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© 2014, JANNEY MONTGOMERY SCOTT LLC 2 Non-inflationary growth continues in the U.S. Longer-than-average economic expansion, extended by job growth and business spending. Global trends impart deflationary pressures, suppressing global bond and cash yields. Full equity valuations in the U.S. increase vulnerability to corrective bouts. Substantial multiple expansion unlikely, unless the market is staging toward a bubble. Mid-upper single-digit profit growth will boost share prices. Volatility will increase as news gyrates across a multi-speed world. The dollar will grind higher, as non-U.S. growth is slow or slowing. Secular rally partially attributed to divergent central bank policies. Currency strength tempers inflation, but saps multinational export activity. Federal Reserve policy will remain uber-accommodative. Increasingly complicated narrative, with zero bound rates intersecting market expectations. Lift-off date may be pushed further out than currently projected. Foreign central banks adopt liquidity policies to stoke growth and inflation. Many countries are struggling with weak economies and disinflation. Competitive devaluation via monetary intervention could lead to currency skirmishes. Talking Points
© 2014, JANNEY MONTGOMERY SCOTT LLC 3 Economic growth will remain positive, but at or below trend. Source: Janney ISG, BEA Source: Janney ISG ISM Source: Janney ISG, Conference Board Source: Janney ISG ISM 5 ½ years and more No sign of losing momentum
© 2014, JANNEY MONTGOMERY SCOTT LLC 4 Job growth will drive consumer confidence and spending. Source: Janney ISG, BLS Source: Janney ISG Conference Board Source: Janney ISG, BEA Source: Janney ISG BEA The key to a self reinforcing expansion Above pre-recession levels Economic driver
© 2014, JANNEY MONTGOMERY SCOTT LLC 5 The wherewithal to spend has improved immensely. Source: Janney ISG, Federal Reserve $82 Trillion is 20% higher than previous peak in 2007 Serviceable debt levels
© 2014, JANNEY MONTGOMERY SCOTT LLC 6 Business spending will provide an incremental tailwind. Source: Janney ISG, U.S. Census BureauSource: Janney ISG, NFIB Trending higher Recovering
© 2014, JANNEY MONTGOMERY SCOTT LLC 7 $0.87 decline in 6 mos. adds 0.5% to U.S. economic growth. Source: Janney ISG, AAA Lowest in 4 years! “Tax cut”
© 2014, JANNEY MONTGOMERY SCOTT LLC 8 The housing market will boost economic activity. Source: Janney ISG, NAHB Source: Janney ISG U.S. Census Bureau Source: Janney ISG, U.S. Census Bureau Source: Janney ISG Federal Reserve Creating more homeowner equity
© 2014, JANNEY MONTGOMERY SCOTT LLC 9 U.S. dollar strength will continue. Source: Janney ISG, Bloomberg A secular bull market is underway!
© 2014, JANNEY MONTGOMERY SCOTT LLC 10 Global economic surprise indices have hooked up: Growth is weak in Europe while slowing in China, but the news has stopped worsening. Japan is in a VAT-induced recession but growth will resume and deflation has ended. Emerging markets most often depend on China to pull their economies, so a rebound in the Chinese economy will drive EM activity. Recent signs point to improving conditions abroad. Source: Janney ISG Citigroup Source: Janney ISG, Citigroup Source: Janney ISG Citigroup
© 2014, JANNEY MONTGOMERY SCOTT LLC 11 Valuations are no longer cheap, while volatility is unusually low. U.S. equity markets will require unambiguous good news. The highest trailing P/E of the last decade outside of the earnings meltdown during the financial crisis. Volatility gauge near historic lows Source: Janney ISG, Standard and Poor’s, BloombergSource: Janney ISG, CBOE, Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 12 Lean toward large company stocks. –Dividend payers are preferred. –High conviction sectors include: Business-facing technology companies. Financials such as banks and brokers. Healthcare – including medical device and pharmaceutical companies. Rebalance to domestic-oriented stocks and sectors. –Consumer areas primed to get a boost from lower gas prices. –Defensive sectors, such as Utilities and Consumer Staples, temper volatility. Consider the out-of-favor energy sector for high dividends. –Major integrated oils and large servicers are attractively valued. –Barring a global collapse, energy prices are likely to work higher. What to do with U.S. equities?
