Markets in Focus TD Wealth Private Investment Counsel Winter 2014 Issue 2 The road ahead: Investment outlook for 2014 By Robert J. Gorman, CFA, Chief Portfolio Strategist, TD Wealth As we enter 2014, it is a good time to review what transpired in 2013 and what lies ahead. The defining issues of 2014, positive and negative, will likely reside in the U.S., which is where we focus much of our attention. Looking back on 2013 Let’s examine what we had anticipated would unfold in 2013 and what actually happened. 1. We expected U.S. stocks to rise for a fifth successive year and post a high single-digit total return in 2013. We reasoned that the U.S. would not go over the feared “fiscal cliff,” though there would be some resultant fiscal drag on the economy, which was indeed evident. We also thought that a combination of recovering housing market, solid auto sector, revitalized manufacturing sector and brightening energy outlook would combine with reasonable valuations and supportive monetary policy to generate another year of solid returns. The Standard & Poor’s 500 Index (S&P 500) did, in fact, advance again in 2013, exceeding our forecast with a double-digit return. 2. U.S. large-capitalization stocks (large caps) would outperform smaller companies’ shares. This was not the case as the small cap Russell 2000 Index outperformed the S&P 500 in 2013, as investors took on more risk seeking greater returns. Our short list of preferred U.S. names generally fared well. Dividend growth stocks Johnson & Johnson and Home Depot both posted strong gains, while the technology sector lagged. Oracle recorded a mid-single- digit advance while IBM was down marginally. Within the financial sector, both J.P. Morgan and Wells Fargo posted very good total returns. Meanwhile, in a lacklustre resource group, Exxon-Mobil and Freeport-McMorran managed to notch solid returns. 3. The S&P/TSX Composite Index (S&P/TSX) was expected to rise 5 – 6%, with the less economically sensitive sectors once again outperforming the resource sectors. This was largely the case, as dividend growth stocks again dominated performance. At the time of writing (early December), the S&P/TSX was slightly ahead of our forecast. Among our focused list of Canadian stocks were Royal Bank and Bank of Nova Scotia, both of which generated robust, double- digit returns. Shaw Communications was among the strongest performers in its sector for a second year, while Brookfield Asset Management fared well as its operating performance improved. Suncor did well, outperforming its peer group for the second successive year, while Teck Resources fell due to continuing weak metal and coal prices. 4. Bond returns were expected to be modest, in the 0 – 2% range. This was indeed the case, with investment grade corporate bonds faring better than government issues.
Transcript
Markets in Focus TD Wealth Private Investment Counsel
Winter 2014Issue 2
The road ahead: Investment outlook for 2014ByRobertJ.Gorman,CFA,ChiefPortfolioStrategist,TDWealth
As we enter 2014, it is a good time to review what transpired in 2013 and what lies ahead. The defi ning issues of 2014, positive andnegative,willlikelyresideintheU.S.,whichiswherewefocusmuch of our attention.
Looking back on 2013Let’s examine what we had anticipated would unfold in 2013 and what actually happened.
1. We expected U.S. stocks to rise for a fi fth successive year and post a high single-digit total return in 2013. We reasoned that the U.S.wouldnotgooverthefeared“fiscalcliff,”thoughtherewouldbesome resultant fi scal drag on the economy, which was indeed evident. We also thought that a combination of recovering housing market, solid auto sector, revitalized manufacturing sector and brightening energy outlook would combine with reasonable valuations and supportive monetary policy to generate another year of solid returns. The Standard & Poor’s 500 Index (S&P 500) did, in fact, advance again in 2013, exceeding our forecast with a double-digit return.
2. U.S. large-capitalization stocks (large caps) would outperform smaller companies’ shares. This was not the case as thesmallcapRussell2000IndexoutperformedtheS&P500in2013,as investors took on more risk seeking greater returns. Our short list ofpreferredU.S.namesgenerallyfaredwell.DividendgrowthstocksJohnson & Johnson and Home Depot both posted strong gains, while the technology sector lagged. Oracle recorded a mid-single-digit advance while IBM was down marginally. Within the fi nancial sector, both J.P. Morgan and Wells Fargo posted very good total returns. Meanwhile, in a lacklustre resource group, Exxon-Mobil and Freeport-McMorran managed to notch solid returns.
3. The S&P/TSX Composite Index (S&P/TSX) was expected to rise 5 – 6%, with the less economically sensitive sectors once again outperforming the resource sectors. This was largely the case, as dividend growth stocks again dominated performance. At the
time of writing (early December), the S&P/TSX was slightly ahead of our forecast.
