Investment Opportunities in 2014
• There are select opportunities in a variety of asset classes in 2014.
• U.S. and European equities appear positioned to trend higher.
• Overweighting credit, such as senior bank loans, is the best option for fixed income investors.
2013 was kind to equity investors; more so to those with heavy exposure to U.S. stocks and less so to those with relatively high amounts of emerging market equities. Still, investors remain gun-shy and therefore under-allocated, in aggregate, to stocks. This misallocation of capital is less glaring than it was in the years immediately following the financial crisis, and valuations are generally not as enticing as they were back then. Still, bargains are to be found in a variety of asset classes as we head into 2014, and investors should focus on those that stand to benefit from the continuation of a handful of global megatrends, which should once again dictate financial markets’ course.
U.S. and Europe: Slow and steady wins the race
Against a non-inflationary but lackluster growth backdrop, U.S. and European equities appear positioned to trend higher over the course of 2014. Given the pace of the recent rally, however, a mid-year pullback (likely short-lived) may be possible, and the overall pace of gains probably won’t be quite as torrid as it was in 2013.
In the U.S., slow growth and accommodative monetary policy should keep business-cycle risk low, while several factors—re-emerging loan growth, increased housing demand, an uptick in capital spending, further gains in domestic energy production, and reduced fiscal drag—should create a tailwind. U.S. equities enter 2014 close to their long-term average valuations, but with earnings growth expanding at a reasonable clip, multiples could expand further. Investor sentiment 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 very undervalued compared to Treasuries, suggesting potential further upside.
The Eurozone, meanwhile, continues to wrestle with deep-seated economic problems, but the debt crisis is largely contained and a range of indicators indicate slowly improving conditions. Such gradual improvement may be enough for markets, however, given that stocks trade not on whether things are good or bad, but on whether they appear to be improving or deteriorating. 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, to provide a smoothed gauge of current valuations).
How to play the reorientation of the Chinese economy
The pace of Chinese expansion has cooled as the government works to reposition its economy away from growth driven by credit, exports and investment, and more toward consumption-led growth—a more sustainable economic path. Though the Chinese economy may no longer be expanding at double-digit annual rates, the largest emerging market (and second largest economy in the world) will likely offer many avenues of potential opportunity in 2014 and beyond. Among the best of these may be exposure to well-run companies with a focus on the Chinese consumer.
About one-quarter of the Chinese population, or 300 million people, has attained some type of middle-class lifestyle, and that number should continue to rise at a rapid clip for many years. Even as the economy grew by “only” 7.8% year over year in the third quarter of 2013, urban disposable income grew at 14.1% and retail sales climbed by 13.3%.1 Poised to benefit from the rising Chinese consumer are companies able to cater to their needs, particularly those that aren’t overly capital intensive. Examples include firms that stand to capitalize on rapidly expanding Internet adoption, from e-tailers, social media and gaming sites to online advertising firms. Discretionary spending on education, healthcare, travel and leisure, and luxury goods is also likely to rise, to the benefit of well-positioned firms in these industries.
Investors are likely better served owning such companies rather than less efficient state-owned enterprises (often energy and financial behemoths), many of which dominate the holdings of Chinese and emerging market index funds. This is all the more true now that the commodity super-cycle appears to have died down on lower emerging-market demand for raw materials, and because many Chinese banks appear undercapitalized.
Although valuations are somewhat elevated for consumer-oriented companies headquartered in China and elsewhere in Asia, plenty of attractive investment opportunities remain. And with consumer spending in Asia forecast to eclipse that of North America by 2020, the pace of demand for consumer goods is likely to be robust for years to come.2
Fixed income: Easy monetary policy to persist
With 2014 growth in both the developed and emerging worlds expected to be modest, and inflation generally subdued, interest rates should remain low in many areas, making it more challenging for fixed income investors to find attractive real (net of inflation) yields.
