Issue 27: 2014

Future Perspective

Welcome to the Era of Innovation

The bull-market cycle should last longer than many are expecting.

Photograph by Andy Ryan

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We’re in the early stages of what stands to be an extended business cycle. We’re calling the cycle the era of innovation, and it has some definite characteristics. We’re seeing aggressive technological advancement, a manufacturing renaissance, easier access to liquidity and cash-rich entities spanning the globe, supply-demand mismatches in key industries, and lower barriers for entry for startups. Major advances are underway in areas like robotics, 3D printing, cloud computing, big data, mobile payment systems, medical technologies, energy and many others.

Five years into a 20-year bull market

Compared with many previous cycles, this new cycle could potentially be longer and more favorable to equity assets, specific macro-based mega themes and the United States in general. Why? We are in the midst of a massive global recycling of growth, and the vast scale of this transition should lead to a much longer business cycle than many are expecting.

The last cycle saw the buildup of global imbalances

In the last cycle, large surpluses in emerging markets and large deficits in developed markets were being driven by the low cost of production overseas and the ever-increasing debt of many developed-country consumers. Domestic manufacturing was an afterthought, as the United States was the world’s largest oil importer and the commodity countries were benefiting from the bulk-buying power of China, where big cities were being built practically every month in key areas of the mainland.

At the same time, the dollar weakened as U.S. borrowing from abroad surged. Europe was trying to come to grips with its single-currency economic block, European exporters were benefiting from China trade ties, and foreign exchange reserves of non-U.S. countries were being recycled back into the U.S. Treasury market to finance rising fiscal deficits. These factors kept interest rates down and subsidized the extension of the U.S. housing cycle while also keeping the U.S. consumer afloat. All of this eventually ended in the credit crisis and the Great Recession in 2008 and 2009.

This global transition is likely to lead to a long and broad cycle of equity outperformance.

Imbalances correcting themselves

This new cycle’s massive macro transition is changing the nature of asset returns in the short term as we move further past the credit crisis. More important, the bull cycle in equity assets could potentially be much longer than most investors are anticipating. In fact, U.S. Trust's investment thought leadership believes we could be five years into a two-decade-long bull market.

As the imbalances continue to correct, we can expect U.S. growth to remain higher relative to Chinese growth on a normalized basis. Emerging markets dependent on China in the last cycle should also experience lower relative growth. This should lead to lower growth overall in emerging markets compared to the last cycle. It should also lead to more consistent growth for the developed markets, led by the United States. European growth should struggle to rise and stay above 1% in the coming years as a steady deflationary breeze blows across the continent.

 


Solar panel: Thomas Winz/Getty Images; In Vitro: Shutterstock; Robot arm: Shutterstock;
Cables: Monty Rakusen/Getty Images

 

The market outlook favors equities

This global macro transition is likely to lead to a long and broad cycle of equity outperformance. Bonds should underperform as rates normalize as investors modify their investment flows to seek higher returns elsewhere. Emerging-market assets as a group should underperform relative to the previous cycle and to U.S. equities. Furthermore, the dollar should remain uptrending. U.S. manufacturing is undergoing a renaissance, there should be fewer boom-bust cycles versus the last cycle, and demand for real assets — particularly productive land — should continue to rise.

Corporations are flush with cash, balance sheets are healthy, and banking activity has perked up.

The excess return above the broader equity indexes should continue to come from many of the major themes that are the primary catalysts in this cycle. These themes are mega trends that can be placed in five broad areas: The Markets, Earth, Innovation, People and Government. Within these areas, we foresee areas of low supply and increasing demand in a number of subthemes related to global infrastructure needs, such as water scarcity, Africa’s ascent, the rising economic influence of women, demographic trends pivoting around the young and old, and — perhaps most important — technology, given the breadth and depth of its impact on a host of industries.

We believe the equity markets could rise by another 4% to 5% this year, driven by the following:

  • Profits in the United States are on track for close to 8% growth, or approximately $118 in earnings per share for the S&P 500 Index for 2014.
  • Interest rates should remain at historic lows for the foreseeable future. We still view the rate path as a grind upward on the back end in the second half of this year and a nudge upward on the front end, starting in 2015.
  • Inflation, as measured by the Federal Reserve, is creeping upward with the recent rise in wage costs but should remain within the Fed’s target zone in the near future.
  • Employment growth should be consistent with the most recent trends and help lower overall unemployment steadily between now and the end of 2015. Structural issues for long-term unemployment trends should still be dominated by demographic factors, but job activity in key-growth areas has started to rise.
  • Trends in manufacturing, new orders and inventory building have been gathering momentum after a poor first quarter dominated by severe weather conditions in much of the United States.

