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BBVA Compass

Quarterly Market Update

Q&A

In this edition of BBVA Compass Market Outlook, Chief Investment Officer John Sawyer urges investors to maintain a welldiversified portfolio of both stocks and bonds. Even after 2013’s run up, large-cap equities remain moderately priced, and bonds, as they demonstrated in 2013, can survive a range of modest performance to modest underperformance without significant valuation changes.

1. The U.S. economic expansion continued at a moderate pace in 2013 while stocks roared ahead. Do you anticipate that the economy will finally gather steam in 2014?

From a broader perspective, although we have seen stronger economic growth in the last few quarters, I believe 2014 will be another year of only moderate expansion. Congress has to some degree removed itself from the picture for the next two years with the recent budget resolution, which has allowed the Federal Reserve (the Fed) to move forward with plans to unwind current bond-buying programs without the threat of another government shutdown. This tapering, although a positive indication that the economy is improving, will keep a lid on the pace of expansion for the foreseeable future, or at least until we are further along in the process.

2. In your opinion, what was the biggest surprise in terms of financial markets or economic outcomes in 2013? What was the most predictable?

The biggest surprise was that while we were very optimistic for the equity markets in general going into 2013, no one expected a year like we had. The S&P 500 Index return of 32.37% ranks as the 3rd highest annual return since 1908. What makes the return so surprising is that they were supported by very modest economic growth. In essence, 2013 was a multiple-expansion year rather than one characterized by substantial earnings growth.

The most predictable event of 2013 was that for all the turmoil related to the Congressional budget discussion, the divisiveness ultimately had no impact on market valuations. Markets do not generally react to those issues although they are much made over by the press and certainly by firms focused on transactions, but the reality is that Congressional wrangling seldom affects the long-term viability of equity ownership in strong companies with solid earnings and cash flows.

3. Stocks were the clear winners in 2013 while commodities, emerging markets, gold and bonds posted negative returns. In your opinion, what did stocks have that other asset classes lacked?

Even though 2013 was the fifth year of positive equity returns, the advance has been off a very low base. At the end of 2008, stocks were considerably undervalued relative to other assets. There were a couple of 10-year periods when returns were negative, and so it is only reasonable to expect stock prices to normalize and trend back in line with the long-term return averages.

Even after the run-up, the Dow Jones industrial average still has a price-toearnings (P/E) ratio of 15.5 and a dividend yield of just over 2% which means that large-cap equities remain moderately priced. However, P/E ratios jump considerably as we move down the capitalization structure – for example the NASDAQ, which contains a number of smaller companies, has a P/E of a hair over 26.

When 2013 began, emerging markets was the allocation ‘du jour’, but by and large commodity markets, including gold, did not perform. The bulk of emerging markets are biased to commodity production and export and they faced headwinds from the U.S. tapering which forces them to raise interest rates and subsequently their currencies to appreciate, thereby reducing demand for their produced goods and basic materials.

It seems almost unfair that some of those emerging countries have been fiscally responsible and used account surpluses from a number of good years to pay down debt. Because of this, their real or perceived credit rating has improved so people want to put money there which drives interest rates down, but drives up their currency valuation making it more difficult for the country to export. While a better return for the foreign investors, it becomes almost a counterproductive drag on emerging market economies.

4. At some point do you anticipate the "wealth effect" may result in investors redeploying assets currently invested in the stock market? And if so, where might these assets be redeployed?

We have seen a significant recovery in residential real estate and undeveloped land. Here in Texas, which is probably the single best-performing market in the country, we have seen price increases although homes in other places in the country have not recovered to the same degree. There has been a considerable amount of activity from higher creditquality buyers, effectively retirees who probably have benefited from this recovery who may looking at a second or even third home as a place for retirement. So yes, there is some potential that the baby boomers will monetize the wealth effect from the stock market run up and utilize that for consumption and lifestyle issues including housing purchases. They were certainly doing so before the housing bubble burst in 2008.

5. At the December Federal Open Markets Committee meeting, the Fed announced plans to pare back monthly bond-buying beginning in January. Is the taper real this time?

The taper is real, it is a continued program to which the Fed is committed and one which they will implement. But it is very important to understand that quantitative easing is only one tool at the Fed’s disposal – they also control short-term interest rates. In my opinion, the Fed would very much like to get back into the more traditional role of managing short-term rates from a stimulus or restrictive position and get out of bond-buying programs entirely. While we doubt that the Fed will be able to exit the bond-buying program by the end of the year, we do believe they would like to set a path so that markets clearly understand the measured exit strategy.

New chairwoman Janet Yellen’s recent seating confirmation removes some concern about beginning the exit strategy too soon. Chairwoman Yellen is a fan of the exit strategy, an extension of the Bernanke plan which she originally supported and probably helped author, and so she has every conviction to move forward. Subsequently we will likely see even greater discipline, clearer guidance and a faster exodus from the bond-buying program.

6. What does the two-year budget agreement reached by Congress in December portend for the upcoming debt ceiling debate?

I’m afraid that the debt ceiling debate will continue to be a partisan issue, although there appears to be some maturity reflected in the resolutions reached in December in that our elected officials realize that the political bickering is not playing well in the heartlands, and that it is time for a new approach. We saw more balance between cost cutting and revenue generation with both sides getting something of what they wanted, something to take back to their constituents. Because this is an election year, we may see fewer actual conciliatory voting changes, but while the rhetoric might still be there, nobody wants a closed government on the eve of an election.

7. What is your outlook for global economies and financial markets in 2014?

From a perspective of the financial market performance, while there is unlikely to be a repeat of 2013, the synchronized global growth story is intact and continuing. Although moderate rather than robust, the economic expansion can still support a good equity market globally. While still biased towards equities compared to other asset classes, the large-cap space is the most attractive area from a valuation perspective. We also favor developed markets as while they have been improving behind the U.S. cycle, we could see a turnaround this year.

8. What are the most significant considerations for investors in 2014?

Investors should continue to focus on developing a well-diversified portfolio. Biases probably need to begin gravitating from an overand under-weighting towards those assets that have not performed as well, and where valuations are still reasonable. Developed markets are attractive because they largely underperformed for several years. With commodities still underperforming, it is unlikely that there will be a significant turnaround in the emerging markets, but coming on the heels of poor performance in 2013, there could be some opportunity. And, given the overall sentiment of the markets, investors would not want to get out of asset classes like U.S. stocks simply because they performed well in 2013. But all that again lends itself to maintaining a broadly allocated portfolio.

As we enter 2014, and as we have done since 2008, the expectation is that interest rates will run up and that bond values will get killed. But while bonds did not perform well in 2013, they did better than most people expected. We believe we will see more of the same in the coming year – continued modest performance to modest underperformance in bonds without significant valuation changes. This ties back to how we believe the Fed will execute their exit strategy. They certainly want an orderly process for normalization of interest rates and that includes price stability on bonds as well as stocks and consumer goods.

BBVA Compass is the trade name for Compass Bank, which is a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, and are NOT bank guaranteed. May LOSE value, are NOT insured by any federal government agency.

This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.

Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.

Indexes are unmanaged and investors are not able to invest directly into any index.

International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.

Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.

Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.

In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.

Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.

The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.

Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.

The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.

Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.

Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), Bloomberg 7-10 Year U.S. Treasury Index (USG4TR), Morningstar U.S. Agency Bond TR Index (MSBIUATR), Municipal Bond Buyer 40 Index (BBMIRNEW), Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).