Investors take an opportunistic approach as economy improves

The US economy is expected to strengthen this year, with consensus around 2.6 percent growth. Global business confidence continues to improve with manufacturing in the lead.  With both consumers and businesses more optimistic heading into the new year, the combined strength in shipments could lead to a rise in equipment investment which bodes well for a rebound in global business activity. Consumption growth also rose in November, with core retail sales reflecting better than expected holiday spending despite some concerns about budget priorities in the lower-income group. The general backdrop suggests that investors could continue to seek higher returns in riskier assets that are more economically sensitive as the focus returns to fundamentals.

Allocation still favors equities
Fund managers are increasing weightings in developed market equities: Europe, Japan, and the US being the most favorable markets. There is still the chance for a pull-back in equities this year. The S&P 500 started 2014 in the red, and Asian shares followed lower as the Nikkei moved below 16,000. This could reflect some positioning amid lower volume, but some analysts suggest that this could be another buying opportunity.

For now, there is still room to extend margin debt as traditional bond outflows continue. Historically, investors have been extraordinarily leveraged during market rallies such as the tech bubble in 2000. Times are different now as fundamentals improve and central banks continue to support a stimulative environment. The case is stronger in Europe where valuations are still relatively cheap and in Japan where more easing from the BoJ coupled with large pension funds shifting allocation to equities could prove attractive from a global perspective.

Economic slack remains
Despite the optimistic outlook for 2014, there are still some concerns in the real economy. The lower income group tends to be hit the hardest during budget issues which leads to political dithering. Wage growth has improved, but labor productivity has risen by only 0.3 percent on year, but the rise to 3 percent during the third quarter of 2013 was impressive given the solid GDP report and non-farm payrolls during the same period. Andrew Smithers of Smithers & Co states that bad news on productivity could lead to signs of realism that will continue to make the case for a low rate environment. If the market outlook is premature, higher inflationary expectations without the true fundamental backdrop could be a problem.

An opportunistic approach
After a period of lower interest rates and soft demand for loans, US large cap banks could benefit from an improving economy especially as the yield curve steepens. Profit margins expand as banks borrow at lower short-term rates and lend at higher long-term interest rates. The rebound in housing and auto demand suggests that consumers are more comfortable with taking out loans as the economy improves.

Industrial strength is leading demand for non-residential construction where wages are higher and supply is limited. This will be an important year which will test the true strength of the economy. We are still in a stimulative environment, and even as the Fed reduces its pace of asset purchases, rates could find some comfort around 3.5 percent on the 10-year this year. Financing conditions are still favorable for many sectors which could support expansion. For example, US airlines are posting stronger gains as nominal GDP is upwardly biased, but we will need to see capacity expand as demand picks up to confirm further strength into the next year.