A Great Time for Investors

(Strategy Update Winter 2014)

2013 was a very good year to own U.S. equities. It was hard to argue that the much questioned Federal Reserves economic stimulus program has not been effective given the U.S. unemployment rate fell below 7% in December, a five year low, job has been running at 200,000 newly created monthly jobs since the summer, inflation has been stable at around 1%, and major stock indices have been hitting new highs. In the last meeting of the year of the Federal Open Market Committee (FOMC), Chairman Ben Bernanke announced a tapering of the Federal Reserves bond purchasing program of $10 billion per month and issued an open ended, cautiously optimistic assessment of the state of the U.S. economy. The long-awaited Federal Reserve December tapering announcement arguably represents a turning point for many global capital markets. A level of uncertainty has been removed from U.S. monetary policy. The taper is a signal of a macroeconomic consensus that U.S. economic growth is likely to be sustainable. After years of a global recovery characterized by fits and starts, we could finally see synchronized global growth in 2014. Economists widely expect growth to accelerate modestly from 2.7% in 2013 to approximately 3.5% in 2014, primarily driven by larger advanced economies. Looking ahead to 2014, the fundamental drivers of this favorable equity market performanceaccommodative central banks and moderate but consistent US growthremain intact. These factors should be supported by new fundamental drivers in 2014, including positive European growth and Japans accelerating corporate earnings. If global earnings growth improves in 2014, investors may be in a position to build on recent gains. Specifically, US earnings growth should continue to follow the mid to high single-digit path of recent years. While European earnings have remained weak, they should improve as the European recovery strengthens. Developed economies are slowly progressing toward modest but synchronized growth, where consumers gain confidence and companies shift toward more hiring and investment. The favorable outlook for lower energy prices should allow for a more sustainable period of global growth, unlike the recent past when rising energy prices curtailed potential growth rates. That said, risks to this generally favorable outlook remain; we could experience some short-term volatility due to a jump in bond yields. Specifically, aggressive Fed tapering of its stimulative bond buying program could drive a reduction of leverage in financial markets and lead to increased volatility in asset prices. We could also see another showdown over the US debt ceiling, a fall in Japanese consumer spending driven by a legislated sales tax hike due in April, or social discontent across emerging markets if their economies underperform. With ongoing structural issues, Europe also remains a concern.

Finally, another risk could be investment risk. The U.S. equity market was a dominant performer for the quarter and year. Even perennial bulls were surprised at the robustness of U.S. equity markets. It is always tempting to overweight best performing assets when formulating an investment policy. However, investors should note that the high performing asset in one period is seldom persistently so in future periods. Given the size of the run up, it would not be very surprising to experience more limited returns and periods of downturns in 2014. Investors are well advised to consider the historical evidence of the benefits of globally well-diversified strategic portfolios for meeting longterm objectives.

Summary While there are areas of concern, economic prospects for 2014 look very favorable overall. Stronger growth should generate stronger corporate profits, a lift in confidence and a more resilient economic environment. Though many countries are engaged in a significant transition of one kind or another, US growth appears to be sustainable and the US could serve as ballast for the global economy over the next few years. The majority of the world appears to have entered the latter half of the credit cycle, meaning that rising interest rates, moderating liquidity and increasing corporate leverage could lie ahead. Stocks should continue to outperform bonds through the end of this cycle, and depending on how companies manage their capital structures going forward, corporate bonds could be poised to outperform US Treasuries for a few more years. Overall, we may be in for a generally good, improving economic and investment climate. I am more than happy to share thoughts with you in greater detail, and welcome any comments you may have. Thank you for your support.

Amin Khakiani January 20, 2014