The Global Expansion That Wasn’t
In this Issue:
- 2014 In Review – If there is one thing investors will remember about 2014, it will likely be the unexpected collapse in oil prices in the second half of the year. At least that gave everyone a little extra spending money during the holidays. While the decline in oil prices is an important global development, it is particularly significant when coupled with the surprise slowdown in European economic growth. These actions interrupted the global economic growth that had been on track for most of the year, erasing much of the earlier equity market gains. Nervousness in global equity and commodity markets and the return of very high daily market volatility, led to yet another “flight to quality” in the bond markets, and the increased demand for U.S. Treasuries. The bottom line was a year where only U.S. large cap growth showed significant gains. Nearly all other parts of the global investment markets turned in flat or negative performance, and did so in an environment of increased volatility and general nervousness.
- Investment Factors for 2015 – Given the many macro-economic concerns currently playing out, and a few which we think will be the most meaningful to watch in 2015, the one that will likely stand out is market volatility.
- Portfolio Positioning – We made several tactical adjustments in our portfolios last year to align portfolios with market trends as the year unfolded, and we remain positioned for a gradual continuation of the global economic expansion in 2015.
2014 In Review
A diversified approach to portfolio management, defined as one that includes multiple asset classes, can be challenging when just about all global assets underperform U.S. large cap stocks and Treasury bonds as they did in 2014.
As the table shows, Large-Cap Benchmarks for domestic stocks were up around 13% for the year, but Small Cap Benchmarks were only up about 5%, and foreign market benchmarks were down. The benchmark for foreign stocks, the FTSE Developed Markets Index, was down 6%, European equities were down 7%, and Emerging Markets were generally flat for the year.
Bond markets ranged from up almost 6% for the Total Bond Market Index to up only 1.6% to 2.5% for domestic corporate bond markets, and down 0.5% for the World Government Bond Index.
These results reflect investor preferences for high quality U.S. investments, even if these assets were the most expensive of them all.
Like many, we were positioned going into 2014 for a break-out year for the global economy and a time when U.S.-led economic growth finally started to spread to Europe and the rest of the world.
But 2014 didn’t start well, as severe winter weather in the U.S. was blamed for surprising negative GDP growth in the first quarter of the year. While economic growth continued overseas, the U.S. market was expected to continue its growth trend. This turned out to be accurate, as Second Quarter economic data was much better than expected and global stocks, led by foreign markets, rebounded.
At the mid-point of the year everything looked rosy. The global economic expansion thesis was on-track, except for falling bond yields that were seen as the result of continued Central Bank purchases (Quantitative Easing, or “QE”) here and in Europe. Global equity markets were headed higher, and our analysis showed bond yields should eventually rise as well, once the Federal Reserve (the “Fed”) agreed that the economy didn’t need its further support.
It was at this point that foreign developed markets lost their market leadership on the news of more banking problems in Spain, and which turned out to be a harbinger of things to come for Europe. At the end of the Third Quarter, foreign and U.S. markets were stalling, and then turned down violently in October with worries that even included the Ebola disease and fear that it was out of control in the U.S.
It wasn’t until early November that the fears of Ebola subsided. This occurred at the same time it became clear that more European economic stimulus was going to be needed. Persistent growth in the U.S. attracted capital to U.S. assets, pushing the U.S. Dollar, stocks, and bonds all higher.
Meanwhile, the Fed’s bond-buying spree appeared to be ending in December, and this should have led to higher U.S. interest rates. Instead, the weakness in Europe and Asia caused the opposite to occur, and global investors flocked to the safety of U.S. Treasuries, further depressing yields. We saw the U.S. 10-year Treasury bond yield drop to a scant 2.2% by year end (see chart), and yields are even lower as this commentary is being written.
Instead of bonds reflecting the domestic economy’s improving strength as they usually do, our bonds reflected the rest of world’s relative weakness. The added demand for U.S. assets from overseas pushed U.S. currency, stock and bond prices to new highs at the end of 2014, much at the expense of foreign markets that fell as a result of the capital flight.
Investment Factors for 2015
- Interest rates
- Global economic growth
- Market volatility
The investment landscape for 2015 is an interesting replay of last year’s anticipation of real economic growth, but now with an international focus that may take a year or more to unfold. The U.S. economy has finally gotten into gear, and has improved to the point where jobs are being created and the Fed can start to slowly normalize interest rates.