Among our focused list of Canadian stocks were Royal Bank and Bank of Nova Scotia, both of which generated robust, double-digit returns. Shaw Communications was among the strongest performers in its sector for a second year, while Brookfi eld Asset Management fared well as its operating performance improved. Suncor did well, outperforming its peer group for the second successive year, while Teck Resources fell due to continuing weak metal and coal prices.
4. Bond returns were expected to be modest, in the 0 – 2% range. This was indeed the case, with investment grade corporate bonds faring better than government issues.
2Markets in Focus Winter 2014
5. Northern Europe exchanges were once again forecast to be top international performers and the MSCI Europe Index did post very good returns. Our picks in the consumer sector, Diageo and Nestlé, both registered another year of very good returns, as did Swiss pharmaceutical fi rm Novartis. BP bounced back strongly in 2013, while Vodafone was a stellar performer, benefitingfromVerizon’sbidforVodafone’s45%interestinVerizonWireless. The sole loser among our top international picks was Standard Chartered Bank, down slightly refl ecting weakness in the Asian economies where Standard Chartered operates.
6. Emerging markets were expected to continue their recovery which commenced in 2012. This did not take place, as risingbondyieldsinmajordevelopedmarketstriggeredoutflowsfrom emerging economies and contributed to falling currencies and declining stock markets.
What’s in store for 2014Our overriding message is that we continue to favour stocks over bonds in 2014.
1. We expect U.S. equities to continue to advance for a sixth consecutive year, despite some noteworthy risks:Risk 1: Tapering of Quantitative Easing. The anticipated and much feared withdrawal of Quantitative Easing (QE) is a risk in 2014.
Potential QE tapering will almost certainly dominate the headlines andcauseshort-termvolatility;however,webelieveinvestors’worstfearswilllikelynotberealized.First,U.S.FederalReserve(the“Fed”)ChairBenBernankeandhissuccessor,JanetYellin,have stated that tapering will only take place when economic growth is suffi cient.
This was well illustrated in September, when the widely anticipated, initial reduction in bond purchases did not take place, as the pace of the recoverywasdeemedinsufficient.Secondly,BenBernankehasoftenstatedthattheGreatDepressionofthe1930swaslengthenedbythepremature withdrawal of stimulus. The Fed’s actions to date suggest it will be very cautious and attempt not to repeat the same mistake.
Thirdly, while tapering of QE will reduce demand for bonds, this will bepartlyoffsetbyreducedsupply,astheU.S.federaldeficithasdropped from well over $1 trillion at its peak to $670 billion in the fi scal yearendingSeptember30,2013.TheCongressionalBudgetOffice’sUpdatedBudgetProjectionsDocumentexpectsthedeficittofallto$370billioninfiscal2015.Finally,theFedFundsRatewillverylikelystay near zero until 2015, which is supportive of the economy and fi nancial markets.
Overall, while there is risk attached to withdrawal of Quantitative Easing, the associated fear will likely prove greater than the impact.
Risk 2: Simultaneous reduction of monetary & fi scal stimulus. As indicated above, we anticipate some reduction of QE (monetary stimulus)andtheU.S.federaldeficit(fiscalstimulus)intheyear
ahead. Will cutting back on both sources of support for the economy imperil growth in 2014?
We doubt it. Aside from the many factors that are currently supportingU.S.stocks,weseeanincreaseinU.S.consumerspending on the horizon, as households no longer have to focus soheavilyonpayingdowndebt.By2007,nearthepeakofthehousingbubble,Americanhouseholddebtapproached140%ofdisposable income. During the gradual recovery from the credit crisis,U.S.households,accordingtotheFed,sharplyreducedtheirdebt—to120%ofdisposableincomeby2011;115%by2012;andabout106%today.
Asaresult,U.S.households,whichtheCommerceDepartmentstatesaccountfor70%ofGDP,willbeabletodirectmoreoftheirincometo spending, rather than paying down debt, which will help offset reductionsinpublicsectorstimulus.TDEconomicsprojectsanincreaseinU.S.GDPgrowthto2.6%in2014,fromlessthan2%in2013.
Risk 3: External factors: Europe, China & Iran. Last year, we stated that Europe’s travails, including sovereign debt, would not likely have a majornegativeimpactonU.S.stocks.Todate,thishasbeenthecase,andboththeEuropeanUnionandEurocurrencyremainintact.Inthesecond quarter of 2013, the Eurozone economy stopped shrinking and posted its fi rst, modest quarterly growth in years, which was again repeatedinQ3.TDEconomicsprojectsthatEurope’seconomywillgrowby1%in2014,whichwouldmakeitthefirstyearinwhichallmajoreconomies record growth since the credit crisis of 2008.
China, we reasoned, would not suffer the hard landing feared by many and would instead see a moderation in its growth. SubsequentChineseGDPandPurchasingManagersIndexdataseem to support our view and, while excesses are evident in both China’s credit markets and real estate, overall China-related risks have declined.
