CKBlog: The Market

Monday, January 12, 2015

2014 Market Review

It may be surprising that in a year where the S&P 500 Index and the Dow Jones Industrial Average were both up more than 10%, 2014 was a challenging year for the global investor. 

2014 will be remembered as the year of the US Dollar as all major currencies depreciated against it in 2014. This was principally the result of the following factors: (1) growth prospects in 2015 are better in the US than other parts of the world and, (2) the expectation is that the US will raise interest rates in 2015 whereas most of the other developed countries were in the midst of or are embarking on their early versions of quantitative easing (printing money) to stimulate their respective economies (implying low or lower interest rates). In short, the US is much further along in its recovery from the financial crises.

In addition, there were three important developments which affected both the bond and equity markets in 2014:

1. The second half of 2014 saw petroleum prices drop by over 50%. Demand from Europe was lower, but the major impact was the much larger than predicted supply of oil and gas in the US.
2. As Chinese growth projections eased, metals and agricultural commodity prices declined. It is now clear that there was considerable commodity accumulation both internal and external to China, fueled in part by low carrying costs. When growth targets were lowered the accumulation was “re-released” into the markets, further putting additional downward pressure on commodity markets.
3. Long term interest rates dropped in developed countries. The drop in rates in the US bond markets was contrary to practically all analyst and pundit predictions in late 2013. More surprising was that this was in the face of larger than predicted growth in the US. The US 10 Year Treasury yield dropped from 3.05% on January 2nd, 2014 to 2.17% on December 31st, 2014 (it trades at 1.9949% as of the time of this writing). Contributing to the drop was global demand for the relatively high US Government interest bearing debt relative to the bonds of other developed countries. Consider the global investor’s choice at today’s rates.  He or she can choose between a yield of 1.9449% from a US 10 Year Treasury Bond versus 0.49% from a 10 Year German Bund.

2014 Investment Results:

Clearly the best investment location in 2014 was the US. Most sectors within the US markets did better than anticipated, especially in the first half of the year. Continued positive economic news fueled the S&P 500’s bull-run. While “mini” corrections did occur in 2014, namely during the Ebola scare and more recently amidst the volatility in petroleum prices, such corrections were short lived.  In the end, investors were rewarded by investing in the US both in terms of equity prices as well as the appreciation of the US Dollar. 

An example of the effect of the stronger US Dollar is evident in the performance of the European stock market. In Euro terms the MSCI Europe Index increased +7.6% in 2014. However, due to the depreciation of the Euro versus the US Dollar, investors experienced a -5.5% decline in the Index in US Dollar terms.

The net result was that global diversification was painful to dollar referenced investors in 2014.

2015 Expectations:

The drop in petroleum prices in the third and fourth quarters of 2014 negatively impacted the share prices of petroleum related companies. It was also met with a sell-off in high yield debt as concern about the default risk of non-investment grade US petroleum exploration companies increased. 

There is no doubt that the drop in oil prices will cause short term pain within the oil industry, but we expect that low petroleum prices will have a positive impact on consumer spending in most developed countries (especially in the US as consumer spending accounted for 71% of the US GDP in 2013).  Have we reached a bottom in petroleum prices? The inability to accurately assess the cost of extracting the next marginal barrel of petroleum from shale deposits as well as the unpredictability of OPEC decisions make this impossible to predict. But if prices remain at or near these levels throughout 2015, it will be very bullish for global economic expansion.

Despite the strong US equities performance over the last 3 years, they are within their historical valuations. While we foresee increased volatility in 2015, we expect modest returns for equity investors unless we experience a very rapid, unexpected rise in interest rates. 

It is difficult to envision how interest rates could go much lower in developed countries in 2015 (of course most analysts said the same thing last year). It would require continued weakness in Europe and Japan and/or one or more unpredictable global shocks. And while both of those scenarios are possible, we believe rates should rise in 2015. For that reason, in today’s environment, we prefer the risk/reward of equities over fixed income securities. However, bonds do have a place in nearly every investor’s portfolio since their presence helps to reduce overall volatility.

We expect a stronger housing market in 2015 as lending standards loosen, first time home buyers enter the market and families feel the positive impact of lower gas and heating expenses. 

Outside of the US, we continue to believe European multinationals are more undervalued relative to their peers in the US and should prove lucrative for patient investors. The ultimate result of the massive quantitative easing in Japan remains unclear (we have been saying this for two years now). Their market is heavily influenced by the demographic reality of an aging and conservative population. Emerging markets which are reliant on commodities will struggle, especially those dependent on oil revenues. 

It is nearly impossible to predict short term fluctuations in currency markets. Almost universally, analysts believe that the US Dollar should continue strong in 2015. But as we saw with predictions of rates rising in 2014, we are weary when everybody is on the same side of a trade. Given the volatility of currency markets, a global investor should maintain currency diversification and maintain a 3-5 year time horizon for measuring investment results.

In conclusion, our expectations for 2015 favor equities over fixed income securities. We think the US market still has legs but are becoming increasingly attracted to European equity valuations. We are not yet comfortable with emerging markets.

Volatility will continue, enabling long term equity managers to find more attractive opportunities. Despite what happened in 2014, diversification still matters. If everything you own goes up at the same time, it can all go down at the same time. Stay the course, stick to your game plan. That is what matters most.