By: Warren Averett
February 26th, 2015 |
By: Warren Averett
February 26th, 2015 |
Looking back on 2014, the “Year of the Horse,” most investors will exclaim it was a great year for the U.S. markets, as both stocks and bonds rose. Keeping with the theme of horse racing, the Barclays Aggregate Index (bonds) finished in third place returning 6.0%. The S&P 500 (large cap stocks) finished in second place returning a strong 13.7% in 2014. The winner of 2014 was Real Estate Investment Trusts (“REITs”) which rose 28.0% in 2014, with 12.9% coming in the fourth quarter.
The asset classes that fared poorly in 2014 included the MSCI EAFE (large foreign stocks), emerging market stocks and commodities. All of these asset classes had one thing in common – they were hurt by the rise in the U.S. dollar versus other currencies. Both the EAFE and emerging markets generated positive returns in their local currencies, rising 6.4% and 5.6%, respectively. However, when these returns are translated back into U.S. dollars, the EAFE and emerging markets fell 4.5% and 1.8%, respectively. Commodities had the worst year of all, dropping 17.0% due to concerns of weakening global growth and an oversupply of oil. When combining all of these asset classes, a diversified moderate portfolio returned on average 4-5%.
One of the most interesting aspects of 2014—and, indeed, the entire U.S. bull market period since 2009—is that so many people think portfolio diversification was a bad thing for their wealth. When global stocks are down compared with the U.S. markets, U.S. investors tend to look at their statements and wonder why they’re lagging the S&P index that they see on the nightly news. But that’s the point of diversification: when 2014 began, none of us knew whether the U.S., Europe, both or neither would finish the year in positive territory. Holding some of each is a prudent strategy, yet the eye inevitably turns to the declining investment which, in hindsight, pulled the overall returns down a bit. At the end of this year, we may be looking at U.S. stocks with the same gimlet eye and feeling grateful that we were invested in global stocks as a way to contain the damage. There’s no way to know in advance, but we do know that International valuations are significantly cheaper than U.S. valuations.
Heading into 2015, the economy appears to be on the most solid footing since before the Great Recession. The latest third Quarter GDP report showed the economy rose 5% on an annualized basis, the fastest rate of growth in more than a decade. Additionally, the unemployment rate has fallen over 1% since the end of 2013. Since seeing all of this positive economic data, the market has begun bracing for the first rate hike in June 2015. However, the biggest story has been the continued and intense fall in oil prices. As the two charts below from J.P. Morgan demonstrate, both oil and gasoline prices had remained relatively steady from 2011 until this past summer, when they began their sharp move down.
The fall in oil and gas prices is a boost for global consumers, since most countries are importers of oil. According to AAA, Americans saved $14 billion on gasoline costs in 2014 (or $200/person) and are expected to save $75 billion in 2015.
In addition, the decline in energy prices aids the poorest households the most. According to the Bureau of Economic Analysis, the lowest income households spend 12% of their income on gasoline which compares to only 2% of income for the wealthiest households. This is an immediate benefit for consumers and the economy. However, it’s important to note that the longer that oil prices remain lower, the less of a benefit it has on the overall economy. As investor Howard Marks recently wrote, this is because over time as prices remain lower, both producers and consumers change their habits. If oil prices stay low, drillers will quit producing as much because it is not as profitable. At the same time, if oil and gas prices stay low, people will begin to drive more, thus increasing the demand for oil. Further, instead of opting for the fuel efficient Toyota Prius, they may purchase the larger and less fuel efficient Ford F-250. Consequently, due to higher demand and less supply, prices will begin to rise…and thus the cycle continues. From a geopolitical perspective, lower oil prices hurt countries such as Russia and OPEC nations that depend on oil production to meet their budgets. As geopolitical risks rise in these oil producing nations, prices rise to account for the risk of a slowdown in production. Because of all of these reasons, we expect to see higher oil prices in the intermediate term.
While there is little fear the Fed will accelerate its first rate increase in interest rates in nine years, the fact remains they are on track to raise them in 2015. At the same time, the spigots of monetary stimulus look to be opened even wider in Europe and Japan. Because of this, bond yields outside the U.S. are at or approaching all-time lows. As Spencer Jakab noted in the WSJ, U.S. yields are like the tallest munchkin in Oz. This has resulted in U.S. bonds attracting more global capital and pushed the dollar to an 11-year high versus other major currencies. As we noted last quarter, 40% of the companies in the S&P 500’s revenue is earned abroad. A rising dollar could hurt sales and squeeze their all-time high profits.
As we look at the investment markets for 2015, we expect more volatility and would not be surprised if we experienced a correction in the market, or a fall of over 10%, which we haven’t seen since 2011. Historically, there are three mechanisms that cause large market declines: economic recession, spike in oil prices or tightening monetary policy. The first two seem very unlikely in the U.S., but the third one is causing some angst for investors. The S&P 500 has now posted positive returns in six consecutive years, with five of these being double digit returns. However, since 1875 the S&P 500 has never risen for seven consecutive years in a row. With the dollar strengthening and the Fed tightening, could 2015 break that streak?