In addition, more micro areas such as merger-and-acquisition activity, capital expenditure growth, and U.S. housing activity are all likely to influence the amount of risk investors are willing to take. Corporations (and private equity companies) are flush with cash, balance sheets are healthy, and banking activity has perked up.

After about a two-point rise in the market multiple last year, valuation in U.S. equities has been sticky at 16- to 17-times earnings estimates for 2014, which we view as generally fair value. We do not expect much change in this valuation, so we expect return on equity in the United States to remain in line with profit growth. However, given that we are still early in the cycle for investment flows into equities, price-to-earnings multiples could rise as investor enthusiasm builds with economic momentum in the coming months.

Portfolio Considerations Click to expand
Portfolio Considerations by Asset Class

Equities and fixed income: We remain overweight equities and underweight fixed income as rising global growth and relative valuations still favor stocks over bonds.

U.S. equities: Within equities, we would emphasize U.S. equities, as we expect them to outperform their foreign peers — and other asset classes. We have slightly lowered our tactical allocations to large caps and mid caps, and would emphasize small caps.

International equities: We have reduced our allocation to international developed equities, where we remain slightly overweight. The recent rally in European equities is somewhat overdone, in our view. The European Central Bank’s latest steps are a good sign but not enough to change the long-term economic backdrop. As a result, we are market weight Europe.

Emerging market equities: We have raised emerging markets from underweight to a neutral weight, but we remain selective with a preference for Mexico, South Korea and Poland and are focused on owning what the emerging market consumer needs and buys.

Sectors: We would emphasize financials, information technology and energy. We remain neutral weight in materials, industrials and healthcare, as well as in the consumer sectors. We would underweight utilities and telecommunications.

Commodities: We have increased our recommended commodities weight to neutral.

The U.S. dollar: Our macro view implies that the dollar has ended its downtrend against other rich-country currencies and even has the potential to rise substantially against the euro and yen. However, still-too-tight European Central Bank policy has forced us to abandon our weaker euro forecast. Selected emerging market currencies (yuan, Korean won, and Taiwanese dollar) are most likely to prove exceptions to a stronger dollar.

We believe the upper end of our 1950–2000 range for 2014 and 2100–2200 for 2015 for the S&P 500 is achievable. Any volatility spikes are likely to be the result of unforeseen central-bank policy changes or geopolitical strife.

As growth in the world continues to rebalance in the years ahead, we do expect spikes in volatility, even though the overall level of volatility should remain low. And although we believe we are in the early stages of a long bull cycle, that does not mean equity returns are likely to keep pace with last year’s gains. In our view, returns should follow profit growth in the high single-digit percentages. We also caution that deep corrections are likely over the course of the cycle. Some of the current risks to our story include the Iraq insurgency and a resulting oil price spike, which could hurt consumer spending, additional fallout in Ukraine, a major central bank policy mistake, an unexpected rise in inflation, a China credit bust, and European financial distress.

Some of the current risks include the Iraq insurgency and a resulting oil price spike.

As a consequence, we need to fully diversify, allocate across the mega themes in each asset class, take advantage of the growth pockets in key sectors, and be on the lookout for stress building up in the system. We would use periods of volatility to add to equities in portfolios that are underexposed to the asset class. For investors that are fully allocated, we would maintain the current policy positioning while rebalancing to the growth themes highlighted previously. In more conservative portfolios, our get-paid-to-wait strategy of allocating to dividend-growth investments and maintaining a cash-flow bias appears most appropriate at this stage in the cycle.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Fixed Income
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities
Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.

Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.

Other
Technology stocks may be more volatile than stocks in other sectors.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.

We’re in the early stages of what stands to be an extended business cycle. We’re calling the cycle the era of innovation, and it has some definite characteristics. We’re seeing aggressive technological advancement, a manufacturing renaissance, easier access to liquidity and cash-rich entities spanning the globe, supply-demand mismatches in key industries, and lower barriers for entry for startups. Major advances are underway in areas like robotics, 3D printing, cloud computing, big data, mobile payment systems, medical technologies, energy and many others.

Five years into a 20-year bull market

Compared with many previous cycles, this new cycle could potentially be longer and more favorable to equity assets, specific macro-based mega themes and the United States in general. Why? We are in the midst of a massive global recycling of growth, and the vast scale of this transition should lead to a much longer business cycle than many are expecting.

