David Joy: Surveying 2013 - a mixed bag for investors

The first half of the year has been quite gratifying for investors in the equities of most of the world’s developed economies. It has been a somewhat different experience for investors in emerging market equities and for investors in most of the world’s bond markets.

A mostly strong start for stocks
Rising stock prices have, for the most part, reflected relatively stronger economic performance, or the expectation thereof. Japanese equities have led the way, with gains exceeding 40% in yen terms midway through July. Efforts to jumpstart the economy through a program of aggressive monetary easing has weakened the currency and encouraged investors that rising earnings and an end to deflationary pressure may finally become a reality. In the United States, where stocks are higher by almost 19%, the combination of modest economic growth, low inflation, and an accommodative monetary policy has propelled stocks higher, despite relatively flat corporate revenue growth and only modestly higher earnings. Stocks are also higher in most of Europe in local currency terms, although less so. The promise of central bank support and some relaxation of the push for austerity have brightened the prospect for a return to modest economic growth later in the year. German stocks have risen 10% and stocks in the U.K are higher by 12%. Markets in Spain and Italy are fractionally lower. The commodity-sensitive economies of Canada and Australia, although higher on the year, have struggled with declining global demand for raw materials, particularly in China. The Dow Jones UBS Commodity Index is 7% lower on the year.

The influence of the economic slowdown in China, as it attempts to transition to greater reliance on domestic consumption to drive economic growth, has been felt throughout much of the developing world. Rising inflationary pressures and structural imbalances in some countries have represented additional economic headwinds. Among the hardest hit countries have been the commodity producers in Latin America. In local currency terms, stock markets in Brazil are down 20%, in Chile stocks are lower by 10%, and in Peru by 25%. Asian markets have experienced varying results. China itself is down 11%, and South Korea is down 5%. In contrast, Taiwan is higher by 5%, Malaysia by 6, as are Singapore and Thailand, while India is 3% higher. Philippine stocks are higher by 14%. Stocks in Russia are modestly lower. A broad measure of global equities, the MSCI All Country World Index, is higher by 10% on the year in U.S. dollar terms toward the end of July, 13% in local currencies.

A tougher road for bonds
It has been a different story for bond investors. After fluctuating within a narrow band between 1.80 and 2.00% for much of the first quarter, the yield on the ten-year U.S. Treasury note fell sharply to a low of 1.63% in early May in response to weak economic reports, in particular concerning the strength in the labor market and consumer spending. The dual effects of higher tax rates as part of the fiscal cliff deal early in the year and the sequester spending cuts late in the first quarter were apparently beginning to bite. That sentiment soon changed, however, as the Federal Reserve began to signal that its bond buying program, QE3, could begin to be scaled back later in the year if the economy strengthened as the Fed expected. Suddenly, bonds looked decidedly less attractive at such low yields, which soon began to rise. By July 5, the ten-year note yield had reached 2.74%, representing a loss of roughly 8% in just eight weeks. Foreign sovereign bond markets suffered in response, as yields around the globe began to rise. German bond yields rose 65 basis points to a high of 1.81%. Ten-year bond yields in the U.K. rose from 1.62 to 2.53%. In Spain, they spiked to 5.10% from 4.02, and in Italy yields climbed to 4.85% from 3.76. But it was the bonds of emerging markets countries, especially those with current account deficits and therefore more heavily dependent upon capital flows from the developed world, particularly the U.S., that suffered the most as those flows, which had been positive for so long, began to reverse. In Turkey, yields soared from 3.22 to 5.61%. South Africa saw a yield increase of 200 basis points to 7.98%. Elsewhere, in Brazil the ten-year yield rose from 2.61 to 4.47%, and in Mexico, the yield rose from 2.35 to 4.17%. More recently, these yields have either stabilized or receded somewhat, as the Federal Reserve has made it clear that any change in policy is dependent upon the strength of the economic data, which has been decidedly mixed. A broad measure of global bonds, the Barclays Unhedged Global Aggregate Index is lower by 4.0% midway through July.

The months ahead
There is a widespread expectation that the U.S. economy will improve during the second half of the year. The headwinds of restrictive fiscal policy are expected to wane, and the recoveries in housing and employment are expected to continue. The issue for investors will be the pace of any such improvement. The consensus forecast anticipates that growth will accelerate to an annualized pace of approximately 2.5% over the remaining two quarters. If realized, this would represent an appreciable improvement over the first half, when growth likely averaged closer to half that. This question of growth presents a conundrum for investors, however. Faster growth would likely translate into faster earnings growth, allowing stock prices to continue to climb. However, it would also make it more likely that the Federal Reserve will, indeed, begin to taper its program of quantitative easing, pulling back on what many believe to be a major support for capital markets. So far, the economy has not exhibited the kind of improvement that would suggest 2.5% growth is achievable, although the data was a little stronger at the end of the second quarter than at its start.

