2015 Outlook and Commentary
2015 Outlook and Commentary
The year 2014 was one in which we were again reminded of how resilient, robust, and relevant the U.S. economy is. The Dow Jones Industrial average finished the year up 7.5% while both International developed and Emerging markets were down 7% and 5% respectively. Europe alone was down more than 10%.
Our expectation of a continuing U.S. recovery was confirmed by the results: a pickup in GDP, solid jobs growth (best since 1999), improving corporate sales, and surging consumer confidence.
We also expected more volatility due to uncertainty over the U.S. Federal Reserve’s (the Fed) unwinding of the Quantitative Easing (QE) program, and the likelihood of an interest rate hike in the not-so-distant future (The Fed Funds rate has been at zero since the end of 2008). Indeed, we did see more volatility. The S&P 500 (S&P) had five declines throughout the year with an average drop of over 5%. Our view in 2014 was that this volatility would present buying opportunities as long as the U.S. economy continued recovering, which was the case, with each drop being followed by a new high.
Globally, our expectation was that we would see a pickup in growth from anemic levels. This never happened, and our allocation to the international markets was overall low, and remained primarily in our exposure to U.S. multinationals.
Disappointing global growth was also the main reason we did not see a sustainable reading on inflation. Commodity prices are at their lowest levels since 2009! Weaker global growth also put downward pressure on U.S. interest rates, making the bond market a surprise performer for the year. The high yield market was the exception and did perform poorly. Cash wasn’t a bad investment, even at a zero percent interest rate. The U.S. Dollar index was up over 12% in 2014 (foreigner investors and U.S. world travelers really appreciated that).
Strategy for 2015
R.O.C.K. in the U.S.A. – John “Cougar” Mellencamp
As we start the year we recognize that the U.S. bull market is a little long-in-the-tooth. Since the summer of 2011 the U.S. stock market returns are up double-digits. In comparison, the International developed markets have zero returns over that entire period and the Emerging markets are down nearly 20%. Our decision to overweight towards U.S. stocks goes back a few years and will continue into 2015. A premium exists in owning U.S. stocks and that “price” is getting increasingly expensive. Price is something we are certainly mindful of when making investment decisions yet we feel that given the divergences underway between the U.S. and much of the rest of the globe, the premium will persist, and will likely expand into and thru 2015.
Lower oil prices
The U.S. will be a net-gainer if oil prices remain at lower levels, but it’s not at zero cost. Billions of dollars have been allocated to capital investment in oil and oil infrastructure over the last 5 years. Approximately 1/3 of all capital investment in the U.S. has been in this area. Capital expenditures (Capex) will likely plummet in 2015. This will lead to a reduction in earnings not only from oil companies (which account for about 10% of U.S. earnings), but also large industrial companies. Many quality jobs will be temporarily lost.
The positives are that the U.S. is still a net importer of oil and lower oil prices will have a direct impact on every person who goes to the pump (assuming no large gas-tax hike). This is an instant stimulus (like a tax cut), especially for the lower and middle classes who spend a greater portion of their income on food and energy. Lower energy will also reduce production and logistics costs for many companies leading to better margins and profits.
The crash in oil prices will start to cull out the winners and losers from company all the way to country.
The Fed
It is undeniable that low rates have helped fuel the U.S. stock markets to these levels. Lower rates have not only lifted stock markets but have also supported momentum in debt-financed purchases such as real estate and auto sales.
Our view is that the Fed will not “materially” raise short-term rates until the market forces their hand. The catalyst for an aggressive rate hike would be a rapid decline in the dollar and/or spike in long-term interest rates. Both of these indicators are moving in the opposite direction. Consider this; if the dollar continues to strengthen the Fed may delay raising rates until 2016!
Strong Dollar
We expect more volatility in currencies in 2015, with the U.S. dollar remaining the favored currency. This can have a negative effect on earnings if the strong dollar momentum continues unabated. Close to 40% of S&P profits comes from overseas and a stronger dollar will have a material negative impact, at least initially. Domestic growth can help offset this imbalance. The second-half of the 1990s was a period of strong dollar growth and the U.S. stock market did very well. We are much less dependent on exports than the rest of the world. Again, our view is that the Fed will delay a rate hike if dollar strength becomes too much of a problem.
Global Environment
Europe and Japan have been in secular stagnation for years much like the old beat up car that won’t start unless you give the car a little push and then have someone inside the car “pop” the clutch. With each unsuccessful attempt, the car sputters for a few yards and then loses momentum and rolls to a stop. Japan started a massive QE program to “push-start” their economy in late 2013 and initially Japanese stocks rallied sharply. Recent tax increases however, have slowed momentum in Japan. In Europe, Germany appears to have acquiesced to the idea of QE and the European Central Bank (ECB) is getting the primer ready for their version of QE. Expectations are so low in both regions that we feel one or both could surprise to the upside. With low stock valuations these regions might be a good area to invest in 2015.
