2014 Wrap up:
While the rapid decline in energy prices dominated headlines as 2014 ended, the U.S. stock market turned in a 6th consecutive year of positive returns with the S&P 500 up 13.7%, outperforming most major international benchmarks. Despite a third consecutive year of double digit returns, there was a defensive tone to U.S. equity returns, as the best performing sectors were utilities and health care, while cyclical sectors like consumer discretionary and industrials trailed. The energy sector was the only group posting negative returns for the year, declining 7.8%.
Driving U.S. equities higher was improving economic growth, something that’s been lacking for some time. U.S. GDP for the 3rd quarter grew 5%, the highest rate in 10 years, and revenue and earnings for the S&P 500 came in at 4% and 8%, respectively. We’ve also seen a meaningful decrease in unemployment, with close to 3 million jobs added last year, bringing unemployment below 6% for the first time since 2008.
While the U.S. economy continued to recover, particularly in the second half of the year, other major economies struggled, with Japan entering a recession after reporting a second consecutive quarterly decline in GDP and China growing a disappointing 7.3%, its slowest rate in five years. Finally, the Eurozone barely eked out a positive result, reporting GDP growing 0.6% over the same period.
Concerns over global economic growth led to a continued fall in interest rates, perhaps the biggest surprise in 2014. Despite the much anticipated end of further U.S. quantitative easing in October, demand for U.S. bonds remained strong, leading the U.S. Credit Index up 5.01% and driving U.S. Treasury yields to 50 year lows. While the Federal Reserve has indicated a mid 2015 increase in interest rates is likely, the impact may be muted if strong demand from overseas continues, particularly as monetary policies decouple. With the European Central Bank (ECB), the Bank of Japan (BOJ) and the People’s Bank of China (PBOC) all advocating their own accommodative policies for 2015, demand for U.S. debt and the dollar are likely to continue.
What’s ahead for 2015?
The U.S. economy enters 2015 with the strongest momentum in at least a decade and as the fittest industrialized nation. We expect the U.S. to continue to grow faster than the rest of the developed world due to a variety of factors which include improving business activity, moderate improvement in housing starts and stable inflation expectations. These factors, combined with the recent decline in oil, should continue to drive a further acceleration in consumer spending and temper inflationary pressures, allowing the Federal Reserve additional latitude for rising rates. We expect earnings growth to be in the mid to high single digits for 2015 allowing for moderate index returns. Given that valuations are in line with longer term averages at 16x forward earnings, we expect future gains to be driven largely by earnings growth and return of capital.
Certainly the path will not be easy and we are sensitive to disruptions to the energy industry as a result of declining oil prices. However, energy earnings represented just 11% of the S&P 500 earnings in 2014 and we believe the benefits of lower energy prices outweigh the risks. While we do expect the stronger dollar to be a slight drag on earnings for U.S. based multinationals, this will conversely be a positive for globally based multinationals, particularly companies based in Europe.
Our Investment Approach
Given the possibility of potentially higher rates and, at a minimum, the improbability that rates can continue to decline at their recent pace, we remain in favor of equities versus bonds. The impact of globally divergent monetary policies will likely lead to lower rates internationally and eventual rising domestic rates, albeit slower than what many anticipated. But, with real rates below zero for much of the world, the impact of any further rate decreases will be nominal. Hence, we expect U.S. based assets to continue to hold up favorably particularly given the relatively encouraging interest rate and economic backdrop.
Looking globally, we anticipate ECB policy initiatives, which could exceed 1 trillion euros in liquidity over the next two years, along with a better external environment (including lower oil prices and favorable exchange rate) will allow for a modest rebound in Eurozone GDP in 2015 and recovering corporate earnings growth. We have slowly but consistently increased exposure to international equities over the last 18 months and continue to evaluate positioning relative to our outlook that valuation multiples have room to expand.
In developing markets, earnings growth has been relatively stagnant over the last 4 years and, while we expect earnings to recover in 2015, we believe current expectations may be optimistic given divergent currencies and monetary policies. Earnings growth is key to higher multiples as valuations are at a 12.0x forward earnings multiple, which is above their 10 year average.
We expect performance in the developing world to continue to be bifurcated, particularly as commodity exporting economies struggle with lower energy based revenues (like Russia, the Middle East and parts of Latin America), while net importers like China and India benefit. Russia, already struggling from global sanctions and a massive devaluation, has a huge gap to fill as energy revenue accounts for more than half its budget. On the flip side, China achieved two major milestones this year; surpassing the U.S. as the world’s largest economy (as measured by the IMF) and earning status as the world’s largest importer of oil, which means it should disproportionately benefit from falling prices. So, while China faces headwinds due to credit issues and a slowing real estate market, the impact may be partially offset by policy reform and declining commodity prices. Given the wide divergence of fortunes amongst the emerging market countries, we believe active management, which can better favor higher quality characteristics and navigate country specific risk, is most appropriate at this point.
For bond investors, we do not see rates moving meaningfully higher near term. We believe increased capital flows to the U.S. will keep rates under pressure as the U.S. offers a better return opportunity. Credit sectors remain supported by strong fundamentals but are not immune to bouts of equity market volatility, particularly lower quality bonds. We believe the mortgage sector continues to offer incremental yield over Treasuries and an attractive outlook. While bank loans recently underperformed expectations due to energy weakness in the second half of the year, energy exposure is less than 5% of the market and actual defaults and default risk is quite low. We favor bank loan exposure for its short maturity profile and attractive current yield.
Though we have a positive view and favor growth assets in particular, we believe risk management is critical as recent periods of volatility (May-June 2013, September-October 2014, early 2015) resulted in sell offs of global equities and bonds. With this in mind, we continue to hold a small allocation to gold. While gold was weak in the latter half of the year and ended 2014 flat, it was up 9% through June, when U.S. equities were weak and geopolitical risks in the Middle East and Eastern Europe were elevated. While we expect an improving economy and higher real rates to be a headwind for gold and keep prices relatively stable in the near term, with the volatile start to 2015, gold is up about 5%.Although we anticipate positive momentum into 2015, we are confident a globally diversified portfolio will best maximize returns and mitigate against local market disruptions, which we will inevitably continue to experience. We expect this disciplined and thoughtful approach to continue to hold up well during periods of volatility and are constantly monitoring changes in the global landscape and considering how this may impact your portfolio.