slightly negative territory. Our overweight to this asset class early in the year was removed mid-year in light of the struggles this asset class experienced in 2013.
Bond prices suffered as interest rates began to increase. Our decision to underweight sovereign debt (including U.S. Treasuries) proved beneficial during the year.
Commodities as a group posted negative returns for the year as supplies outpaced demand and lower overall prices in the developed world nudged investors out of inflation hedges such as gold and silver. Our underweight to commodities implemented near mid-year helped to mitigate some of the downside risk in this asset class. Also, gold’s 28.3 percent decline in 2013 broke its 12-year uptrend and gives investors the option to exploit other opportunities.
Hedge funds posted mid-high single-digit returns providing an effective hedge against falling bond prices.
2013 Global economic highlights
The Fed surprised markets in May with an announcement that soon it would begin to decrease its bond-buying program. Even so, political uncertainty contributed to a delay in action until the final meeting of the year. In 2013, the Fed’s Balance sheet reached an all-time high of $4.07 Trillion.
Importantly, the U.S economy added jobs at an average rate of 189,000 per month in 2013, and the unemployment rate dropped from 7.8 to 7.0 percent during the year. While a falling unemployment rate and steady job creation are positive signs, the challenge for the U.S. economy now appears to be how to generate higher wages to stimulate further discretionary consumption. We believe the U.S. unemployment rate will continue to trend lower through 2014.
The U.S. housing sector contributed to economic growth in 2013 as home prices recovered and sales of new and existing homes improved considerably. Rising interest rates may slow the pace of gains in the housing sector, but given that interest rates are still quite low by historical standards, we expect the housing market to continue to mend.
Rising asset prices raised Americans’ net worth to its highest level in the past seven years.
The Eurozone emerged from recession in 2013 and managed to stabilize its financial system more quickly than many market observers had forecast. Countries within the region are recovering at different paces, but overall the region is expected to continue to make gradual progress with unprecedented support from the European Central Bank.
In Japan, monetary and fiscal easing policies (known as Abenomics) helped to alleviate deflationary worries for the time being, improving the prospect of a long-awaited rebound in the Japanese economy.
China did not collapse economically or from its transition to new leadership, however, its growth rate slowed to 7.5 percent from a cycle high of over 10 percent. This year, we expect the Chinese economy to slow a bit more, to roughly 7.0 percent.
Brazil, India and certain other emerging markets struggled with inflation and current account deficits as the U.S. dollar strengthened against their local currencies.
Following a year of strong domestic equity returns, investors may wonder if broad diversification is still appropriate for their portfolios. In economic terms, it appears that the U.S. economy may be close to a mid-point for this cycle and while many attractive opportunities for investors still exist, the market recovery could be maturing. Data from prior recoveries show that the first four years of a recovery generate consistently positive returns in the surprisingly narrow 22 – 24 percent range. The second four-year period of a recovery historically has been far less predictable for U.S. equities. As we enter the second half of this economic cycle, we expect greater volatility in domestic markets.
Early and Late Cycle Performance
Source: Ned Davis Research, Global Asset Allocation Outlook for 2014, 12/3/13
Broad diversification for 2014
While we remain constructive on U.S. equity markets, it is very difficult to predict the performance of a single asset class in any given year. The chart below shows the performance of various asset classes over an extended period of time. What the chart clearly illustrates is that a diversified balanced allocation portfolio—with an appropriate mix of stocks, bonds, real assets, and complementary strategies—is never the top performer nor is it ever the bottom performer. Surprisingly, however, its performance over the full cycle is better than the majority of its components—that’s the beauty of diversification.
Using a carefully constructed portfolio to generate smoother returns over time has proven to be a prudent way to invest. Global diversification may be especially important in the coming year as interest rates are expected to continue to rise and global monetary policies diverge. We recommend that you work with your investment professional to determine an investment approach that is suitable for your specific circumstances.