We had characterized military intervention in Iran as a low-probability event, but a risk that nonetheless dictated prudent oil exposure in client portfolios. The recent agreement with Iran regarding its nuclear
3Markets in Focus Winter 2014
program further reduces this risk but does not eliminate it. We maintain select oil investments in our portfolios.
Overall, we believe global risks continue to diminish, a key reason the TD Wealth Asset Allocation Committee eliminated the last of our tactical position in gold Exchange Traded Funds in the spring of 2013.
Positive factors for U.S. stocks. The six factors cited a year ago in support of our positive outlook are generally intact and briefly updated below:
•Housing recovery continues. Boththeinventoryofunsoldhomesand shadow inventory (the current supply of pending foreclosures) have been halved since their peak. Affordability remains very good andhouseholdformationissolid,reflectingdecentjobgrowth.WeexpectU.S.housingstartstorisetoover1millionin2014.
•Auto industry powers ahead.ThereplacementcycleforU.S.autos should continue, as the average car on the American road is now 11.4 years old according to Polk auto analysts, up from 11.1 years old, twelve months ago.
•U.S. manufacturing’s revitalization picks up steam. Continued narrowing of the skilled wage gap with China, a rising Chinese renminbi, escalating transportation costs for Chinese exports and cheaper AmericannaturalgasarerepatriatingmanufacturingjobstotheU.S.
•U.S. energy outlook continues to improve. American daily oil consumption, which was 21 million barrels in 2005 and 19 million barrels a year ago, has declined further to 18.6 million today,evenasU.S.oilproductioncontinuestorise.Theresult,theU.S.EnergyInformationAgencyreports,isthatimportedoilisnowlessthan40%ofconsumption for the first time since 1991 which, together with abundant natural gas, improvesU.S.growthprospects.
•Valuations are only fair. The S&P 500 is currently trading at about 16.4 times estimated 2013 earnings of $110 and 15.5 times our 2014 earnings estimate of $116.Bothmultiplesarehigherthanthoseof a year ago and represent reasonable but not exceptional value. Meanwhile, stocks’ earnings yield (earnings per share/share price) ofaround6%remainswellabovethe10-yearU.S.Treasuryyieldoflessthan3%,makingstocks better value than bonds.
•Monetary policy is accommodative, though less so. TheFedFundsRatewillremaininthe0–0.25%rangeuntil2015.QE will be only gradually withdrawn, thus monetary policy will be supportive but less so than has been the case.
Overall, we believe the positive factors outweigh the negative, and that the S&P 500 will rise for a sixth successive year. However, it is improbable price-earnings (P/E) ratios will expand further in a climate of less expansive monetary policy. As a result, we expect the S&P 500 to advanceinlinewithearningsgrowthofover5%which,togetherwithdividends,shouldgeneratetotalreturnsinthe7%range.
2. We expect a rotation into U.S. large caps in 2014.American small caps outperformed in 2013, opening up a substantial valuation gap versus the larger, cheaper household names. We believe this is not sustainable, particularly in the face of improving global growth that will disproportionately benefit larger, more internationally oriented companies.
Within the dividend growth stock category, United Health Groupshould benefit from its current low valuation and solid growth prospects, while we expect Home Depot should ride the recovery in housing and renovations. Technology staples Oracle and Cisco Systems have endured several poor quarters, trade at depressed valuations and will likely fare better as business investment picks up. We continue to favour J.P. Morgan and Wells Fargo among the financials, Freeport-McMorran in resources and United Parcel Service in the transportation sector, as a beneficiary of escalating online shopping.
3. The S&P/TSX and S&P 500 should see their returns converge in 2014. After three years of pronounced underperformance (see Chart), the S&P/TSX should advance in line with the S&P 500, both indicesreflectingsimilarearningsgrowthofabout5%.Canadianstockswith both a history and prospect of increasing dividends will likely
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S&P/TSX Composite Index S&P 500 Index
CanadianandU.S.stocksexpectedtoriseintandemin2014
S&P/TSX Composite vs. S&P 500 (2011-2013)Source:ThomsonReuters
After soundly underperforming the S&P 500 over the past three years, the S&P/TSX is expected to close the gap in 2014.
4Markets in Focus Winter 2014
continue to dominate, though the depressed resource groups should demonstrate improved relative performance as synchronous global growth provides a modest tailwind.
Among the banks, Bank of Nova Scotia should benefit from its international holdings in 2014. Power Corporation affords good exposure to life insurance, the potential to benefit from any rise in bond yields, a reasonable valuation and a good dividend yield. Rogers Communications has lost some market share, is currently out of favour and should benefit from its new CEO, ex of Vodafone. Brookfield Asset Management’s three core businesses of office properties, infrastructure and renewable energy seem poised to again do well in 2014 while Suncor’s growing free cash flow augurs well and Teck Resources’ risk/reward relationship seems favourable.