Our view on the Emerging Markets (EM) is that country/region selection will be very important. Most EM countries are not economically diverse and their financial markets are fragile. This can lead to major disruptions based on sudden capital inflows or outflows. As in the 1990s, weak commodity prices and a strong dollar make many EM counties vulnerable to financial crises. We are especially concerned with oil-producing countries. Conversely, many Asian countries (India included) benefit greatly from lower oil prices. China will be the country to watch. China has been trying to diversify to a more consumption-based economy. Because of its massive size, any missteps in China would not only affect the region, but the global economy.
Investment Implications
These are our primary themes as we move into 2015:
–We continue to favor U.S. markets over International
–Greater emphasis on stock and sector selection: Last year less than 20% of actively managed funds beat their respective index. We believe you will see more divergence within stocks and sectors of the market than in prior years. Picking the right sectors and stocks will be a differentiator in 2015.
–Dividend growth vs. dividend yield: Quality of dividends and not the actual dividend rate will become more important. With high yield debt rates increasing, it will be difficult for many high dividend-yielding companies dependent on debt to finance dividends, to be able to raise their dividends. Our view is that healthy companies with strong free cash flow will be more desirable for the income community of investors.
–Sectors/Industries we like: We continue to favor Health Care (demographics and biotech advances), Technology (mobile ubiquity and productivity advances), and Consumer sectors (low interest rates and commodity prices). Within the consumer sector, we believe the Discretionary sector will outperform through the course of the year based on lower oil prices and consumer confidence.
–Energy sector: We expect oil prices to remain volatile and possibly reach absurdly low levels, but we also do not expect sub $50/barrel to be the new equilibrium. The mathematics simply does not support this unless we assume an extremely weak global economy. The implication to investments is that some producers with heavy debt loads will go bankrupt and producers with manageable debt levels and low costs of production will generate very high cash flows and will make great investments over the long term. Industrial companies and oil service companies will struggle because the Capex spending cycle will have peaked in 2014.
–Rate-sensitive investments: Bonds, REITs, Utilities, performed surprisingly well in 2014. We were not heavily invested in these areas and missed out on some of this performance. Rates may even continue to move lower into 2015. The U.S. 10-year treasury finished the year slightly above 2%, while the equivalent German Bond ended the year paying 0.5%. It is possible for long-term U.S. rates to move lower, especially in the first half of the year, with the 10-year U.S. Treasury potentially breaking the 1.4% level of 2012 (all-time low). This means these investments could outperform in the short term. If we are correct however, inflation expectations will pick up in the second half of the year and long-term rates will have to move higher. We are cautious in this area and feel that these are poor long-term investments (until rates make the adjustment higher). Shorter duration TIPS bonds and Bank stocks look appealing as rates start to pick up.
–Global markets: We believe Europe could be the surprise performer because of low expectations and the inception of a QE program. Our focus here is on large-cap, quality companies. For the more aggressive portfolios, we feel Asian economies present opportunities.
–Aggressive opportunity: As oil finds a bottom there could be some huge upside for oil producing countries/companies. This could make for some interesting opportunistic investment plays.
Risks to Outlook
The U.S. economy accounts for about 20% of global GDP. This means that it will be difficult, if not impossible for the U.S. to continue growing if the world economy slows further. If the global economy did pull the U.S. into a slowdown, all stock markets would enter a correction.
The U.S. stock market is trading at an elevated level and any of these shocks could create violent “air pockets”. The recent decline in oil is an example of an air pocket. This is why only the most aggressive investor should be fully invested at this time.
Here are some risks to our 2015 outlook:
- Earnings drop is larger than expected due to weak global growth, lower Capex, and consumer spending disappoints (people save instead of spend)
- Fed raises rates to test the market and market reacts adversely
- Lack of stimuli actions in Europe, Japan, and China lead to weaker than expected growth/deflation
- Junk bond yields continue to move higher, leading to more bankruptcies as companies cannot roll over debt, eventually spreading to other markets
- Margin debt balances peaked in early 2014, and if margin debt starts to fall it could lead to substantially less liquidity and demand in the stock markets (margin debt levels have a good track record of predicting market tops)
- Geopolitical instability in oil producing autocracies (75% of oil reserves are owned by national oil companies) could lead to skirmishes, wars, etc.
Conclusion
We expect higher volatility in financial markets, but with a coordinated effort from world central banks and a growing U.S. economy, we see another year of positive investment returns.
Stock and sector selection will play a key role and, if inflation picks up in the second half of the year, we expect interest rate sensitive investments to begin to underperform. Some international markets could surprise to the upside because of rock-bottom expectations.
It is an exciting time. There are some wonderful advances happening in health care and technology and the U.S. has the greatest financial asset of all: Innovation.
R.O.C.K. in the U.S.A!
All of us at Vigilare are grateful for your trust and support.
The Vigilare Wealth Management Team