Market Review (December 31, 2014):
2014 returns in equity and fixed income markets defied all market pundits from their initial prognostications for the year. Instead of stock markets limping ahead in 2014 due to fears of significant interest rate increases by the US Federal Reserve, just the opposite happened. The broad US market did much better than anticipated in large part due to continued growth in the US economy, inflation significantly below the Fed’s 2% target rate and 10 year government interest rates which ended the year at 2% instead of the 3.5% most had anticipated. As such, fixed income markets delivered positive rather than negative returns for 2014.
Lower global interest rates resulted from a confluence of factors. The plunge in bond yields in the Eurozone and Japan due to anemic growth and large bond purchases by the European and Japanese central banks to help stimulate their economies caused global investors to seek the safety and higher yields of US government bonds. Such purchases, combined with periodic flights to the safety of US treasury bonds due to global crises in the Ukraine and the Middle East continued the downward pressure on US interest rates. Moreover, deflation rather than inflation (the enemy of bond holders) was the concern expressed by central bankers around the world.
Given 2014 forecasted growth of 2.2% in the US vs. 0.8% in Europe and 0.9% in Japan and decelerating growth in China, the US was really the best house in the neighborhood. The unexpected stock market increase was primarily due to inflows from both domestic and foreign investors in well known, large cap names in the face of a rising dollar as well as unexpectedly strong GDP results in the second half of the year. Further, a 50% decrease in the price of oil in the second half of 2014 and restrained wage growth has resulted in a very odd situation wherein we’re having continued growth in the US with inflation staying very low between 1-1.5%. This is highly supportive of stocks as the quality of earnings is high in the absence of any inflationary influence. Market P/Es are slightly above historical averages since the 1930s, but still below the averages over the past 20 years which indicates that there might still be some room for equity upside all other things being equal.
However, specific market performance by sector tells a different story for 2014. As you can see in the chart on page 1, only large cap US stocks did well in 2014 as most investors sought the safety and security of large cap, dividend paying US names with lessened risk. Not all large cap stocks did well as the Dow Jones average, which is more highly concentrated than the S/P 500 in terms of names, trailed that index by a wide margin. European, emerging market and US small cap stocks all significantly underperformed vs. the S/P 500. The causes were many including a strengthening of the dollar as well as investors’ less optimistic view of their future growth expectations.
Looking to 2015, the lack of clarity on the timing and amount of the Fed’s interest rate increase will cause volatility in markets all year. The flow through of the 50% decrease in oil prices since last summer will also cause volatility until investors see how this carnage plays out through the global economic ecosystem. On balance, the impact of lower oil prices should be a net positive for the US and global economies as the price reduction acts as tax relief for the general public. However, parts of the global economy will suffer and capital investment in our global oil infrastructure will reduce, including investments in alternative energy. Weak growth from our global partners might just stay the Fed’s hand at increasing rates this summer as most people predict. The strengthening dollar will also restrain earnings growth of S/P 500 companies whose foreign operations represent almost 40% of their revenue currently. So, even though the US economy seems on solid footing for 2015, there are many headwinds which could limit earnings growth in 2015 and heighten volatility. And, ultimately, markets do follow corporate earnings.
Market Review (June 30, 2014):
Both equity and fixed income markets trended modestly higher in the first half of 2014. After large gains in 2014, global stock markets paused in Q1 and rebounded in Q2. The general mood in US stock markets for the current period is one of uncertainty as to the future direction of the economy due to very weak GDP results in Q1 and ongoing concerns as to the rate of economic growth for all of 2014. This mind set change from the upbeat assessment exiting 2013 was due to the harsh winter conditions experienced in Q1 and the impact of the active but planned withdrawal of financial stimulus to the economy by the Federal Reserve by year end 2014. Markets are also concerned as to the timing and amount of short term rate increases by the Fed sometime in 2015 which could further reduce economic activity. In our “new normal” post the 2008 recession , the direction of markets and interest rates are significantly influenced by central bank policy and actions as opposed to just the performance of individual sectors and companies. As such, the Fed has significantly helped fuel stock market gains for the past five years with its application of unprecedented amounts of stimulus . In essence, they are now removing the intravenous from the patient and markets are wondering how the patient will function out of the hospital environment. Global tensions in the Ukraine and the Middle East certainly haven’t helped either although the US’ increasing energy independence has reduced the potential impact of rising oil prices in comparison to prior periods of instability. Similar to 2013, US stock markets have exceeded returns in Europe and emerging markets this year. Europe continues struggling to exit a recession and is now adopting more aggressive monetary stimulus to promote growth. Emerging markets gains have been volatile and limited relative to the US due to continuing concerns about a slowdown in the Chinese economic growth rate and its collateral impact on trading partners and commodities needed to fuel China’s growth engine. In general, our exposure to both European and emerging markets have detracted from aggregate equity returns relative to the S/P 500 index for the first half year.
