Current Thinking

First Quarter, 2014

Has The Economy Finally Reached Escape Velocity?

The term escape velocity comes from the world of physics, which describes the moment when an object
travelling away from a planet has enough speed to avoid being pulled back down again by gravity. In
economic terms, it is often depicted as a virtuous cycle of growth that creates jobs, which in turn generates
income, which then supports further growth. When escape velocity is finally achieved, the economy will no
longer need support from the Federal Reserves massive bond purchase program (quantitative easing or QE)
in order to keep the economy and markets afloat. In essence, escape velocity is a fancy term for a selfsustaining economic recovery that allows the Fed to finally take the training wheels off the economy.
After a surprisingly strong fourth quarter last year, theres a growing chorus of economists that believe the
U.S. economy can achieve escape velocity in 2014. The economy continues to improve due to broad-based
strength in many leading indicators, benign inflation and low short-term interest rates. Also, the expected
fiscal drag of roughly 1.9 percent of GDP has been markedly reduced, as the RyanMurray budget deal
unwound much of the expected sting of sequestration. Amid this market-friendly backdrop, stocks soared to
record highs following the Feds very dovish FOMC statement on December 18, despite the announcement
that they would begin tapering monthly bond purchases from $85 billion to $75 billion in January.
Our interpretation is that Fed policy will continue being very supportive of risky assets such as stocks because
further tapering will remain data-dependent it could be stopped or reversed if the economy begins to falter.
Also, the policy of not raising interest rates any time soon was reinforced by Fed commentary. The federal
funds rate will likely remain near zero well after the unemployment rate crosses the previous threshold of 6.5
percent. Translation, the so-called Fed put remains firmly in place. At this point, we see QE ending late this
year, and the federal funds rate staying anchored until late 2015.
The chart below highlights the importance of inflation trends and the U.S. dollar on U.S. equities during both
QE2 and QE3. During QE2, the U.S. was easing monetary policy, while much of the rest of the world (ROW)
was tightening. This led to both a weaker dollar and higher inflation, which created a meaningful headwind
for equities. In contrast, the launch of QE3 in the fall of 2012 was accompanied by Japans version of QE
(Abenomics) and ECB President Mario Draghis whatever it takes policies to protect the eurozone. Along
with the likelihood of a new era of slower growth in emerging markets, these events helped strengthen the
dollar and quell inflationary pressures. In our view, lower inflation, not QE, has been the fundamental
reasoning for P/E expansion that has driven U.S. equities to all-time high levels.

Chinas Economy Likely to Stumble Instead of Trot in the Year of the Horse
China is facing both cyclical and structural headwinds, and its influence on both the emerging world and U.S.
has meaningful significance for investors. Regarding cyclical pressures, interest rates in China are near the
highest levels in 10 years, which is troublesome for a debt-driven economy. Government efforts to curb a
decade-long excess in credit creation along with stronger economic growth in developed countries like the
U.S. has led to higher interest rates around the world. The subsequent tightening of financial conditions has
resulted in a decline among many leading indicators due to reduced consumer and business spending. This
has led to weaker corporate earnings, causing many businesses to curtail capital spending and hiring. As a
result of potentially stagflationary conditions, were anticipating continued relative weakness in Chinese
equities compared to most developed world countries.

Higher Rates

Declining Leading
Indicators

Weak Earnings

Source: Cornerstone Macro

Rebalancing in China Signals the End of the Commodity Super Cycle

China is also facing key reforms and structural factors that include an aging population, and the end of cheap
underemployed agricultural labor. An important government reform initiative involves the need to rebalance
the economy from an unsustainable 48 percent of GDP in resource intensive investments like infrastructure, to
a more consumption based economy. Investments have been the engine of Chinas job creation, with the
employment multiplier three times larger for investments than consumption. This transition suggests that
consensus growth estimates for China may be overstated. Also, increasing awareness of huge capital
misallocations in ghost cities like Tieling provide a clear example that the so-called commodity super cycle,
driven by Chinas investment boom has ended.
Source: Wall Street Journal

As a result, commodity producing countries such as Australia,

Canada and Brazil are expected to continue feeling the negative
effects of slower growth and currency depreciation.
In contrast, improving growth trends in most developed countries
should support higher growth in exports for China and other
export-based economies like South Korea and Taiwan. However,
this will likely be accompanied by higher funding costs as the Fed
Zhengzhou
Zhengzhou
continues to taper QE.
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Slowdown in China Fuels Liftoff in the U.S.

Although China constitutes only 11 percent of world GDP, it is the marginal price setter of commodity prices,
representing more than 40 percent of the global consumption of many commodities. Chinas transition to a
consumption-driven economy should produce a slower pace of economic growth, and less demand for
commodities. Therefore, the expected decline in commodity prices can be thought of as a tax cut on food and
energy spending for U.S. consumers.