© 2014, JANNEY MONTGOMERY SCOTT LLC 13 Our favorites are: –European equities Terrible sentiment is shifting positively. Valuations assume no economic improvement. Credit cycle is poised to turn, as lending expands. Operational gearing/GDP is twice that of the U.S. –Japanese equities (hedged) Price-to-cash flow is well below global markets. Currency decline increases competitiveness of exporters. Policymakers are pushing market-friendly reforms. Government Pension Investment Fund significantly raised its equity allocation. Pivot to non-U.S. equity markets.
© 2014, JANNEY MONTGOMERY SCOTT LLC 14 Eurozone: Restoring The Flow Of Credit Is A Prerequisite For Recovery Lending restraint in Europe is about to end. Source: © BCA Research 2014
© 2014, JANNEY MONTGOMERY SCOTT LLC 15 Poised to converge from a positive surprise. 40% discount Cyclically adjusted P/E ratios (Shiller P/E) Source: Thomson Reuters
© 2014, JANNEY MONTGOMERY SCOTT LLC 16 Japanese equities have responded favorably to the weakened yen. Further efforts by the Bank of Japan to stoke inflation and growth will weigh on the yen’s value. The $1.2 trillion Government Pension Investment Fund made a significant shift to weight more in equities. Tactically buy Japanese equities hedged to negate the dollar/yen cross. Japanese equities will rise on currency devaluation. The Yen has lost over 45% of its value against the U.S. Dollar in 2 years Japanese equities have nearly doubled in 2 years Source: Janney ISG, Bloomberg Source: Janney ISG Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 17 Select emerging markets offer appeal. Source: Janney ISG, Bloomberg Emerging market investing is increasingly nuanced. A decade of fiscal mismanagement and capital misallocation will need to be addressed. Invest in economies undertaking structural reforms. –China – Liberalizing financial markets and establishing rule of law. –Mexico – Opening its massive oil fields to third-party investments. –Vietnam – Economic reforms and recipient of huge foreign investments. Cheap!
© 2014, JANNEY MONTGOMERY SCOTT LLC 18 Massive balance sheet expansions being undertaken to reflate growth. European Central Bank scheduled to purchase 1.3 trillion euro dollars of fixed securities in the next two years. The Bank of Japan is on pace to hold assets equal to 56% of the country’s GDP by year-end (U.S. holds 25% of the equivalent). Central banks gone wild. ECB to rebuild asset levels to 2012 in next 2 years Explosive liquidity by buying Japanese bonds, ETFs, and equities Source: Janney ISG, ECB, BloombergSource: Janney ISG, BOJ, Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 19 Federal Reserve policy is diverging with global central banks. The Fed has terminated its bond-buying binge, and is debating the lift-off date for moving interest rates higher. Expectations of a mid-year change from zero-bound rates may shift outward. Low inflation and dollar strength could defer any rate hike to late 2015, even 2016. $800 Billion to $4.5 Trillion but holding Source: Janney ISG, Federal Reserve
© 2014, JANNEY MONTGOMERY SCOTT LLC 20 Competitive devaluation could cause a currency skirmish. Japan and China are among the largest economies and largest exporters in the world. Devaluing a currency can lift export activity, as it makes a country’s goods cheaper for outside buyers. With many countries shipping similar goods and competing in the markets, a stronger currency can be a competitive disadvantage. Countries like China, South Korea and others, may be forced to intervene, even at the risk of being viewed as a currency manipulator. Applying this to other countries competing for a share of global trade could ignite tensions, leading to protectionism or price wars. Source: Janney ISG, Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 21 How low can you go? A world awash in liquidity and a non-trivial threat of deflation warrants low yields. The historic absurdity of the table below demonstrates why U.S. bonds can remain well-bid. Bond yields in the U.S. may drift higher, but short of another “taper tantrum,” yields will remain low. Indicates low inflation and feeble economic growth. GOVERNMENT BOND TWO-YEAR YIELD* Germany–0.046% Belgium–0.017% Netherlands–0.014% Austria–0.011% France–0.001% America0.524% *Data supplied by Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 22 The Federal Reserve judges the economy by, among other things, inflation expectations. The top panel indicates 5-year inflation expectations, set five years from now, are actually falling. A monthly consumer survey by the University of Michigan recently reported the same. No inflation of significance for the foreseeable future. US: 5Y/5Y Forward CPI Swap Rate Source: © BCA Research 2014
© 2014, JANNEY MONTGOMERY SCOTT LLC 23 The lack of inflation in almost any economy assures that a wide-open monetary policy will be shared around the world. Of 46 central banks in the world that have a stated inflation policy, 30 are in countries with inflation running below target. Global disinflation will ensure further financial repression. Source: Janney ISG, Bloomberg
