Dead Souls is an epic novel in which the shyster Chichikov pursues a plan to purchase “dead souls” from Russian aristocrats. At the time of his writing, taxes were levied against the number of serf’s “souls” that one owned to work the land. Much like today, census data was not always up to date, and consequently, aristocrats were often taxed on “dead souls” who remained on the tax register. Chichikov travels across Russia in his troika, a uniquely Russian form of carriage, conspiring to relieve aristocrats of their “dead souls” for a nominal fee. He plans to build his own roster of souls, register them with the government, and then borrow a large sum of money against his non-existent workforce to purchase an estate and live in style. The epic highlights the size, uniqueness, and grandeur of Russia while at the same time illuminating the brokenness of its economic system. At the conclusion of Part I, Gogol highlights the desire of Russians for global recognition through the flight of Chichikov’s troika.
One need look no further than the most recent edition of The Economist for the obvious parallels between the Russia of Gogol’s day and the Russia of the Sochi Olympics. However, as we considered the plot, a thought struck us. Many an economist today would happily draw a parallel between Chichikov and his leveraged utilization of “dead souls” and the interventionist policies of today’s central banks. To the Austrian School of Economics the aggressive utilization of QE, ZIRP, Abenomics, and the ESM, to name just a few of the easy money policies currently employed around the world, are closely akin to Chichikov’s scheme to leverage the souls of the dead for a future of financial prosperity. In such a world it is easy to visualize Chichikov’s flying troika, not as Russia, but as the equity markets of the world flying wildly, perhaps dangerously higher as investors look on askance. Under such a scenario, the more pessimistic among us might liken the denizens of such a world to those of the broken, serf driven, world of Chichikov’s Russia.
While we remain sympathetic to such a view, we cannot fully embrace it. Rather we, like Gogol, have a difficult time embracing such a negative reality. In the short-term there is little doubt that the market was and still is in need of consolidation. Investor sentiment reached extremely high levels in late 2013, and volatility dropped to negligible levels, both contrarian indicators suggesting a pullback was eminent. However, we believe that the underlying support for additional equity market appreciation remains intact in 2014 and will ultimately result in a positive year for global equity markets. Our premise is driven in large part by three rationales and partially supported by a fourth.
Monetary policy in the United States and throughout the developed world remains extremely accommodative. Despite the gradual reduction of the FED’s QE program, Janet Yellen has reassured markets of her intent to keep interest rates at extremely low levels. Further with inflation virtually non-existent, we believe the FED feels free to focus on its secondary mandate of “full employment” rather than its primary mandate of price stability, a situation which in our view, will likely cause the FED to err on the side of further accommodation in the event of a stumble in the global recovery.
The fiscal drag that hampered the U.S. economy in late 2012 and early 2013, along with the correspondingly higher tax rates that negatively impacted consumers, has largely been absorbed. Congress has actually managed to pass a budget and has extended the debt ceiling easing rancor in Washington. Politicians are now focused on mid-term elections and are unlikely to enact any growth damaging legislation in the immediate future.
The macro economy continues to improve. Both domestic and foreign GDP picked up throughout the second half of 2013. Manufacturing and non-manufacturing indexes were up throughout the world while unemployment continued to decline. In the U.S., oil exports are up, fossil fuel production is up, manufacturing has improved, and real estate markets across the country continue to strengthen. While certainly not as strong as past expansionary periods, the current expansion appears to have “legs” and is likely to be with us throughout 2014.
Finally, from a valuation perspective, the market, while no longer cheap, does not appear particularly expensive. At the beginning of 2013 the market was trading at 12.6x forward earnings…today that number is closer to 15.6x. Over the long run the market has traded with an average PE of around 14x. Earnings on U.S. equities are expected to grow between eight and twelve percent in 2014 allowing additional price appreciation with little or no additional multiple expansions. In our view while valuation on its own merit is not a compelling argument for further stock price appreciation, it is, at worst, a neutral variable. Further, when compared to other asset classes like bonds or cash, equities may be viewed in a significantly more positive light.
Consequently, as we consider the prospects for 2014, we find ourselves firmly in the camp of the optimists, and we expect equity markets around the world to perform relatively well.
Commensurately, our outlook for bonds remains more constrained. However, we do not consider ourselves to be blindly optimistic. Threats both known and unknown remain and may yet derail equity markets in the upcoming year. As we consider the situation we find ourselves once again sympathetically aligned with Russian author Gogol. The ultimate irony is that Gogol planned to reform Chichikov, but in a unique twist of fate he never completed his novel. He stopped in mid-sentence, and so we find ourselves today skeptical of interventionist central banks, but with an optimistic view of a future yet to be written.