We now know that it will take longer for foreign markets to get to normalized growth, largely due to the lingering deflationary effects of the Credit Crisis and the multi-country structure of the European Union that has created critical delays. This has caused interest rates here in the U.S. to remain lower for longer than we expected. However, once the European economy starts to show some signs of growth, U.S. interest rates should start to reflect our strong domestic growth and the coming change in domestic interest rate policy.
The “QE” stimulus programs sponsored by the U.S. Fed have successfully supported a strong economic recovery in the U.S. Now it is time for the Bank of Japan (the “BOJ”) and the European Central Bank (the “ECB”) to shoulder their share of required economic stimulus for the rest of the world (see chart). The results of these efforts are still unknowable, and investors are not likely to celebrate these efforts until real GDP growth in Europe returns.
We remain convinced that these stimulus efforts will show positive benefits, perhaps as soon as late 2015. And as Europe is Asia’s largest customer, increased European economic activity should inevitably expand to Asia.
Market volatility is the by-product of all of these issues. Volatility, which is still well below its historical average, will likely rise in 2015 due to the uncertainty and timing of all of these important economic factors. With the price of oil gyrating, the Fed ready to change tack on interest rates, the European economy struggling, and geopolitical tensions in and around places like the Middle East and Russia, we expect global markets to be more volatile in 2015.
Portfolio Positioning and Investment Strategy
Trends in 2015 will likely continue where they left off in 2014 – with U.S. markets out-performing foreign markets, interest rates and oil prices remaining low, and market volatility higher due to oil swings and the uncertainty of the political and economic consequences.
However, as 2015 progresses we expect foreign markets to regain leadership, and oil and interest rates to move moderately higher as the uneven global economic recovery continues. Below is our strategy and positioning for each asset class:
Stocks remain the most attractive asset class today. U.S. equities should continue to benefit from strong earnings, low interest rates and falling energy prices. Foreign equities, which are considerably less expensive than U.S. equities, should benefit from the substantial monetary stimulus in Europe and Asia.
While we continue to favor U.S. equities over foreign, we believe in a global equity portfolio for added diversification. We have also refined our approach to equities generally by including lower-cost index holdings along-side our active managers.
Bonds remain moderately attractive. During periods of deflation, even low-yielding Treasury bonds will be in demand as they are now. However, while we still don’t see inflation as a problem, we do see the U.S. economy operating at a level that historically has been associated with inflation. For this reason we continue to like the more credit-centric sectors of the bond market that benefit from economic growth.
We continue to favor specialty bond sectors such as shorter-dated U.S. corporate bonds (outside of the energy sector) and asset-backed securities.
Commodities remain unattractive due to slack global demand for many raw materials. Oil is a current high-profile example. Its recent price drop reflects the slower economic growth outside the U.S. and the ongoing evolution of China from an industrial to a service-oriented economy.
We continue to underweight commodities, with our only investment being a managed fund that benefits equally from positive and negative trends in a diversified set of commodities, currencies, and other assets.
Alternative Investments are selectively attractive, primarily to mitigate interest rate and overall portfolio risk. While alternative investments continue to proliferate in the marketplace, we have found that their usefulness has been limited to these specific roles in the portfolio.
Due to the headwinds facing longer-term bonds in a growing global economy, lower-volatility alternative investments continue to be helpful in providing portfolio stability without the interest rate risk associated with traditional bonds. Our fixed income portfolios are over-weighted low-volatility liquid alternatives to manage risk within this generally expensive asset class.
Additionally, we have select opportunistic strategies that are helpful to increase overall portfolio diversification through their capacity to access other asset classes, such as currencies, and their ability to tactically benefit from market volatility.
We anticipated that economic growth would start to spread globally in 2014, and in hindsight we were early in our positioning as European and Asian growth are only now poised to further develop. Signs of deflation from uneven global demand, such as oil prices, should continue in 2015 and are reminders that U.S.-style monetary policy action is needed in Europe and elsewhere to combat lingering effects of the 2008 debt bubble and associated market volatility.
– Peter Lowden, CFA