What 2014 meant for 2015

U.S. financial assets delivered another year of strong investment returns as the economy finally exhibited signs of accelerating growth.  The domestic economy has posted real GDP gains of at least 3.5% in four of the last five quarters, and although the fourth quarter of 2014 did not match this pace, U.S. economic activity is clearly gathering momentum. Against this backdrop, U.S. stocks shrugged off a number of worrisome developments in 2014, including less monetary stimulus by the Fed, Russia's invasion of Ukraine, and continued economic weakness in Europe. The S&P 500 Stock Index gained 13.7% in 2014 (dividends reinvested), and has delivered double-digit gains in five of the last six years.
Fixed Income investors also experienced respectable gains. Investment grade bond portfolios delivered returns above their coupon interest, boosted by last year's surprising decline in interest rates. Bold investors who ignored consensus forecast of higher interest rates and bought long-term Treasury bonds enjoyed gains of more than 25.0%. Investors in shorter-term bonds experienced returns in the low-to-mid single digits. Municipal bonds did especially well, as higher tax receipts strengthened state and local balance sheets.
Equities overseas generally failed to keep pace with the U.S. Both the MSCI EAFE Index (measuring mostly European and Japanese stocks) and the MSCI Emerging Markets Index (weighted toward large developing economies such as China, India, and Brazil) posted negative returns in 2014 (in USD). The diverging market performance of these countries versus in the U.S. reflected their disparate economic trajectories.  The big story roiling markets as 2014 closed was the stunning 46.0% decline in oil prices. Led by energy, the broad commodity index fell by 17.0%, the fourth straight year of decline. While I believe lower energy prices is a net positive for the U.S. economy, the speed and magnitude of the decline will likely have unanticipated consequences. One consequence may be heightened geopolitical tensions between energy-consuming nations (e.g. U.S. and Europe) and energy-producing nations (e.g. Russia, Venezuela, and Middle East countries).
After several years of outperformance by U.S. stocks, conventional investment wisdom might argue for rebalancing portfolios toward asset classes that have lagged, look to rebalance portfolio's. Our philosophy is based on a diversified investment approach with modest tilts towards asset classes expected to deliver above-average risk-adjusted returns.  On that score, I still see the best combination of supportive economic fundamentals and reasonable valuations in U.S. equities. I am not abandoning other parts of the world; I simply believe the trends that propelled U.S. stocks strongly in 2014 are likely to remain in place for 2015.  However, with short-term interest rates likely to rise this year, lower returns in

  1. stocks, accompanied by bouts of higher volatility should be expected.  U.S. stocks will likely outpace their European counterparts and I anticipate only a modest rise in U.S. long-term interest rates, as low European bond yields anchor U.S. rates at low levels.
    • I remain somewhat optimistic regarding global equity markets.
    • Developed international markets should provide more consistently positive performance in 2015, given the tailwind of lower energy prices, more accommodative monetary policies and some easing of the fiscal constraints that have hurt the eurozone in particular.
    • With valuations in the U.S. higher than in some other countries, shifting to a more balanced view of relative performance is preferred. The U.S. may still do well, but some other markets might do better.
While it's often been said that bull markets climb a wall of worry, what happens when that wall crumbles? Amidst slow but mostly positive economic growth, an historic decline in oil prices, near-zero interest rates, non-inflation and the ardent pursuit of unconventional monetary policies by the world's most important central banks, it is tempting to be clever and assume that the bull market is in jeopardy: If everyone is bullish who's left to buy? The volatility in equities and other riskier assets since September would seem to confirm this view, but that login might be a bit too clever. In my view, it is probably a mistake to over-think things. Rather, as we look ahead to 2015 I believe there are a few simple points to keep in mind.
  • The collapse in oil prices is a net positive for oil consuming countries and regions, both developed (the U.S., Europe, Japan) and emerging (China, India, Asia-Pacific including South Korea).
  • Lower energy prices will encourage central banks to keep ultra-easy monetary policies in place for a longer time and encourage additional governmental measures aimed at economic stimulation (i.e. more aggressive quantitative easing, less fiscal restraint) in countries and regions where inflation is already well below target (eurozone, Japan, South Korea, India).
  • Equity valuations may be elevated in the U.S. compared to other countries, but relatively strong and steady profits growth justifies the higher earnings multiple applied to the U.S. stock markets. Meanwhile, equity markets that have badly lagged the U.S. in recent years could start to play catch-up, assuming economic growth starts to gain tractions.
  • While it's still a scary world out there, as I stated earlier, the oil price slide hurts some of the more nefarious actors on the world stage--Russia, Iran, Venezuela, the Islamic State (ISIS), etc. Anything that constrains or moderates their aggressive behavior is good for the investment outlook.
End 2014 begin 2015 volatile high. I believe that will remain for sometime. Issues in Yemen remain, co- op with Iran, Russia, China, Venezuela. Obama will allow Iran to get Nuclear Bombs and missiles to strike the U.S. Our base-case scenario remains an essentially constructive one, with high single- or low double-digit equity gains in many developed markets, a wide variety of outcomes in emerging stock markets, modest upward pressure in global bonds yields as economic growth prospects improve and challenging commodity markets within a strong-dollar environment. Every year has its share of surprises and unanticipated market reactions.