A U.S. rate hike in 2014 is exceptionally unlikely, given that the U.S. economy is not apt to reach the Federal Reserve’s employment and inflation targets of 6.5% and 2.5%, respectively, for at least a few years. While the Fed’s efforts to taper its large scale asset purchases may temporarily push bond yields higher (and, as a consequence, prices lower), Treasury rates are unlikely to climb much higher than 3%; a self-correcting mechanism likely comes into play above such levels. Elsewhere in the developed world, central banks won’t be inclined to raise rates.
In this “low rates for a long time” world, we believe a carry-driven strategy is the best option. That involves underweighting Treasuries and overweighting credit, such as senior bank loans.
Senior loans currently offer highly competitive real yields, provide a natural hedge against rising rates, are usually collateralized, and are higher in the corporate structure than many other bonds. Yes, these loans are potentially prone to greater default risk than higher quality fixed income investments. However, corporate balance sheets are healthy enough to make large-scale defaults unlikely. Senior loans’ yield spreads to Treasuries have narrowed from their post-crisis peaks, but have yet to return to “fully valued” levels.
International bonds, including emerging market debt, also offer areas of opportunity heading into 2014, with real yields currently well above those of the Barclay’s U.S. Aggregate Bond Index in many cases. Though emerging market debt took a hit during last summer’s “taper tantrum,” many such economies sport solid debt-to-GDP ratios and credible central banks.
For investors seeking tax-advantaged income, municipal bonds enter 2014 truly cheap given their credit profiles. The Merrill Lynch BBB Municipal Master Index offers a taxable equivalent yield of 10.2%* as of November 22, 2013. Rate fears and headline-grabbing events in 2013, such as the Detroit bankruptcy and concerns over Puerto Rico hurt prices across the asset class. Detroit, however, represents an exceptional case among municipalities, and Puerto Rico continues to take steps to strengthen its finances. By and large, improving state and local finances mean default rates should remain exceedingly low—much lower than among similarly rated corporate bonds, for example.
While benchmark interest rates in the U.S. are unlikely to spike in 2014, investors must appreciate that the risk of a rate back-up does exist. To seek protection against the effect of rising rates, investors should remain mindful of duration (interest rate risk) and keep maturities short.
Game changer: The U.S energy renaissance
The revolution in U.S. energy remains under way, with massive domestic shale oil and gas resources positioning the country to become the top global energy producer in fairly short order. We believe the effects of the boom will continue to reverberate throughout the economy in 2014 and beyond, especially within the energy infrastructure space. This space (among other energy-related sectors) should continue to provide potentially fertile ground for investors.
In 2012, daily crude oil production in the U.S. rose by a million barrels, representing the largest annual production increase in U.S. history.3 The gains continued in 2013, with natural gas production following a similar path. By 2015, the International Energy Agency estimates, U.S. crude oil production will surpass that of the current top producer, Russia, with the U.S. reaching energy self-sufficiency by 2035.4
The U.S. energy revolution is gradually transforming the U.S. economy and could help boost U.S. growth over the long term by reducing the trade deficit and lowering costs for manufacturers and consumers. To keep up with steadily increasing production, however, the U.S. needs to significantly expand its energy infrastructure, including the “midstream,” or transportation and storage, component. This expansion is already well under way. Between 2000 and 2012, investment in extraction-related infrastructure grew eight times faster than overall infrastructure spending, but much more investment is still needed—perhaps $250 billion worth or more, on midstream infrastructure alone, by 2035.5
With pipelines already the dominant and most efficient mode of transporting oil and natural gas domestically, master limited partnerships (MLPs) with a focus on energy are likely to remain key beneficiaries of this investment boom; significantly more capacity in the face of rising production should continue to translate into higher revenue streams for such firms over a long period. This very dynamic was largely responsible for MLPs’ 8% average annual distribution growth between 2001 and 2012.6
Although pipeline MLPs have grown somewhat more expensive in recent years as markets have increasingly recognized their value, many continue to pay highly competitive yields in addition to offering growth potential. MLPs appear even more compelling in light of their favorable tax treatment and the fact that their performance has historically exhibited a very low correlation to rising benchmark interest rates.
