U.S. equity markets outpaced other markets last year as the benchmark S&P 500 Index returned 13.7%, compared to the MSCI World Index which returned 5.5% and the MSCI Europe Index which lost 5.7%. And there are indications that the U.S. may lead the way in 2015, says Jurrien Timmer, director of global macro for Boston-based Fidelity Management & Research Co.
Part of the reasoning is based on the rebounding U.S. economy, where unemployment is falling, interest rates and inflation are low, and corporate earnings remain strong. But another aspect is historical, as U.S. markets have been through similar long phases of strong performance in the past — until the economy began to overheat and markets corrected dramatically.
“U.S. large-cap did well in 2014, and almost everything else lagged, other than investment-grade bonds. The question is, who is right? Is the S&P 500 right, or will the rest of the world catch up?” says Timmer, a 30-year industry veteran who joined Fidelity in 1995 and works in its global asset-allocation division. “Maybe the truth is somewhere in between. The question is, how will this play out?”
In Timmer’s view, history provides some clues. He says the current market is similar to the 1990s, when U.S. markets outpaced everything in sight. “The dollar was up in that period, small-caps did well but underperformed large-caps. And the rest of the world lagged the U.S.”
Then came the 2000s, which saw the global financial crisis that resulted in a state of synchronization among economies, markets, and fiscal and monetary policies. “It didn’t matter if you were in U.S. stocks or emerging markets or high-yield bonds, they all behaved the same way,” says Timmer.
“Now, it’s no longer the case,” Timmer contends. “That creates different outcomes for different regions.” He adds that the U.S. has benefitted from quantitative easing, while other large economic players such as Europe and China have encountered problems such as weak growth in the former and housing bubbles in the latter area. As global economies are less coordinated, “we’re going through a series of episodes, with the U.S. clearly achieving more self-sustaining growth.”
One reason for Timmer’s optimism is that the U.S. economy is still in a mid-cycle expansion. “I’m looking for some signs of a late cycle, when inflation typically moves up, economic growth accelerates and the Fed is forced to act,” he says. “So far, we have decent growth, and inflation is low. What would normally turn a mid-cycle into a late-cycle expansion is not there. That’s why I’m confident that we’re still in that sweet spot.”
There are some similarities to what occurred in the 1990s, when the Federal Reserve stepped into the 1990 savings and loan fiasco, and later raised rates in 1994, without any warning. When inflation did not materialize, the Fed eased once again and markets went into an upward trajectory. That bull market lasted until 2000 when the Fed began raising rates again, and coincidentally the technology-telecom bubble burst.
“I’m not predicting that we’ll do what the market did in the second half of the ‘90s. But there are some parallels, starting with that banking recession and a crisis in 2008 that was much worse, since the banks were overleveraged like in 1990,” says Timmer. “Now we’re looking at the start of a rate cycle, just like in 1994.”
If the Fed does start to raise interest rates, this summer or in the fall, Timmer believes the hikes are likely to be modest and gradual. “It may end at a level lower than previous cycles. It may raise rates from 0% to 2%, and then wait. If that’s the case, it’s unlikely that the yield curve will invert very much, if at all. As in 1994, the yield curve never inverted, and we never had a big recession,” says Timmer.
“If we follow in the same footsteps, in terms of what the Fed does, and how the cycle unfolds, and we don’t get a recession that is driven by aggressive rate hikes, then you can argue we’ll see the same situation. There could be several more years in the cycle.”
To buttress his comments, Timmer notes that valuations are fair, at 17 times forward earnings. “Throughout history, the average P/E ratio is about 14.8 times. But most of the time, the market trades between 10 and 20 times earnings. And it’s inversely correlated with the inflation rate,” says Timmer. “If you take the rule of 20, and subtract the inflation rate of about 2%, that gives you an 18 multiple. It’s not cheap. But it’s not ‘Oh my God, this market is overvalued.’ It’s still within that 10-to-20 band where the market tends to be.”
Looking ahead, Timmer predicts there will be intense volatility when the market responds to a long-awaited rate hike. But he also expects that, based on 7% earnings growth, and 2% dividends, returns in 2015 will be around 9% to 10%. “Valuations may contract because of volatility. That’s an unknown. But you’re looking at high single-digit returns for equities.”