We understand that you are likely to be disappointed with your portfolio returns for 2014. In this piece, I’ll review the very real global problems causing this lackluster performance, and the actions we have taken and continue to take to mitigate these effects, while protecting your portfolio from the expected challenges of the current global marketplace.
The Good News….
There have certainly been many stories of good economic news reported by the popular U.S. news organizations and from various online sources. It is fair to ask, “If the news is so good, why are my investment returns so weak this year?” In fact, the Large Cap U.S. stock market had a pretty good year, and our portfolios have certainly enjoyed the strong performance provided by our U.S. Large Cap stock holdings.
The Semi Good News….
While our U.S. Large Cap stock holdings did well, our portfolios are globally allocated to help manage the inevitable risks of any single country or market sector. Due to this required diversification, Large Cap U.S. stocks occupy only a portion of our globally allocated portfolios.
In this very unusual year, the U.S. Large Cap Growth sector was nearly the only area with decent performance. More “Value-oriented” (safer) U.S. stocks fared less well.
You have undoubtedly noticed that the good performance of U.S. Large Cap stocks came at the price of sharply increased volatility risk, especially near year end. In fact, this volatility has continued as we move into the New Year.
The Not So Good News…
If you live in the U.S., and are among those well employed or retired, it is easy to think things are “back to normal” everywhere and the Great Recession is well behind us. Unfortunately, nothing could be farther from reality.
With few exceptions, the rest of the global economy continues to face serious economic and political challenges, including ongoing recession (or at least recessionary fears). As we monitor developments in Japan, Germany and Spain, we see protracted weakness. This is even more true of Venezuela and most other South American countries. We see sharply lower growth forecasts for India and Brazil, and a general weakness globally. Even China (the world’s 2nd largest economy behind the U.S.), with GDP growing at over 7% last year, is seeing the lowest growth rate in 24 years, and that is in spite of a surprise Chinese interest rate cut in November.
During “normal” periods of global stock market weakness, one could reasonably expect bond investments to help out. Unfortunately, the effects of the Great Recession are still very much in evidence. Global weakness, especially outside the U.S., requires central banks to maintain very low interest rates in the hope of stimulating growth, and those low interest rates lead to ever lower bond yields and thus low bond returns for investors.
Small Cap stocks have had a very difficult year, both U.S. and non-U.S. alike, as their perceived added risk caused many investors to leave this sector.
Newer economies and especially those deemed to be “emerging” saw increased weakness throughout the year, again as investors prefer “safer” investments.
As recently as this week, the International Monetary Fund (IMF) lowered its forecast for global economic growth in 2015 from 3.5% to 3.2%, and called for governments and central banks to pursue “accommodative monetary policies” (low interest rates) and structural reforms to support growth. Here’s a quote from Olivier Blanchard, the IMF’s chief economist: “New factors supporting growth, lower oil prices, but also depreciation of euro and yen, are more than offset by persistent negative forces, including the lingering legacies of the (2008) crisis and lower potential growth in many countries. . . .” The report noted that the United States is the lone bright spot in an otherwise gloomy report for major economies, with its projected growth raised to 3.6 percent from 3.1 percent for 2015.
Tactical Portfolio Adjustments…
During difficult times, our focus on investment decisions takes on even greater importance. As you can see from the list below, we have been very active in investment research and decision making over the past year.
- In early 2014 we sharply reduced our already small emerging market holdings in both stocks and bonds. Proceeds were redeployed to short term, higher yielding corporate bonds. This turned out well as many emerging economies continue to decline.
- In mid-year and late year we added to our U.S. stock positions and reduced stock holdings in Europe and Asia. We replaced some active non-U.S. equity managers with lower cost ETF (exchange traded fund) equivalents. This turned out well as non-U.S. stocks declined.
- Toward year end we reduced dependence on stocks of specific natural resources companies (including petroleum) and added a broader “basic materials” ETF for improved diversification. This turned out well as oil stocks plummeted.
- We recently added a specific allocation to the Health Care sector. We have seen above normal growth and a resistance to short term market declines in this sector.
- At year end we added a low expense ETF for US bonds and another ETF for the growth portion of the S&P 500 index. This placed some added emphasis on U.S. stocks over non-U.S. stocks, and should be advantageous as the U.S. continues its dominant global economic position.
- Toward year end we selectively captured tax losses for clients in taxable accounts. These booked “paper” losses will be used to offset tax on future capital gains.
Although it is always difficult to get the timing exactly right on allocation shifts, we feel that most of our decisions have benefited our client’s portfolios.
Moving Ahead in 2015…
We hope you read the above comments as “realistic,” rather than “pessimistic.” A realist sees that other than the reasonably good situation in the US, we are in a virtually “flat” period in the global investment marketplace.
This may very well prove to be just another “bump in the road” for investors, but until we see signs of improvement outside the U.S., we plan to remain cautious and a bit defensive. In spite of this caution, there are many opportunities ahead as we all work through the (hopefully) last lingering effects of the Great Recession. We remain confident that our global allocation approach continues to provide an appropriate balance between acceptable risks and reasonable return expectations, especially when viewed over a longer term.
We expect to see substantial opportunities in Europe, but the timing depends on many factors, including an accommodative policy by the European Central Bank (ECB). Announcements by Germany and England last week are encouraging.
While the recent drop in oil prices brings on renewed concerns about possible deflation, lower prices for energy are a significant advantage for transportation and utilities and many other sectors. Over time the shock of lower oil prices should level out and could be a needed growth stimulus for many companies.
While other central banks will need to maintain accommodative policy for quite a long time, there is mounting expectations on the U.S. Fed to allow rates to very gradually rise. However, there is also concern that any rate increases by the U.S. Fed could lead to a dampening of the struggling economic recovery with our trading partners overseas. Whenever this process begins, you can expect increased market volatility as investors try to determine whether rate increases are good news about the strength of the global economies, or bad news about future earnings growth. Over time, we know that we will be better off with more normalized interest rates.
Mandate of Global Diversification…
Looking back, we see that the only way we could have gotten “U.S. Large Cap stock like” returns in 2014 would have been to abandon our tried and true global diversification mandate, and sell out of everything except those Large Cap US stock funds. We naturally see that as an unacceptable risk for our managed client portfolios.
We continue to believe that maintaining broad global portfolio diversification is the best (and perhaps the only…) way to achieve desired returns, while mitigating the unknowable shocks that will certainly be part of our investing future.
We simply cannot know whether a “full” recovery from the Great Recession will occur this or next year. We are optimistic that the desirable market “normalization” progress will continue in 2015. We see signs of this progress in corporate earnings growth, the supportive behavior of the central banks of Japan, mature Europe, and others. At some point the U.S. Fed will be able to reduce the “life support” for our economy provided by quantitative easing, and interest rates will gradually rise to “normal” levels. These trends are not likely to be smooth or regular, but will eventually bring about a return to more predictable “normalized” portfolio returns.
We appreciate your continued patience and your continued confidence in our work on your behalf. We all look forward to the return of “normalized” economic conditions, and will be rewarded by the results that global diversification brings.
Pat Day, VP