During 2014, we marked several 25th anniversaries. It has been a remarkable period of change. The World Wide Web was born on March 12, 1989, forever changing commerce and our lives. The citizens of China and Germany have experienced significant changes in the 25 years since the Tiananmen Square protests and the fall of the Berlin Wall. Going forward, we are restoring our relationship with Cuba, and are still figuring out who our allies are in the fight against extremists. With the rate of change accelerating, of one thing we are certain: the future is one of constant change that will require us to adapt without getting whipsawed.
For 2015, the prospects are good. In the U.S., the unemployment rate fell to 5.6% at year-end 2014, the U.S. budget deficit shrunk to $488 billion in December ($72 billion less than in 2013), and the U.S. trade deficit was lower since domestic energy production has reduced our imports. Improving economic conditions have resulted in higher car sales, improving home prices, and a 62% increase in capital raised by venture capital (VC) firms to fund startup companies and initial public offerings (IPOs). In 2014, VC firms brought 105 companies public, the most in a year since 2000. On a global scale, 2014 was a strong year for IPOs (with $249 billion raised globally), showing an increased appetite for smaller companies.
From a U.S.-centric lens, the U.S. is stronger than it has ever been and is leading the global economy. GDP growth was revised to 5% for the third quarter of 2014. Looked at a little closer, we are not as much in the lead as we were. With their October 2014 estimates of global GDP, the International Monetary Fund (IMF) has ranked China as the number one economy, regaining a status it had held for many centuries and bumping the U.S. to second place. The IMF uses the Purchasing Power Parity (PPP) methodology, which is also used by The Economist Magazine for its “Big Mac Index.”
Following the mixed signals of 2014, we expect another confusing year ahead for investors. Our five themes for 2015 are:
- North American energy production has changed the dynamics for oil prices.
- A strong dollar does not make the U.S. the best place in which to invest.
- A strong economy pressures the Fed to make a move on interest rates, but will they stall?
- The bond market is not what it used to be.
- Active and passive (non-index) managers who have an emphasis on quality and valuations will again look smart.
The Energy Boost
Our efforts toward energy independence have been so successful as to change the supply and demand dynamics for oil sooner than anyone expected. North American production has resulted in less control over prices by OPEC and sharp reductions in the price of oil. It is remarkable that oil prices above $100 per barrel were so quickly assumed to be the new constant.
The chart below is a reminder that prior to 2006, prices under $60 per barrel were the norm. According to our portfolio managers at First Eagle, rising costs from greater complexity has driven up the capital expenditure per barrel of oil from $5 to $30, still allowing margins for efficient producers. During a recent call with Ruchir Sharma (lead portfolio manager of the MSIM Emerging Markets portfolio), he discussed the 100-year history of oil prices and their conclusion that oil prices are getting back to their 100-year average of $55 per barrel, which could be the “new normal”. In his view, we needed the additional production to force the adjustment in prices. The law of supply and demand is playing out in energy prices.
Going into 2015, declining energy prices are having a dramatic and positive impact on the global economy. Lower energy prices help economies that import energy (the Asian countries) and hurt those that rely on their energy exports (including Russia).
Conservation and improving efficiencies have kept consumption levels fairly stable. According to Jack Hafner at Credit Suisse, consumption levels are currently 90 million barrels of oil per day globally, versus daily production of 91 million barrels. North America has been producing more, and global consumers might begin consuming more. Will we see more SUVs and recreational vehicles sold, will we see the scale of exploration and production projects reduced, or will OPEC reduce production in an effort to push prices back up to the $60 to $80 range? It will be important to monitor how consumption and production trends respond to oil prices.
The Dollar: Boost or Drag?
The strengthening of the U.S. dollar in 2014 was one of the year’s surprises. A strong dollar does not make many American businesses happy since it makes our goods and services more expensive, negatively impacting our exporting companies. A weaker currency in the Euro bloc and Japan help those companies that export to us. Central banks are motivated to narrow the spread in exchange rates to keep their economies stable. In the past, the strength of the dollar has moved in line with the direction of interest rates. These have not been normal times, with central banks outdoing themselves to bring yields to record lows, and even to negative territory.
In the chart below, we illustrate the relationship between the U.S. dollar and the euro, versus the 10 Year Treasury Rate. As you can see, they generally follow the same direction, except for recently – the dollar strengthened while rates fell in 2014.