The last cycle saw the buildup of global imbalances

In the last cycle, large surpluses in emerging markets and large deficits in developed markets were being driven by the low cost of production overseas and the ever-increasing debt of many developed-country consumers. Domestic manufacturing was an afterthought, as the United States was the world’s largest oil importer and the commodity countries were benefiting from the bulk-buying power of China, where big cities were being built practically every month in key areas of the mainland.

At the same time, the dollar weakened as U.S. borrowing from abroad surged. Europe was trying to come to grips with its single-currency economic block, European exporters were benefiting from China trade ties, and foreign exchange reserves of non-U.S. countries were being recycled back into the U.S. Treasury market to finance rising fiscal deficits. These factors kept interest rates down and subsidized the extension of the U.S. housing cycle while also keeping the U.S. consumer afloat. All of this eventually ended in the credit crisis and the Great Recession in 2008 and 2009.

This global transition is likely to lead to a long and broad cycle of equity outperformance.

Imbalances correcting themselves

This new cycle’s massive macro transition is changing the nature of asset returns in the short term as we move further past the credit crisis. More important, the bull cycle in equity assets could potentially be much longer than most investors are anticipating. In fact, U.S. Trust's investment thought leadership believes we could be five years into a two-decade-long bull market.

As the imbalances continue to correct, we can expect U.S. growth to remain higher relative to Chinese growth on a normalized basis. Emerging markets dependent on China in the last cycle should also experience lower relative growth. This should lead to lower growth overall in emerging markets compared to the last cycle. It should also lead to more consistent growth for the developed markets, led by the United States. European growth should struggle to rise and stay above 1% in the coming years as a steady deflationary breeze blows across the continent.

 


Solar panel: Thomas Winz/Getty Images; In Vitro: Shutterstock; Robot arm: Shutterstock;
Cables: Monty Rakusen/Getty Images

 

The market outlook favors equities

This global macro transition is likely to lead to a long and broad cycle of equity outperformance. Bonds should underperform as rates normalize as investors modify their investment flows to seek higher returns elsewhere. Emerging-market assets as a group should underperform relative to the previous cycle and to U.S. equities. Furthermore, the dollar should remain uptrending. U.S. manufacturing is undergoing a renaissance, there should be fewer boom-bust cycles versus the last cycle, and demand for real assets — particularly productive land — should continue to rise.

Corporations are flush with cash, balance sheets are healthy, and banking activity has perked up.

The excess return above the broader equity indexes should continue to come from many of the major themes that are the primary catalysts in this cycle. These themes are mega trends that can be placed in five broad areas: The Markets, Earth, Innovation, People and Government. Within these areas, we foresee areas of low supply and increasing demand in a number of subthemes related to global infrastructure needs, such as water scarcity, Africa’s ascent, the rising economic influence of women, demographic trends pivoting around the young and old, and — perhaps most important — technology, given the breadth and depth of its impact on a host of industries.

We believe the equity markets could rise by another 4% to 5% this year, driven by the following:

  • Profits in the United States are on track for close to 8% growth, or approximately $118 in earnings per share for the S&P 500 Index for 2014.
  • Interest rates should remain at historic lows for the foreseeable future. We still view the rate path as a grind upward on the back end in the second half of this year and a nudge upward on the front end, starting in 2015.
  • Inflation, as measured by the Federal Reserve, is creeping upward with the recent rise in wage costs but should remain within the Fed’s target zone in the near future.
  • Employment growth should be consistent with the most recent trends and help lower overall unemployment steadily between now and the end of 2015. Structural issues for long-term unemployment trends should still be dominated by demographic factors, but job activity in key-growth areas has started to rise.
  • Trends in manufacturing, new orders and inventory building have been gathering momentum after a poor first quarter dominated by severe weather conditions in much of the United States.

In addition, more micro areas such as merger-and-acquisition activity, capital expenditure growth, and U.S. housing activity are all likely to influence the amount of risk investors are willing to take. Corporations (and private equity companies) are flush with cash, balance sheets are healthy, and banking activity has perked up.

After about a two-point rise in the market multiple last year, valuation in U.S. equities has been sticky at 16- to 17-times earnings estimates for 2014, which we view as generally fair value. We do not expect much change in this valuation, so we expect return on equity in the United States to remain in line with profit growth. However, given that we are still early in the cycle for investment flows into equities, price-to-earnings multiples could rise as investor enthusiasm builds with economic momentum in the coming months.