These dynamics have been important factors in the

surge to record high stock prices, led by multiple
expansion. The coinciding broad-based strength in
many leading indicators suggest that earnings
growth may surprise to the upside in support of
current equity valuations.

Thomson Reuters/Jefferies CRB

Commodity Index
Source: FactSet

500
450
400
350
300
250
200
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13

Consumption-based economies like the U.S. are very

sensitive to the trend in inflation. Lower inflationary
pressures in
the U.S. have clearly led to an
improving economy, and this provides the
foundation for a stronger U.S. dollar as well as higher
interest rates. Rather than being a headwind for U.S.
equities, the Feds tapering of QE actually supports a
stronger dollar. With many commodities traded in
U.S. dollar terms, a strong dollar fosters higher
growth via lower imported inflation. For example,
U.S. GDP may be able to rise above 4.0 percent
without stoking a rise in gasoline prices.

Inflation Remains Well Below the Feds Target Rate

Decembers core PCE inflation rate (the Feds preferred gauge of inflation), came in at an anemic 1.2 percent
annual rate, well below the Feds target rate of 2 percent. This ongoing disinflationary trend in core PCE
remains troubling for the Fed. As the Fed begins to taper the pace of QE, their policy on the path of short-term
interest rates may be a more important driver of asset prices in 2014. Low rates can support equities in various
ways, such as lower borrowing costs, higher profits and higher valuations. Also, short-term rates have a larger
impact on corporate earnings, since most business loans have variable rates.

Headline and Core PCE,

% Change Year Ago, SA
6.0

Source: U.S. Dept. of Commerce, BEA

4.0
2.0
0.0
-2.0
Jan-07
Jul-07
Jan-08
Jul-08
Jan-09
Jul-09
Jan-10
Jul-10
Jan-11
Jul-11
Jan-12
Jul-12
Jan-13
Jul-13

As the Fed has expressed growing concern about the

net benefit of QE, they may be willing to exchange a
faster tapering of QE for a longer period of ZIRP
(zero interest rate policy). At this point, it doesnt
appear that the Fed will raise rates until mid-2015 at
the earliest. When it eventually starts, the pace is
expected to be much slower than the typical 25 bps
per meeting pace in previous cycles. At least for now,
the current market-implied pace of rate increases in
2015 is aligned with the Feds forward guidance.

Headline PCE

Core PCE (ex Food and Energy)

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Moving From Expectation to Validation

The S&P 500 closed the year at 1848, delivering a total return of 32.4 percent. This was the highest yearly
return since 1997, and the fourth highest over the last 40 years. With U.S. equities trading much closer to fair
value, we believe that corporate earnings growth will be the dominant driver of equities this year, not P/E
multiple expansion. Its worth noting that the S&P 500 NTM (next 12 months) P/E multiple expanded from 13x
to 16x in 2013, and accounted for almost 80 percent of the price return. We remain tactically overweight in U.S.
equities, based on expectations of stronger earnings growth and further potential upside surprises in U.S.
economic activity. While dividends remain important to many investors, we believe that large dividendgrowth companies with high cash flow are more attractively valued than stocks with very high but stagnant
yields.
Our continued underweight allocation to emerging markets remains a high conviction thesis due to our
forecast for rising inflationary pressures, a stronger U.S. dollar and the problematic unwinding of a decadelong credit boom in China. The higher trajectory of economic growth in the U.S. and gradual winding down
of QE has reinforced our focus on bonds with shorter maturities. Although credit spreads for corporate and
municipal bonds are tight, we continue to find marginal relative value in these sectors compared with
Treasuries.
Our overweight allocation to alternative assets remains in place primarily due to the improved risk/return
profile versus fixed income. For example, we currently favor long/short strategies that include both stocks and
bonds, which can offer both a differentiated source of return and reduce portfolio volatility.
Kevin A. Lenox, CFA
Senior Investment Strategist / Portfolio Manager

Disclosures

Views are as of the date above and are subject to change based on market conditions and other factors. The views
expressed are those of the author(s) and are subject to change at any time. These views are for informational purposes only
and should not be relied upon as a recommendation to purchase any security or as a solicitation or investment advice from
the Advisor.
The information contained in this presentation has been compiled from third party sources and is believed to be reliable,
but its accuracy is not guaranteed and should not be relied upon in any way, whatsoever. This information does not
constitute, and should not be construed as, investment advice or recommendations with respect to the securities or sectors
listed. Diversification and asset allocation do not assure a profit nor protect against loss.
The actual return and value of an account fluctuate and, at any time, the account may be worth more or less than the
amount invested. Past performance results are not indicative of future results.
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Presentation is prepared by: IBERIA Wealth Advisors
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