This post is one of a series of notes on the sessions I attended at the AICPA’s 2014 Advanced Personal Financial Planning Conference. You can find links to all my notes from the conference here.
This past Monday (1.20.2014)  Rebecca Patterson, Managing Director and Chief Investment Officer at Bessemer Trust, presented her investment outlook to the attendees at the AICPA conference.
Rebecca opened her talk by asking us if we were anxious about 2014. About 1/2 the audience raised there hands (which means the other 1/2 are optimistic about 2014:-))

Risks, Worries & Concerns…

There are some good reasons for 1/2 of the advisors in the room to be nervous:
The Fed
Patterson believes that the Fed is the most important factor to watch in 2014 as it will likely be the primary driver of the markets. The Fed’s “QE” has been fueling higher stock prices. Last week the Fed balance sheet hit a new milestone…$4 Trillion. She thinks it’s likely that we will see the Fed continue to taper by reducing bond purchases at rate of $10 Billion per month. Will the end of easy money mean the end of rising stock prices?
It is important to remember that tapering isn’t tightening. Monetary policy is still easy and tapering remains a dovish stance.
However, there will be ripple effects from the Fed taper including:

  • higher longer-dated US Treasury yields
  • a stronger US Dollar
  • pressure on commodity prices
  • pressure on emerging markets

Washington
The US remains politically challenged.

  • Congress approval rating went from 9% to 12% in the last year…not very impressive! (the long-term average is 33%)
  • 2014 mid-term elections (House & Senate) may add to stock market volatility

Jobs
For the average American who loses their job today it takes 9 months to find a new job.
Government Debt
Governments don’t have much room for further fiscal stimulus.
Government Debt to GDP:

  • Japan >200%
  • Italy & portugal ~125%
  • US ~100%
  • France, Spain & Germany ~75%

Emerging Markets
Last week Brazil raised short-term interest rates (Fed’s equivalent) to 10.5%.
Emerging markets are unlikely to sustain a rally in the short-term. Valuations are attractive, but there are too many headwinds including the ripple effects of the Fed tapering.
The worst case for emerging markets: Yellen and the Fed turn out to be more hawkish than expected, and we see a repeat of last May and June where yields spike and the emerging markets come under pressure.
Watch the “Fragile Five” currencies that are under the most pressure against the US Dollar:

  1. The Brazilian real
  2. South Africa’s rand
  3. The Indian rupee
  4. Turkish Lira
  5. Indonesian rupiah

But, It’s Not All Bad…

Patterson’s most out of consensus view is that the US economy will surprise to the upside, despite all of her concerns.
The US economy is still recovering slowly, but it is moving in the right direction. Here are some things that lead Patterson to this optimistic outlook:
Exports
The US economy is currently at record exports. Why? Because the US Dollar is weak and demand from Europe and Japan is increasing.
Energy Independence
In 2008 the US produced 78% of the energy it consumed. Today, we produce 90% of the energy we consume.
Global Liquidity
…will continue to be very supportive for financial markets.
Inflation
Over the next five years we will see relatively higher inflation, but inflation is not a concern for 2014.
Europe & Japan
…are showing relative economic improvement.
China
…looks stable in the near-term, but longer-term challenges remain. China’s investment is nearly 50% of GDP, and household consumption is around 34% of GDP. China is faced with the challenge of rebalancing to a consumer based economy.
Valuations

Valuations

Presentation Slide from Rebecca Patterson, Managing Director and Chief Investment Officer at Bessemer Trust


US equity valuations are not at highs.

  • The 12-month Forward P/E of the S&P 500 is 15.4…a tiny bit above the long-term average, but not an egregious valuation.
  • This valuation is similar to the 2007 peak, but nowhere near the 200 peak of 25.2.

The market is fully priced, but Patterson wouldn’t sell stocks solely on this measure.
Market Positioning
From 1.1.2007 to 11.30.2013 cumulative net fund flows into bond funds have been $1.3 Trillion. Flows into equity funds have been $496 Billion. There was a reversal in 2013 as we started to see investors pull money out of bond funds and add to their stock funds. With interest rates as low as they are and the possibility of rising rates, this trend is expected to continue. Fund flows into equities are also likely to continue given the good year for stocks in 2013.
Profit Margins
In the near term, corporate profit margins are sustainable. Historically profit margins peak when wage growth hits 3.5%. We’re not there yet. We are a long way from meaningful wage inflation.

Conclusion & Portfolio Positioning

Patterson identified four reasons the market can go up despite valuations:

  1. Capital Flows
  2. Share Buybacks
  3. Higher Corporate Revenues
  4. Supportive Central Banks

So, what’s the bottom-line? Going into 2014 Patterson is positioning portfolios according to the following outlook:

  • Traditional Government Bonds: Down/Underweight
  • Credit: Sideways/Neutral
  • Commodities: Sideways/Neutral
  • Developed Market Equities: Up/Overweight
  • Emerging Market Equities and Debt: Sideways/Neutral
  • US Dollar: Up/Overweight
  • The firm currently has its largest overweight to equities in years.
  • “We have one of our biggest overweights in our portfolio to healthcare.”

Question: What’s your economic or investment outlook? Share your thoughts in the comments.
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