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U.S. and Europe: Slow and Steady

Source: FactSet, as of 10/31/13.

Highlights

  • U.S. and European equities are positioned to trend higher in 2014.
  • Europe's debt crisis seems contained and the U.S. economy is in reasonable shape.
  • Developed market stocks remain undervalued compared to Treasuries.

Against a backdrop of non-inflationary, but lackluster economic growth, we believe U.S. and European equities are positioned to trend higher over the course of 2014. However, given the pace of the recent market rally a mid-year pullback (likely short-lived) is possible, and we believe the overall pace of gains won't be quite as torrid as in 2013.

The U.S. economy, despite what many people perceive, is in okay shape. The slow overall rate of growth and an accommodative monetary policy should keep business-cycle risk low. At the same time, there are several economic tailwinds, including re-emerging loan growth, increased housing demand, an uptick in capital spending, gains in domestic energy production and reduced fiscal drag.

U.S. equities enter 2014 close to their long-term average valuations. Nonetheless, earnings growth is expanding at a reasonable clip, which could further expand multiples. Investor sentiment also appears to have turned a corner, with robust inflows of more than $100 billion into U.S. stocks alone in 2013 suggesting a "great rotation" into equities has begun.

Despite the gains of the past few years, however, investors do not appear irrationally exuberant.  Additionally, stocks remain undervalued compared to Treasuries, suggesting further potential upside.

Source: FactSet, as of 11/22/13. Past performance does not guarantee future results.

Meanwhile, the Eurozone continues to wrestle with deep-seated economic problems. But,  the debt crisis is largely contained and a range of indicators show slowly improving conditions.

Such gradual progress may be enough for markets given that stocks often trade on whether the situation appears to be improving or deteriorating and not on whether it is good or bad. Even against such a weak macroeconomic background, we believe Eurozone earnings growth is poised to be among the highest in the developed world in 2014 and may benefit from the effects of a weaker Euro, which helps export-oriented European firms.

As with the U.S., valuations have grown richer, but they're not unsettlingly high by any standard. In fact, many European equity indices finished 2013 trading well below their long-term average, cyclically adjusted, price-to-earnings ratios (a measure that divides a market's price by 10-year average inflation-adjusted earnings in order to provide a gauge of current valuations).

Source: Bloomberg, as of 11/22/13. Estimates may not be achieved.

Access our complete 2014 Market Outlook or handy infographic summary for more information.

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