*Taxable equivalent yield is based on the standardized yield and the combined effective federal and state tax rate of 43.4% for 2013 and assumes that alternative minimum tax (AMT) does not apply. Past performance does not guarantee future results.
1. Morgan Stanley, as of 2/28/13. Bloomberg, as of 10/31/13.
2. Wall Street Journal, In Asia, Consumer Discretionary Sector Outperforms, November 5, 2013.
3. “Statistical Review of World Energy 2013.” BP p.l.c.
4. Bloomberg News, U.S. to Be Top Oil Producer by 2015 on Shale, IEA Says, November 12, 2013.
5. Study completed by ICF International, a consultancy, for the International Natural Gas Association of America (INGAA) Foundation in 2011.
6. Barclays Research estimate via Salient, as of December 31, 2012. Past performance does not guarantee future results.
The Credit Suisse Leveraged Loan Index tracks the performance of senior loans. The Barclays U.S. Aggregate Bond Index is an investment-grade domestic bond index. The Merrill Lynch BBB Municipal Index measures the performance of U.S. tax-exempt bonds rated BBB. Each index is unmanaged and cannot be purchased directly by investors. Index performance is shown for illustrative purposes only and does not predict or depict the performance of any fund. Past performance does not guarantee future results.
Fixed income investing entails credit risks and interest rate risks. When interest rates rise, bond prices generally fall, and a fund’s share prices can fall. Further, a portion of a municipal bond fund’s distributions may be taxable and may increase taxes for investors subject to the alternative minimum tax (AMT). Capital gains distributions are taxable as capital gains. Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk.
Foreign investments may be volatile and involve additional expenses and special risks, including currency fluctuations, foreign taxes and political and economic uncertainties. Emerging and developing market investments may be especially volatile. Diversification does not guarantee profit or protect against loss. There is no guarantee that the issuers of stocks held by mutual funds will declare dividends in the future, or that dividends will remain at their current levels or increase over time. Senior loans are typically lower-rated and may be illiquid investments (which may not have a ready market).
Investing in MLPs involves additional risks as compared to the risks of investing in common stock, including risks related to cash flow, dilution and voting rights. Each Fund’s investments are concentrated in the energy infrastructure industry with an emphasis on securities issued by MLPs, which may increase volatility. Energy infrastructure companies are subject to risks specific to the industry such as fluctuations in commodity prices, reduced volumes of natural gas or other energy commodities, environmental hazards, changes in the macroeconomic or the regulatory environment or extreme weather. MLPs may trade less frequently than larger companies due to their smaller capitalizations which may result in erratic price movement or difficulty in buying or selling. Additional management fees and other expenses are associated with investing in MLP funds. The Oppenheimer SteelPath MLP Funds are subject to certain MLP tax risks. An investment in an Oppenheimer SteelPath MLP Fund does not offer the same tax benefits of a direct investment in an MLP. The Funds are organized as Subchapter “C” Corporations and are subject to U.S. federal income tax on taxable income at the corporate tax rate (currently as high as 35%) as well as state and local income taxes. The potential tax benefit of investing in MLPs depend on them being treated as partnerships for federal income tax purposes. If the MLP is deemed to be a corporation, its income would be subject to federal taxation at the entity level, reducing the amount of cash available for distribution which could result in a reduction of the fund’s value. MLP funds accrue deferred income taxes for future tax liabilities associated with the portion of MLP distributions considered to be a tax-deferred return of capital and for any net operating gains as well as capital appreciation of its investments. This deferred tax liability is reflected in the daily NAV and as a result a MLP fund's after-tax performance could differ significantly from the underlying assets even if the pre-tax performance is closely tracked."
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