© 2014, JANNEY MONTGOMERY SCOTT LLC 24 The path of least resistance for the dollar remains upward, and wage inflation is only slowly awakening from its long slumber—both offer enough reasons not to expect an imminent increase in bond yields. Bonds offer strategic value for multiple purposes: –To provide a predictable stream of income. –To temper the volatility of equities in a balanced portfolio. –To match a liability with a targeted maturity. Bond yields sufficiently high to offer a coupon at par of historic proportion are not likely to be seen this year, and perhaps beyond. A likely intervention by the Federal Reserve, if it felt the need to reset rate expectations, would be to shift its fed funds forecasts (via the inventive dot matrix). The bond conundrum.
© 2014, JANNEY MONTGOMERY SCOTT LLC 25 A structural bear market may be underway for commodities. Each decade tends to build a new bubble candidate, and commodities (using iron ore as a proxy) were last decade’s fancy. A stronger dollar, abundant capacity, and China’s “new normal” growth rate, conspire to undermine the commodity complex. We favor palladium (a replay of last year’s top pick), as its use in auto catalysts can grow to overcome the currency–induced pressure applied to many other metals and minerals. Commodities will continue to suffer. Commodity Prices in Real Terms Source: © BCA Research 2014
© 2014, JANNEY MONTGOMERY SCOTT LLC 26 A summation of our favored investments for 2015 follows: Risk assets – stocks – will once again provide the best potential for capital growth. U.S. stocks are fully valued, but prices have room to rise on profit growth. –Lean toward Tech, Financials, and Health Care—and embrace rising dividend-paying stocks. –Industrials and Materials face profit headwinds from weak end market activity. –Consider currency exchange impact, which could impair earnings estimates for multi-nationals. European equities should find a catalyst in the form of evidence that growth is no longer faltering. –A modest shift in GDP will catapult profits and be the driver of valuation expansion. –Consider a currency hedge where applicable, to ward off euro/dollar cross-effects. Japanese equities should be bought as a trade. –Further yen depreciation is highly likely, and the Nikkei is negatively correlated. –Hedge exposure to negate the yen/dollar cross. Emerging market investing demands a more surgical approach. –Best-suited for active managers to place country-specific allocations. –Own countries whose economies are undertaking legitimate fiscal/monetary reforms. High-yield bonds offer a spread that more than compensates for default assumptions. REITs offer yield, and better economic growth should support rents and commercial activity. Palladium presents attractive upside on the back of steady car sales in China and the U.S. Where will capital be treated the best?
© 2014, JANNEY MONTGOMERY SCOTT LLC 27 OPTIMISTIC CASE – 25% PROBABILITY Economy and Markets The economy continues to provide unambiguous evidence that the expansion is intact, helped by modestly improving conditions abroad. While the Fed begins to lift interest rates, it is well-telegraphed and expected to be gradual. With bond markets medicated by the Fed’s explicit forward guidance, yields drift higher but glacially, exerting little pressure on earnings expectations. The P/E multiple expands to 18/19 on $128 of earnings, and the S&P 500 melts up to 2,400. Approaching this level engenders talk of a “bubble” in equity prices. It may warrant scrutiny for profit-taking opportunities because history is replete with bubbles ending badly. Investment Strategy Stocks prosper as investors project further profit gains and lack of competition for risk-based capital from other asset classes. Favor large cap dividend “Aristocrats” in the areas of technology, financials, and health care. Consumer-facing companies should be owned as well. Bonds struggle in price, but generally cover any loss in principal by the yield. Avoid gold. Scenario Analysis (S&P price is 2,069 as of this writing) BASE CASE – 65% PROBABILITY Economy and Markets The “goldilocks” economy continues to print positive growth. Job growth and spending fuel a reinforcing expansion cycle, and global activity stabilizes. The Fed debates a mid-year liftoff in the fed funds rate but defers—deciding to err on the side of allowing any overheating it might generate to occur. The conflict for market participants about when the Fed might pull the punch bowl away creates anxious moments and increased market volatility. Corrective bouts are common but do not disrupt the long- lasting bull market. Stocks beat bonds as the S&P rallies through occasional pullbacks to 2,175. Investment Strategy Stocks should be at or above weight against portfolio targets. Bond prices waver, but global disinflationary forces and the arbitrage by country agnostic yield-seekers tame bond market volatility. Hedges may be helpful to temper swings in equity prices. Low or non-correlated instruments may be augmentative within a portfolio construct, including alternative investments, gold, and the U.S. dollar.