This imbalance may last a little longer because of the scramble by the non-U.S. central banks to keep stimulating their economies. Short-term currency fluctuations can be unpredictable and at crosshairs. We rely on our active non-U.S. equity managers to employ curr= Markets do not always move in lockstep with the growth rate of their economies, but there should be a benefit to being in a fast-growing economy. Global diversification remains important. The World Bank’s January 2015 report, “Global Economic Prospects, Having Fiscal Space” includes their estimates for real GDP growth in 2015. The results are summarized below:
All regions are expected to grow except for Russia. For Latin America and the Caribbean (not included in the chart), estimates are for growth of less than 2%, with the Caribbean leading the region with projected growth of 4% in 2015. The direction of energy prices and shifting consumption patterns and actions taken by the central banks currencies will have an impact on the actual results – some negative and others positive. The unknowns are to what degree ongoing innovation and efficiencies will take hold, particularly in the developing world, accelerating their pace of change.
During 2014, the U.S. was not the top performing market but a stronger dollar muted the impact in many cases. One of the standouts was India, which was up 23.9% in dollar terms. Investors who shop globally but invest domestically may benefit in a year like 2014, however; over the long term, non-U.S. markets can experience extended periods of outperformance.
During the past 25 years (the period from 1999 through 2014), the MSCI All Country World ex-U.S. has outperformed the S&P 500 in 11 years (44% of the time);. There are two distinct periods: from 1999 through 2009, the MSCI ACWI ex-U.S. outperformed in 8 of 11 years (almost 73% of the time) and only in one year for the period of 2010 through 2014. The last period in which the S&P 500 dominated was from 1995 through 1998.
The Bond Market: Avoiding the Stampede when the Fed Makes its Move
Under normal conditions, a stronger economy, a declining unemployment rate and falling energy prices would force the Fed to begin raising rates in 2015. Lower energy prices have whittled away any near-term concerns about inflation. However, there is the possibility that weakness in Europe and Japan could alter the Fed’s course. We are currently observing a stampede of central banks to ultra-low interest rates, with investors so eager for “safety” that they join the buying frenzy. How will investors react when interest rates are no longer suppressed and rates adjust? We have never been in this situation before, nor have the leaders of the central banks.
By buying bonds, the central banks take bonds out of the market, reducing supply. The demand for bonds from investors can easily overwhelm the supply of bonds on any given trading day. When buyers bid up prices on the bonds that are available, it drives down yields. Also impacting supply is that banks and broker-dealers are less eager to hold bonds due to post-crisis capital requirements, with fewer U.S. primary dealers in the market (down from 46 in 1988 to 22 in mid-2014). As these effects converged, yields have fallen sharply. Unusual trading volume on October 15, 2014 has regulators concerned about the impact of high-frequency traders in creating artificial and temporary demand. As we have discussed in the past, the bond market is far more complex than the stock market, making its risks greater when its bull market ends.
Our bond managers are using a number of tools to avoid being overcome at either end of the stampede. Rick Rieder of BlackRock expects longer-term interest rates to remain relatively low due to the growing demand for income assets by pension plans, insurance companies and retirees, but a 10 Year Treasury yield below 2% is not rational at this stage of the economy.
Our Commitment to Active and Passive Managers
After a year like 2014, in which only 19.9% of U.S. equity managers outperformed their benchmarks, many investors decided to abandon their active managers in favor of index strategies. We have not. We believe that the most prudent way to achieve diversification and take advantage of mispricing in the market is to combine both active and passive managers.
Not all passive managers are alike, and the results are not always what they seem. We employ the passive strategies of Dimensional Fund Advisors (DFA). Their exclusion of REITs and regulated utilities caused them to trail the large cap benchmarks, and their policy to not be hedged in non-U.S. equities also led to underperformance in 2014. The ability of DFA to buy or sell based on valuations without regard to the actions of an index committee has been of great benefit to our clients. In an index, you are always buying its constituents high (you are buying more of what has done well). Another key difference is that many index funds attempt to replicate the index in order to reduce costs. DFA controls cost and has very low fees, yet they cover the universe of securities in their strategies.
As discussed in our Annual Attribution Study, several of our long-term top-performing managers underperformed during 2014, after generating extraordinary returns in 2013 and in prior years. Their discipline to sell stocks that become overvalued and buy companies out of favor results in occasional underperformance. Active managers focus on quality, earnings, price and risk management. An index does not care about these factors.
We remain disciplined in our process of investing in companies of quality that can endure market disturbances and that can be bought at attractive prices, due to the skill of our managers. We monitor our managers carefully, and will be compiling our annual manager report in the coming months. Over the long term, our clients have benefited from our disciplined approach of manager due diligence, which considers performance in the context of market conditions, opportunities and the style for which they have been hired.
This has been a very confusing period in market history, and it may become more confusing in the year ahead. The scale and duration of government intervention has skewed not only the bond market, but the equity markets as well. The appetite for income has led investors to some unusual corners of the market, in which quality is weak yet returns have been strong.
A strengthening labor market, low inflation due to lower oil and gas prices, and the growth in global consumers are only three of the reasons for a bullish outlook for the global equity markets if we can return to normal capital markets in 2015.
An original article authored by the Investment Research Group of Wescott Financial Advisory Group LLC
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