Diversification Can Smooth the Ride
Source: Morningstar and FactSet, 1/2/14. Balanced Portfolio Blend: 3% Cash,19% US Agg Bonds, 5% HY Bonds, 5% Developed Bonds, 5% EM Bonds; 15% US Large Cap, 6.60% US Mid Cap, 3.80% US Small Cap, 9% Developed Equities, 6.60% EM Equities; 7% REITS; 5% Commodities; 4% HF Rel Value, 2% HF Macro, 4% HF Event Driven. Note: For 2002-2012 the HFRI Fund Weighted Index was used for the hedge fund return; due to availability, the preliminary return for the HFRX Global Hedge Fund was used for 2013’s hedge fund value.
All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.
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The information and opinions in this report were prepared by the investment management division within Wells Fargo Wealth Management. Information and opinions have been obtained or derived from sources we consider reliable, but we cannot guarantee their accuracy or completeness. Opinions represent Wells Fargo Wealth Management’s opinion as of the date of this report and are for general information purposes only. Wells Fargo Wealth Management does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.
Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses.
Past performance does not indicate future results. The value or income associated with a security may fluctuate. There is always the potential for loss as well as gain. Investments discussed in this presentation are not insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position.
This report is not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned. The investments discussed or recommended in the presentation may be unsuitable for some investors depending on their specific investment objectives and financial position.
Investing in foreign securities presents certain risks that may not be present in domestic securities. For example, investments in foreign and emerging markets present special risks, including currency fluctuation, the potential for diplomatic and potential instability, regulatory and liquidity risks, foreign taxation and differences in auditing and other financial standards.
Fixed income securities are subject to availability and market fluctuation. These securities may be worth less than the original cost upon redemption. Certain high-yield/high-risk bonds carry particular market risks and may experience greater volatility in market value than investment grade corporate bonds. Government bonds and Treasury bills are guaranteed by the U.S. government and, if held to maturity, offer a fixed rate of return and fixed principal value. Interest from certain municipal bonds may be subject to state and/or local taxes and in some instances, the alternative minimum tax.
Balanced Portfolio Blend: 3% Cash,19% US Agg Bonds, 5% HY Bonds, 5% Developed Bonds, 5% EM Bonds; 15% US Large Cap, 6.60% US Mid Cap, 3.80% US Small Cap, 9% Developed Equities, 6.60% EM Equities; 7% REITS; 5% Commodities; 4% HF Rel Value, 2% HF Macro, 4% HF Event Driven.
Indexes represent securities widely held by investors. You cannot invest directly in an index.
U.S. Aggregate Bond. Barclays Capital Aggregate Bond Index is an index composed of the Government Bond Index, the Asset-Backed Securities Index and the Mortgage-Backed Securities Index and includes U.S. Treasury issues, agency issues, corporate bond issues and mortgage-backed issues. It is unmanaged, includes reinvestment of dividends, does not reflect the impact of transaction, management or performance fees and is unavailable for investment.
U.S. Treasury. Barclays Capital U.S. Treasury Index includes public obligations of the U.S. Treasury with a remaining maturity of one year or more.
U.S. Municipal Bond. Barclays Capital Municipal Bond Index represents municipal bonds with a minimum credit rating of at least Baa, an outstanding par value of at least $3 million and a remaining maturity of at least one year. The index excludes taxable municipal bonds, bonds with floating rates, derivatives and certificates of participation.
U.S. High Yield. Barclays Capital High Yield Index covers the universe of fixed rate, non-investment grade debt.
Foreign Bond (Hedged). JPMorgan Non-U.S. Global Government Bond Index (Hedged) is an unmanaged market index representative of the total return performance, on a hedged basis, of major non-U.S. bond markets. It is calculated in U.S. dollars. Unless otherwise noted, index returns reflect the reinvestment of dividends and capital gains, if any, but do not reflect fees, brokerage commissions or other expenses of investing. It is not possible to invest directly in an index.