© 2014, JANNEY MONTGOMERY SCOTT LLC 28 PESSIMISTIC CASE – PROBABILITY – 10% Economy and Markets The economy slips to a sub-trend pace of growth as employment gains slow, while foreign economies fail to reaccelerate. Businesses are unwilling to invest ahead of visible demand, and the consumer saves the oil price “tax cut” rather than spend it. Withering profit expectations cause a de-rating in equity prices. Earnings grow only by low-mid single digits year/over-year, and markets resolve the disappointment by showing little gains. The S&P trades in a range around 2,050. Bond prices rally, and returns rival or exceed that which come from stocks. Income is the driver of results, so dividend stocks and corporate bonds deliver attractive yields and total returns. Investment Strategy Blue chip stocks with predictable growth are rewarded. Defensive sectors such as Utilities and Staples should perform. Stocks should be reduced to target weight or slightly below, as return risk is elevated. Higher-quality bonds hold relative appeal, and duration targets should be extended. Cash, alpha generating hedge strategies, and real assets may be best-suited to augment an unrewarding environment for traditional asset classes. A weighted blend of these scenarios establishes an achievable price target for the S&P 500 of 2,219. Scenario Analysis Risks Worth Monitoring Valuation-agnostic cash and underperforming investors chase the stock market significantly higher. S&P 500 2,500 plus. Lending activity in Europe fails to ignite and demand remains muted, causing the economy to weaken and equities there to suffer. The Fed tightens policy more quickly than anticipated, and jars complacent markets. 2013’s “taper tantrum” is replayed in earnest. Oil prices fall well below the cost of production, and the U.S. energy renaissance stalls costing jobs and business investment. China’s debt problems are unmasked, and worries escalate about its sustainable growth rate and global economic contribution. Russia remains an aggressor in Eastern Europe, and more imposing tit- for-tat sanctions weigh on market confidence. Japan loses its fight to reignite growth as reinvigorating economic policies are thwarted—causing the yen to rally hard. Central bank policies overstep investor confidence, leading to a redo of the Fragile Five currency losses expanding to infect others. A terrorist movement in the Middle East interferes with the oil supply chain, driving prices markedly higher—hurting the global economy. An attack on U.S. soil, physical, cyber, or otherwise, or an ebola-like pandemic scare, darkens consumer sentiment and curbs spending.
© 2014, JANNEY MONTGOMERY SCOTT LLC 29 Disclosure This is for informative purposes only and in no event should be construed as a recommendation by us or as an offer to sell, or solicitation of an offer to buy, any securities. The information given herein is taken from sources that we believe to be reliable, but is not guaranteed by us as to accuracy or completeness. Opinions expressed are subject to change without notice and do not take into account the particular investment objectives, financial situation, or needs of individual investors. Employees of Janney Montgomery Scott LLC or its affiliates may, at times, release written or oral commentary, technical analysis, or trading strategies that differ from the opinions expressed here. Returns reflect results of various indices based on target allocation weightings. Weightings are subject to change. Index returns are for illustrative purposes only and do not represent the performance of any investment. Index performance returns do not reflect any management fees, transaction costs, or expenses. Indexes are unmanaged, and you cannot invest directly in an index. Performance data quoted represents past performance and is no guarantee of future results. Current returns may be either higher or lower than those shown.
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