There are similar expectations for Europe. While growth has so far been difficult to achieve, the rate of decline continues to moderate. A return to growth could come as early as the fourth quarter, and although welcome, it is expected to remain fragile and uneven. Perhaps the biggest wildcard for the global outlook is what happens in China. As its economy matures, the days of double-digit annualized growth appear to be behind it. The question now is to what extent does it slow? The official growth target of 7.5% attempts to strike a balance between acceptable growth and unacceptable speculation. That is a delicate balance that could prove difficult to achieve. At mid-year, the year-over-year growth rate resided right at the target, but that represented a deceleration from the pace of the first quarter. After growing to become the world’s second largest economy, and accounting for much of the world’s growth during the recession, the pace of growth in China is increasingly important, especially for its major trading partners.

For U.S. equity investors, growth in earnings will become increasingly important. During the first half of the year, stock prices rose faster than the growth in earnings. And while this process of price/earnings multiple expansion has not left stocks overvalued, at a current valuation of approximately 15 times this year’s expected earnings, neither are they necessarily cheap. In a low inflationary environment, such as presently exists, stocks can support somewhat higher valuations. And with labor costs and commodity prices subdued, profit margins can remain high. But embedded in the market’s expectations is faster earnings growth in the second half. That will require faster economic growth. The pattern of second quarter earnings reports so far is that companies more focused on domestic demand are faring better than those more reliant on overseas sales. Until we see tangible evidence of economic traction overseas, that pattern is likely to continue. It is for that reason, primarily, that U.S. equities remain the most attractive. It also important to point out that even once the Fed begins to taper QE3, the monetary backdrop will remain exceedingly accommodative. Whether markets react adversely to the onset of tapering remains to be seen. Certainly, the possibility of it has been well telegraphed. And it is likely that investors would prefer stronger economic growth and rising earnings over sluggish growth and more Fed support.

The primary argument for investing overseas is valuation. Stocks are cheaper in Europe and in the emerging world than in the U.S. For that reason, some exposure is warranted. That exposure is likely to be profitable sooner in Europe, but only if their growth expectations are realized. And that is no certainty.

Bond investors have enjoyed a modest reprieve recently from the turmoil they endured in May and June. The realization that neither the commencement nor the pace of any QE tapering is set in stone has allowed yields to fall back somewhat in the past few weeks. But bond investors have been put on notice. Over the intermediate to longer-term, yields are likely to continue to rise. A reasonable expectation for year-end is a 3.00% yield on the U.S. ten-year note. That means that short to intermediate maturities should continue to be favored over longer bonds. And if a further rise in yields comes about as a result of improving economic conditions, rather than an unexpected increase in inflationary pressures, then corporate bonds should continue to represent better value than Treasuries. And if the dollar continues to appreciate in such an environment, dollar-denominated bonds should retain their appeal as well. Municipal bond investors will be watching carefully the bankruptcy filing of the city of Detroit. Especially uncertain is the intended treatment of general obligation bondholders as unsecured creditors. A protracted legal battle is likely to ensue.

On balance, while a diversified portfolio should have exposure to both, at present the return expectation for stocks remains more favorable than for bonds. Whether that expectation is realized over the second half of the year, and to what extent, will depend largely upon the pace of the global economy, the growth in corporate earnings, and the central bank policy response.

Important Disclosures:
The views expressed are as of the date given, may change as market or other conditions change, and may differ from views expressed by other Ameriprise Financial associates or affiliates. Actual investments or investment decisions made by Ameriprise Financial and its affiliates, whether for its own account or on behalf of clients, will not necessarily reflect the views expressed. This information is not intended to provide investment advice and does not account for individual investor circumstances. Investment decisions should always be made based on an investor's specific financial needs, objectives, goals, time horizon, and risk tolerance.

The Dow Jones-UBS Commodity Index℠ is composed of commodities traded on U.S. exchanges, with the exception of aluminum, nickel and zinc, which trade on the London Metal Exchange (LME).

MSCI-All Country World Ex. U.S. Index: Is an unmanaged index representing 48 developed and emerging markets around the world that collectively comprise virtually all of the foreign equity stock markets.

The Barclays Capital Global Aggregate Index Unhedged (Barclays Global Agg Unhedged) provides a broad-based measure of global investment-gradefixed-income debt markets, including government-related debt, corporate debt, securitized debt, and global Treasuries.

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