In 2014, we expect modest economic growth in the United States. The unemployment rate—one of the Federal Reserve’s measuring sticks for withdrawing QE¹—isn’t going to drop very quickly. Despite the heap of liquidity that’s being pumped into the economy, we’re not seeing significant wage inflation. Additionally, the “persistently unemployed” population has doubled since 2007. Therefore, the labor market will remain challenged.
Still, market volatility will ease and the velocity of the largely speculative 2013 rally in stocks is going to slow down, flattening its trajectory over the next 12 months. Investors now know that the Fed will maintain its low-interest-rate policy through perhaps 2016. The modest $10 billion-per-month reduction in bond purchases is consistent with a less-speculative equity market on the upside, but also consistent with one that should still move in a positive direction.
Specifically, higher-quality dividend-paying stocks are likely to demonstrate much better relative performance in 2014. Accordingly, we believe that the stocks we hold in our portfolios—high-quality, low P/E² dividend payers—are well-positioned to outperform lower-quality stocks on a relative basis.
Dividend-paying stocks appreciated substantially in 2013 but were outshined by low-quality companies that were bid up amid a junk rally. Everybody was playing momentum, but that slice of the market isn’t going to look so good in a slower-QE climate. The Fed is now in tapering mode, and we expect only modest economic growth along with a slow reduction in unemployment.
There will still be plenty of uncertainty and renewed concern over rising interest rates. In this type of environment, investors are going to need income. They are not going to get it from bonds, which have been getting squeezed by government policies designed to reduce debt—also known as financial repression. Dividend-paying stocks, on the other hand, while not guaranteed, can be an attractive alternative for income-seekers. With the real growth that we’re seeing, not just nominal growth, companies can use their free cash flow to buy back stock, reduce debt and pay higher dividends. That’s good news for company-management teams—and shareholders.
From a valuation standpoint, the market is at a P/E of about 15, which in the past has been followed by high-single-digit to low-double-digit investment returns. We expect interest rates ultimately to move higher, so we favor the industrials, materials and tech sectors in 2014. To a lesser extent, there are also bargains in financials and energy. These sectors have typically fared well ahead of the first interest-rate hike in a Fed tightening cycle, which is still a few years away. Indeed, financial repression will remain in place for years to come.