Quick Market Update
 

Six Possible Surprises for 2014

January 10, 2014

H. Cameron Hinds, CFA®
Regional Chief Investment Officer

Carol M. Schleif, CFA®
Regional Chief Investment Officer – Abbot Downing

 

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In this Quick Market Update:

We outline six issues that may not be on investors’ radar but could impact markets in the coming year:

  • The U.S. markets could keep “melting up.”
  • Bond investors may “head for the exits.”
  • Emerging markets might “re-emerge.”             
  • Foreign cash repatriation could push U.S. stocks higher.
  • Global geopolitical risk may return.
  • Volatility might surge.

Attempts to forecast global economies and markets are fraught with imprecision. Today’s jobs report is an example of how unexpected data can surprise even the most experienced forecasters. Consensus estimates for 200,000 new jobs in December proved to be overly optimistic when the actual numbers were reported this morning at a mere 74,000 new jobs. Likewise, few market observers predicted last year’s strong, developed-market equity performance. Indeed, last January, the fiscal cliff and sequestration cuts had many investors lowering their expectations for equity markets in 2013. Developed-market stocks charged out of the gate, however, and didn’t look back. Other market observers made predictions of escalating inflation, a “great rotation” out of fixed-income investments and strong emerging-market performance which didn’t work out very well either.

With U.S. equity markets in record territory, investors want to know what’s next. Can U.S. equities stage an encore performance? Will emerging markets and commodities continue to suffer? Will interest rates keep rising? Will we see inflation or deflation? Will political divisiveness continue? In this Quick Market Update, we highlight six possible surprises for the coming year. In investing, it’s typically not the headlines that are problematic; it’s the unnoticed story about to grace the headlines that may have the most notable short-term impact for investors. 

The U.S. markets could keep “melting up”

While another 30 percent increase in U.S. stocks in 2014 is a low-probability event, signs of overheating in the equity market are not readily apparent either. Corporate fundamentals remain strong, with low inflation, high productivity, and solid sales. Judging from mutual fund flows, the long-anticipated great rotation out of fixed income and into equities has barely begun. (See chart 1 below). It appears that many investors, stung by the ‘Great Recession,’ remain wary of equity investments. This lingering reluctance could fuel demand for stocks in the coming quarters as many investors move from fear of loss to fear of being left behind.

Chart 1: Flow of Funds – Cumulative Net New Cash Flow (2007-2013)


Flow of Funds - Cumulative Net New Cash Flow (2007-2013). Contact your Relationship Manager for more information.

Source: FactSet, 1/8/14
 

Bond investors may “head for the exits”

At year-end 2012, the 10-year U.S. Treasury yield stood at 1.78 percent. Twelve months later, it was up 126 basis points to 3.04 percent, yet core inflation remained tame and developed-market stocks had soared.

Billions of dollars have been invested in fixed-income funds of all flavors in recent years; $1.8 trillion in the five years ended 2012 alone. However, for some categories of bonds, returns turned negative in the second quarter of 2013. We suspect that when investors review their annual performance numbers in a few weeks, there will be a lot of handwringing over fixed income vs. equity returns.  Nervous bond-fund investors could exert a much more destabilizing impact on fixed-income markets over the short term than is widely anticipated.

Rising bond yields, inflation, debt and deficits are all independent issues, even if the media frequently chooses to stuff them into the same worry closet. Moderate inflation could actually be a good thing for employees and companies (pay raises and pricing power, anyone?). And, over time, rising bond yields could be beneficial for aging baby boomers looking to lock in steady income streams or match cash flow with liabilities. 

Emerging markets might “re-emerge”

While global equity markets were strong in 2013, emerging-market equities were a major disappointment. In retrospect, the underperformance of this sector was somewhat rational (it was the degree of underperformance that appeared oversized). Many of the leading emerging economies clearly slowed in 2013. Commodity price weakness had a negative impact on stock markets in which commodities are important exports. Emerging countries’ currencies also were quite weak, especially relative to the U.S. dollar. Countries such as Brazil, India and Indonesia remain particularly vulnerable to currency weakness due to ongoing current account deficits; even as some emerging-market exporters see cheap currencies boost their earnings prospects.

All of these trends seem to be persisting as we enter 2014. However, it would also appear that much of the bad news is heavily discounted as emerging-market valuations as a whole remain relatively appealing. In particular, valuations are historically cheap in countries such as Russia, China, India and Indonesia. Yet concern over a continued slow-down in their respective economic growth rates persists. Given the weak performance in 2013 and current economic trends, some emerging markets may find a footing in coming quarters.  Although a quick and significant positive turn in emerging-market equity performance likely would be viewed as a major surprise in 2014.

Foreign cash repatriation could push U.S. equity markets higher

U.S. companies with significant international operations have huge excess cash balances in over-seas accounts. Estimates indicate the balances could be as much as $2 trillion, and 50 percent of the reserves reside in two sectors—health care and technology. These foreign cash holdings are growing at an increasing rate. In 2004, 30 percent of the S&P 500 Index pre-tax profits were earned internationally. This percentage is on track to approach 50 percent in 2014.

