Economic growth was slow but stable during a year in which a federal government shutdown lasted for 16 days and Detroit filed for bankruptcy. The unemployment rate fell to the lowest in five years, to approximately 7% from 7.9% to approximately, as a result of modest job growth and declining labor participation (a 35-year low).
A significant economic head wind was fiscal tightening through a substantial tax increase and spending restraint (sequestration). This may have cost the economy nearly 1.5% in growth. An encouraging bipartisan deal helped fund the government through spending reductions.
Monetary policy supported global growth. In late spring, the Federal Reserve announced it was contemplated tapering its fixed-income purchases, causing a 100-basis point rise in interest rates and creating turmoil in India and Brazil. Although global growth was softer than expected, equity markets performed well. Emerging markets experienced weakness in growth, commodity prices, credit and liquidity. Europe began to emerge from recession with reduced tail risks, Japan benefited from monetary and fiscal policy stimulus, and China engineered a successful soft landing despite remaining imbalances.
Our 2013 theme of a muddle-through economy and grind-higher equity market was influenced by equity valuation (P/E) expansion, perhaps because of reduced uncertainty and rising confidence. We see these factors continuing in 2014.
We expect economic growth will be broader and stronger, yet remain moderate for the United States and around the world. Macroeconomic risks are diminishing as economies improve, which may help reduce fear and strengthen confidence. U.S. fiscal drag is lessening, Europe is emerging from recession, Japan's deflationary head winds are diminishing, and China is showing signs of stabilization. Improving sentiment for U.S. corporations, along with strengthening consumption, should lead to an increase in capital spending and a relatively stronger growth trajectory.
This transition to self-sustaining growth should provide the necessary acceleration in revenue and earnings growth.
Fed tapering likely will be slow and incremental, with U.S. and global monetary policy geared toward stimulating growth. As a result, we anticipate the bond market will continue to experience a gradual climb in interest rates. We believe rising bond yields are not a head wind for equities as long as economic conditions continue to improve.
Skepticism about the durability of the equity rally exists as many argue that stocks have become expensive and profit margins are unsustainably high. We do not think these potential head winds will prevent gains, but instead limit them, and perhaps cause volatility. Inflation is unlikely to be a problem, and deflation is a threat in Europe. Equities are vulnerable to a correction given recent strength and some technical deterioration, but we continue to favor a moderate pro-growth equity posture.
The U.S. equity market should continue to grind higher as a result of central bank liquidity, modest economic acceleration, quiet inflation and an improving fiscal situation. Expect the U.S. and global economies to improve in 2014, encouraging acceptable growth in revenue and earnings. The gradual improvement is not likely to threaten the unprecedented global monetary experiment that has helped underpin the rise in equity valuations. Even though equities may still advance, run-ups since 2009 and throughout 2013 have reduced our forward view for annual returns to mid- to high-single digits. We prefer companies with positive free cash flow profiles, low valuations, economic sensitivity and/or above average secular growth.
Robert C. Doll is chief equity strategist and senior portfolio manager at Nuveen Asset Management.