In contrast, fixed income markets have benefited from many of the issues that are currently restraining equity markets, notably weaker than anticipated US and Chinese growth and increased global tensions which generally encourage investors to seek out the safety and liquidity of US government and high grade corporate bonds. Following a very poor 2013 and predictions of further losses in 2014, fixed income markets have completely surprised pundits by turning in positive results in the first half of 2014. The things that can spook bond markets such as rapid economic growth, higher inflation related to such growth and an increase in interest rates to contain inflation have not materialized. In fact, long term interest rates as measured by the 10 year US treasury bond have actually declined from 3.04% at year end 2013 to 2.53% at June 30, 2014.
Market Review (December 31, 2013):
2013 represented a tale of greatly different market returns and characteristics. The stellar world performer was US equities with a return of 28-30% for major indices, far higher than the 8% originally forecast by market strategists. US markets overcame a number of political and economic uncertainties during the year including the timing of stimulus withdrawal by the US Fed, the nomination of a new Fed chairman, German elections, potential US engagement in the Syrian civil war, the US budget debate, government shutdown and debt ceiling authorization and negative Chinese and European economic development. Half of stock market gains were generated in Q1-2013 which caught the markets very much off guard. Other equity markets such as Europe and Emerging markets didn’t fare as well returning 19.7% and -4.4% respectively. Many sectors within the US stock market also underperformed, as returns for defensive high dividend oriented stocks such as utilities, telecoms, and many consumer staples significantly trailed general market returns as interest rates rose and risk assets became more in vogue. On the other side of the spectrum, bonds as measured by the Barclays aggregate were down 2.0% for the year, emerging market bonds were down by 11.9% and commodities such as gold and copper were down 27.7% and 8.3%, respectively.
What caused such divergence? First, through massive monetary stimulus, the US stock market has been inflated by the easy money policies of the Federal Reserve and other major central banks such as Europe and Japan which kept the world’s markets flooded with cash to try and promote global growth. US market performance also benefited from a significant expansion of P/E multiples in the US in an environment where real inflation averaged only about 1.2% for the year, far below the Fed’s targeted levels. The general thought is that the lower the inflation rate, the more “real earnings” an investor is willing to pay for. Interestingly, S/P earnings, the key determinant typically of stock price returns, were healthy, growing by 5% in 2013 but paled in comparison to a total return of 29% for the S/P. This disjunction can only go on for so long without a reversion to average behavior.
Stocks are fairly valued by most indicators currently. One would imagine that stock returns should revert to earnings growth metrics in 2014 with an easing of monetary stimulus initiated by the Fed in December 2013. As such, corporate earnings are currently estimated to grow by approximately 10% in 2014. Emerging markets were really hit hard this year as Chinese growth slowed and money flowed out of such countries with the abrupt rise in US interest rates which occurred during Q2 and continued through year end. As US interest rates rise, the dollar and dollar denominated assets typically strengthen at the expense of foreign currencies and assets.
On the other hand, the doubling of interest rates during the year, from a low of 1.6% for the ten year bond in March of 2013 to a closing rate of approximately 3.0% at year end, was a direct result of the Fed’s communication with markets that it would start to taper its purchases of US mortgage and government debt with an improving US economy. The first communication, in May of 2013, shocked markets and caused tremendous disruption and losses to fixed income firms and portfolios. As such, bonds were down 2.0% for the year, one of their worst performances in 18 years. Emerging market bonds were down almost 12%, even more pronounced due to capital outflows out of emerging market currencies. Looking to 2014, the withdrawal of US government support for bond purchases combined with estimated US GDP growth of around 3% has caused analysts to forecast interest rates of between 3-3.75%. If rates continue to rise, bonds will have a difficult time generating positive returns in 2014. However, if the economy falters, bonds could post total returns of 3-5%.