Understandably, companies are quite hesitant to pay significant U.S. taxes to bring cash back to the U.S.  In 2004, Congress gave companies a “repatriation holiday” with a 5.25 percent tax rate. This resulted in approximately 45 percent of overseas cash being returned to the U.S.—approximately $360 billion in cash. If a similar policy were enacted in 2014, companies could potentially bring $1 trillion back to the U.S.

There has been some discussion in Congress of a tax repatriation holiday, but we do not envision passage without a major tax overhaul which appears unlikely at this time. Even so, we would not dismiss any strategy that has the potential to generate new tax revenue, and repatriation could do just that. The question of what companies would do with the cash is controversial. It would be more politically feasible if companies were required to use the cash to increase capital spending and create new jobs. Yet that requirement is virtually impossible to track and enforce. It is anticipated that companies likely would use a large portion of the cash to buy back stock and raise dividends—a potentially major stock market positive that we believe is largely unexpected among market observers.

Global geopolitical risk may return

With the exception of the events in Syria and North Korea, and a few regional skirmishes, geopolitical tensions were fairly muted last year. In contrast, 2014 could potentially bring the reemergence of political and economic instability which is currently unexpected by the global markets.

The list of potential catalysts for increased insecurity is large. In Russia, President Putin has been notably amicable recently (most likely due to the winter Olympics), yet his influence in Syria indicates the potential for new conflict to surface. Indeed, Russia could be ground-zero for political instability in 2014. Slowing economic growth in China could produce increased social and political unrest (there is a strong correlation in China between the Purchasing Managers’ Index (PMI) employment sub-index and an increase in social unrest). This risk is likely to increase as China transitions from an investment-driven economy to one that is consumption-driven. It is unclear if the Abenomics experiment in Japan will be successful, putting continued pressure on the yen. Eurozone policy-related concerns could reemerge in 2014. Finally, we note there are a number of important elections in various emerging countries in 2014. It would appear that there is a great deal of unexpected geopolitical instability that could surface this year, putting global markets at risk of a pullback.

Volatility might surge

When volatility drops or there is an extended period when prices only rise, investors may become lulled into thinking there is less risk in their portfolios when, quite often, the opposite is true. As the chart below shows, one of the classic measures of short-term volatility, the Chicago Board Options Exchange Volatility Index (VIX), has been quite subdued for nearly two years.

Chart 2: VIX (1990-present)


Volatility index (VIX) performance from 1990-present. Contact your Relationship Manager for more information.

Source: FactSet, 1/9/14
 

While the chart above shows that volatility can remain low for many years, it also illustrates how volatility can spike when prompted by negative and largely unpredictable events. Currently, given richer valuations, fewer attractive investment alternatives, reduced liquidity, and a panoply of global geopolitical concerns, an unexpected shock could drive markets sharply downward. 

Conclusion

While it is impossible to know if these surprises will occur in the coming year, they are all within the realm of possibilities. It should be noted that risk-based strategies have performed well relative to low-risk strategies over the past few years. Based upon some of the negative risks, we strongly believe now is not the time to back away from portfolio diversification, even though it may be tempting to increase asset classes that have recently outperformed. It could be rationally argued that maintaining a four-asset-group strategy (stocks, bonds, real assets, and complementary strategies) is even more important today relative to five years ago when risks were recognized and priced into securities. At a minimum we strongly encourage investors to 1) ensure their long-term targets are in sync with their goals; and 2) consider rebalancing back to those targets. After all, the most “predictable” thing about the markets in the short term is that they are largely unpredictable.
 

All data for this Quick Market Update was sourced from Bloomberg Finance, LLP, unless otherwise noted.

 


 

Disclosures

Wells Fargo Wealth Management provides products and services through Wells Fargo Bank, N.A. and its various affiliates and subsidiaries.

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.

The Volatility Index (VIX®) is a key measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

Indexes represent securities widely held by investors. You cannot invest directly in an index. 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.

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Investment Products. Not FDIC Insured. No Bank Guarantee. May Lose Value.

 

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Cameron Hinds, CFA®

Regional Chief Investment Officer, Great Lakes Region



Six Possible Surprises for 2014 (PDF)
January 10, 2014

In this Quick Market Update, Regional Chief Investment Officer H. Cameron Hinds, CFA® and Carol M. Schleif, CFA®, Regional Chief Investment Officer for Abbot Downing, highlight six possible surprises for the coming year.

 

Wells Fargo & Company and its affiliates do not provide legal advice. Please consult your legal advisors to determine how this information may apply to your own situation. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared.

Wells Fargo Wealth Management provides financial products and services through Wells Fargo Bank, N.A. and their various affiliates and subsidiaries. The information and opinions in these reports were prepared by the Investment Management arm of Wells Fargo Private Bank, a part of Wells Fargo Wealth Management and a division of Wells Fargo Bank, N.A.

Investments discussed in these reports may not be insured by the Federal Deposit Insurance Corporation and may be unsuitable for some investors depending on their specific investment objectives and financial position. These reports are not an offer to buy or sell, or a solicitation of an offer to buy or sell the securities or strategies mentioned.

Brokerage services offered by Wells Fargo Advisors, LLC. Wells Fargo Advisors, LLC, Member SIPC is a registered broker-dealer and separate non-bank affiliate of Wells Fargo & Company.

 

Investment Products: Not FDIC Insured, No Bank Guarantee, May Lose Value.