Portfolio Considerations Click to expand
Portfolio Considerations by Asset Class

Equities and fixed income: We remain overweight equities and underweight fixed income as rising global growth and relative valuations still favor stocks over bonds.

U.S. equities: Within equities, we would emphasize U.S. equities, as we expect them to outperform their foreign peers — and other asset classes. We have slightly lowered our tactical allocations to large caps and mid caps, and would emphasize small caps.

International equities: We have reduced our allocation to international developed equities, where we remain slightly overweight. The recent rally in European equities is somewhat overdone, in our view. The European Central Bank’s latest steps are a good sign but not enough to change the long-term economic backdrop. As a result, we are market weight Europe.

Emerging market equities: We have raised emerging markets from underweight to a neutral weight, but we remain selective with a preference for Mexico, South Korea and Poland and are focused on owning what the emerging market consumer needs and buys.

Sectors: We would emphasize financials, information technology and energy. We remain neutral weight in materials, industrials and healthcare, as well as in the consumer sectors. We would underweight utilities and telecommunications.

Commodities: We have increased our recommended commodities weight to neutral.

The U.S. dollar: Our macro view implies that the dollar has ended its downtrend against other rich-country currencies and even has the potential to rise substantially against the euro and yen. However, still-too-tight European Central Bank policy has forced us to abandon our weaker euro forecast. Selected emerging market currencies (yuan, Korean won, and Taiwanese dollar) are most likely to prove exceptions to a stronger dollar.

We believe the upper end of our 1950–2000 range for 2014 and 2100–2200 for 2015 for the S&P 500 is achievable. Any volatility spikes are likely to be the result of unforeseen central-bank policy changes or geopolitical strife.

As growth in the world continues to rebalance in the years ahead, we do expect spikes in volatility, even though the overall level of volatility should remain low. And although we believe we are in the early stages of a long bull cycle, that does not mean equity returns are likely to keep pace with last year’s gains. In our view, returns should follow profit growth in the high single-digit percentages. We also caution that deep corrections are likely over the course of the cycle. Some of the current risks to our story include the Iraq insurgency and a resulting oil price spike, which could hurt consumer spending, additional fallout in Ukraine, a major central bank policy mistake, an unexpected rise in inflation, a China credit bust, and European financial distress.

Some of the current risks include the Iraq insurgency and a resulting oil price spike.

As a consequence, we need to fully diversify, allocate across the mega themes in each asset class, take advantage of the growth pockets in key sectors, and be on the lookout for stress building up in the system. We would use periods of volatility to add to equities in portfolios that are underexposed to the asset class. For investors that are fully allocated, we would maintain the current policy positioning while rebalancing to the growth themes highlighted previously. In more conservative portfolios, our get-paid-to-wait strategy of allocating to dividend-growth investments and maintaining a cash-flow bias appears most appropriate at this stage in the cycle.

IMPORTANT INFORMATION

Investing involves risk. There is always the potential of losing money when you invest in securities.

Projections made may not come to pass due to market conditions and fluctuations.

Past performance is no guarantee of future results. Asset allocation, diversification and rebalancing do not ensure a profit or protect against loss in declining markets.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

Equities
Equity securities are subject to stock market fluctuations that occur in response to economic and business developments.

Stocks of small and mid cap companies pose special risks, including possible illiquidity and greater price volatility, than stocks of larger, more established companies.

Fixed Income
Investing in fixed-income securities may involve certain risks, including the credit quality of individual issuers, possible prepayments, market or economic developments, and yields and share price fluctuations due to changes in interest rates. When interest rates go up, bond prices generally drop, and vice versa.

Treasury bills are less volatile than longer-term fixed-income securities and are guaranteed as to timely payment of principal and interest by the U.S. government.

International Investing
International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards, and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility.

Commodities
Trading in commodities, such as gold, is speculative and can be extremely volatile. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest-rate changes, credit risk, economic changes and the impact of adverse political or financial factors. Tangible assets can fluctuate with supply and demand, such as commodities, which are liquid investments, unlike most other tangible investments.

Energy and natural resources stocks have been volatile. They may be affected by rising interest rates and inflation, and can also be affected by factors such as natural events (for example, earthquakes or fires) and international politics.

Other
Technology stocks may be more volatile than stocks in other sectors.

Dividend payments are not guaranteed. The amount of a dividend payment, if any, can vary over time.

The Standard & Poor’s (S&P) 500 index tracks the performance of 500 widely held, large capitalization U.S. stocks.