Emerging Markets Debt (U.S. Dollar). JP Morgan Emerging Markets Bond Index (EMBI Global) currently covers 27 emerging market countries. Included in the EMBI Global are U.S.-dollar-denominated Brady bonds, Eurobonds, traded loans, and local market debt instruments issued by sovereign and quasi-sovereign entities.
Large Cap Equity: S&P 500 Index is a capitalization-weighted index calculated on a total-return basis with dividends reinvested. The index includes 500 widely held U.S. market industrial, utility, transportation and financial companies.
Mid Cap Equity. Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Index is a subset of the Russell 1000® Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Russell Midcap Index represents approximately 27 percent of the total market capitalization of the Russell 1000 companies.
Small Cap Equity. Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Index is a subset of the Russell 3000® Index representing approximately 8 percent of the total market capitalization of that index. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
Developed Markets Equity (U.S. Dollar). MSCI EAFE Developed Market Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure developed market equity performance, excluding the U.S. and Canada. It is unmanaged and unavailable for investment. Statistics are shown in U.S. dollars and local currency.
Emerging Markets Equity (U.S. Dollar). MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. Frontier Markets Equity (U.S. Dollar/Local). MSCI Frontier Markets Index is a free-float-adjusted market-capitalization index that is designed to measure equity performance of the world’s least-developed capital markets. Statistics are shown in U.S. dollars and local currency.
Frontier Markets Equity (U.S. Dollar). MSCI Frontier Markets Index is a free-float-adjusted market-capitalization index that is designed to measure equity performance of the world’s least-developed capital markets. Statistics are shown in U.S. dollars and local currency.
Global REITs. FTSE/EPRA NAREIT Developed Index is designed to track the performance of listed real estate companies and REITs worldwide.
Commodities (DJ-UBS). Dow Jones-UBS Commodity Index represents futures contracts on 19 physical commodities. No related group of commodities (e.g., energy, precious metals, livestock and grains) may constitute more than 33 percent of the index as of the annual reweightings of the components. No single commodity may constitute less than 2 percent of the index.
Global Hedge Funds. HFRX Global Hedge Fund Index is designed to be representative of the overall composition of the hedge fund universe. It is comprised of eight strategies; convertible arbitrage, distressed securities, equity hedge, equity market neutral, event driven, macro, merger arbitrage, and relative value arbitrage. The strategies are asset weighted based on the distribution of assets in the hedge fund industry.
Managed Futures. The Credit Suisse Managed Futures Liquid Index aims to gain exposure to trend-following strategies on futures. The index is valued daily and is constructed using objective and transparent rules-based methodology.
The HFRX Relative Value Index maintains positions in which the investment thesis is predicated on realization of a valuation discrepancy in the relationship between multiple securities. Managers employ a variety of fundamental and quantitative techniques to establish investment theses, and security types range broadly across equity, fixed income, derivative or other security types.
The HRFX Macro Index is comprised of a broad range of strategies in which the investment process is predicated on movements in underlying economic variables and the impact these have on equity, fixed income, hard currency and commodity markets. Managers employ a variety of techniques, both discretionary and systematic analysis, combinations of top down and bottom up theses, quantitative and fundamental approaches and long and short term holding periods. Although some strategies employ RV techniques, Macro strategies are distinct from RV strategies in that the primary investment thesis is predicated on predicted or future movements in the underlying instruments, rather than realization of a valuation discrepancy between securities.
The HFRX Event Driven Index maintains positions in companies currently or prospectively involved in corporate transactions of a wide variety including but not limited to mergers, restructurings, financial distress, tender offers, shareholder buybacks, debt exchanges, security issuance or other capital structure adjustments. Security types can range from most senior in the capital structure to most junior or subordinated, and frequently involve additional derivative securities. Event Driven exposure includes a combination of sensitivities to equity markets, credit markets and idiosyncratic, company specific developments. Investment theses are typically predicated on fundamental characteristics (as opposed to quantitative), with the realization of the thesis predicated on a specific development exogenous to the existing capital structure.
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1 Source: Wells Fargo Wealth Management, and Morningstar Encorr, January 2014.