Waddell & Reed

Market Perspectives


Finding normal? U.S. equities expected to provide solid returns this year

Story Highlights

  • We remain positive on housing, industrials and energy.
  • As the year progresses, stocks should follow earnings, which will begin to improve with a better economy.
  • We don’t see strong expansion in Europe during what remains a recovery period for the region.
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Investment Team

Hank Herrmann

CEO

Across the first quarter and into the second, the U.S. economy has grown more slowly than we expected, primarily attributable to a harsh winter in most of the U.S. As we move toward the middle of the year, we anticipate that more normal temperatures will bring a catch-up in economic growth, which could provide an upturn in the equity markets.

After a strong run for stocks last year, investors are questioning equity valuations and taking profits. More volatility for awhile wouldn’t be a surprise. But eventually, stocks should follow earnings, which should begin to improve with a better economy. The following is an elaboration on how we currently view trends and opportunities across primary sectors of the global market.

Domestic equities

We believe the U.S. now seems on firmer footing than other major economies. Incoming data supporting this view should begin to materialize soon.

We believe that slower growth in the first quarter will be balanced out by stronger growth in the second quarter, resulting in GDP growth for the first half of 2014 of approximately 2 or 2.5%. We are still of the view that the U.S. remains on the cusp of a self-sustaining economic recovery. But, as has been true for several years in a row, unexpected events have arisen to disguise the trend. Looking ahead, we believe:

  • The equity market is likely to fluctuate until the data is clear. As the year progresses, however, and the economic recovery progresses, there remains room for the domestic equity market to rise, perhaps 7 to 8% on the year, in line with anticipated profit growth.
  • Price-to-earnings ratios (P/Es) are not likely to expand much from here. P/Es are not too high, however, at about 15.5 to 16 times earnings. But we don’t see them moving up, given the likelihood that interest rates will rise.
  • We remain positive on the three legs of growth, stated earlier as part of my “14 ideas for 2014” article. Housing may not be as strong as we previously expected, but is still expanding nicely. Industrials are tied to economic activity, which should improve throughout the year. Energy remains very attractive, as shale fields in the U.S. provide tremendous growth impetus to the exploration, production and transportation industries.
  • The technology sector is seeing new names and new innovations arise related to social media and data management. We’re entering a new period of exciting growth for tech that may last the rest of the decade.

Investors seem under-exposed to equities. For most of the past decade, investors sold down stocks and moved into bonds. About 10% of that money has moved back recently. As more and more investors realize that bond returns look unpromising, more money will move back to stocks.

Interest rates and fixed income

For some time, we have not been in a “normal” economic environment in the U.S. Normal in this sense meaning inflation around 2%, GDP growth around 3%. As we normalize over the next 12 months or so, interest rates should rise. While not there yet, inflation will rise and the Fed will follow by tightening short-term interest rates. A rising rate environment, with the 10-year Treasury yield nearing 3.5% to 4%, from 2.5% currently, would likely result in negative returns for bonds. The risk/reward trade-off between stocks and bonds continues to favor stocks.

International equities

Across developed markets in Europe, stocks have had a modest rally year-to-date. European central banks are maintaining easy monetary policy in an effort to boost the euro zone economy. Given broader challenges, however, we don’t see strong expansion during what remains a recovery period for the region. Interest rates have fallen across the euro zone, which has been beneficial to stock prices, but rates cannot go much lower, assuming the recovery continues. Germany and the United Kingdom are the only countries showing any material growth. Though we continue to monitor the region for ongoing opportunity, modest financial market returns seem likely.

Emerging markets

Emerging markets continue to face growth pressure, most notably in China. Investors would be well served by maintaining a small allocation to emerging market equities and emerging market debt. With the headwinds that come with slower growth in China, however, there is reason to remain cautious overall.

 


Past performance is no guarantee of future results. The opinions expressed in this article are those of Mr. Herrmann and are current through April 2014. Mr. Herrmann’s views are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. Waddell & Reed Financial, Inc. is the ultimate parent company of Ivy Funds Distributor, Inc.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for any of the Ivy Funds or Waddell & Reed Advisors Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.

Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, such as political instability and currency fluctuations. These risks are magnified in emerging markets.

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