4. Bond returns will likely be modest again, in the 1 – 3% range.Potential bond returns seem limited as coupons remain modest, especially for government issues and yields, which could well edge higher in 2014. We continue to prefer investment-grade corporate bonds for their combination of higher coupons and shorter duration.
5. Major international markets should see their returns converge with those of the S&P/TSX and S&P 500, reflecting a combination of mid-single digit earnings growth and dividends. We maintain market exposure in Japan, which is benefiting from expansive monetary policy, while Europe should advance again as the Eurozone tentatively emerges from recession and the global economy has its first year of synchronous growth since the credit crisis.
Familiar consumer names Diageo and Nestlé should again do well, and BP still represents good value. We added Roche Holdings, which has a strong pipeline of new drugs under development, to our Novartis
position in the pharmaceutical sector, while Standard Chartered Bankshould recover along with the Asian economies in which it operates.
6. After a disappointing 2013, we expect emerging markets to recover in 2014 and post returns that are in line with major markets. While reforms being initiated by new leadership within China’s politburo and India’s central bank are encouraging and valuations are not unreasonable, we do not see sufficient market strength for an overweight position at this time.
In summary, we anticipate stocks will again outperform bonds in 2014 and large caps will best smaller-cap stocks. After three years of widely divergent results, we expect the S&P/TSX and S&P 500 to converge in 2014, along with those of European stock markets. Equities characterized by substantial, rising dividends will likely dominate for another year, though a year of synchronous global growth will provide a modest tailwind for more economically sensitive sectors.
• Slightequityoverweightinmajorinternationalmarkets;neutral in emerging markets
Percentage return for indices1
(For the period September 15, 2013 – December 15, 2013)
DEXUniverseBondIndex 2.11%
S&P/TSXCompositeIndex 3.16%
S&P500Index 5.17%
MSCIEAFEIndex 1.79%
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1. The index returns are shown for comparative purposes only. Indices are unmanaged and their returns do not include any sales, charges or fees, as such costs would lower performance. It is not possible to invest directly in an index. The information in this newsletter is current as at December 16, 2013, and does not necessarily reflect subsequent market events and conditions. The information contained herein has been provided by TD Wealth Private Investment Counsel and is for information purposes only. The information has been drawn from sources believed to be reliable. Where such statements are based in whole or in part on information provided by third parties, they are not guaranteed to be accurate or complete. Graphs and charts are used for illustrative purposes only and do not reflect future values or future performance of any investment. The information does not provide financial, legal, tax or investment advice. Particular investment or trading strategies should be evaluated relative to each individual’s objectives and risk tolerance. TD Wealth Private Investment Counsel, The Toronto-Dominion Bank and its affiliates and related entities are not liable for any errors or omissions in the information or for any loss or damage suffered. The Toronto-Dominion Bank and its affiliates and/or its officers, directors, subsidiaries or representatives may hold some of the securities mentioned herein and may from time to time purchase and/or sell same on the stock market or otherwise. No endorsement of any third-party products, services or information is expressed or implied by any information, material or content referred to or included in this newsletter. Certain statements in this document may contain forward-looking statements (“FLS”) that are predictive in nature and may include words such as “expects”, “anticipates”, “intends”, “believes”, “estimates” and similar forward-looking expressions or negative versions thereof. FLS are based on current expectations and projections about future general economic, political and relevant market factors, such as interest and foreign exchange rates, equity and capital markets, the general business environment, assuming no changes to tax or other laws or government regulation or catastrophic events. Expectations and projections about future events are inherently subject to risks and uncertainties, which may be unforeseeable and may be incorrect in the future. FLS are not guarantees of future performance. Actual events could differ materially from those expressed or implied in any FLS. A number of important factors including those factors set out above can contribute to these digressions. You should avoid placing any reliance on FLS. TD Waterhouse Private Investment Counsel Inc. may not update any FLS. The TD Wealth Asset Allocation Committee (“WAAC”) is comprised of a diverse group of TD investment professionals. The WAAC’s mandate is to issue quarterly market outlooks which provide its concise view of the upcoming market situation for the next six to eighteen months. The WAAC’s guidance is not a guarantee of future results and actual market events may differ materially from those set out expressly or by implication in the WAAC’s quarterly market outlook. The WAAC market outlook is not a substitute for investment advice. TD Wealth Private Investment Counsel represents the products and services offered by TD Waterhouse Private Investment Counsel Inc., a subsidiary of The Toronto-Dominion Bank. All trade-marks are the property of their respective owners. ® The TD logo and other trade-marks are the property of The Toronto-Dominion Bank.
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