Quarterly Investment Commentary
The fourth quarter got off to a rocky start, with a steep selloff in stock markets due to concerns about global economic growth and the end of the Fed’s bond purchasing program known as Quantitative Easing. This decline proved to be transitory though, as domestic stocks regained ground and posted positive returns for the quarter. Small company stocks reversed their pattern for the year and outperformed both mid and large companies during the quarter, but still trailed their larger counterparts for the year overall. Foreign developed stocks, in U.S. dollar terms, posted losses of -3.6% as the dollar continued to gain strength against foreign currencies. Emerging market stocks returned -4.6% with Russia continuing to struggle amid international sanctions and low oil prices.
Bonds did well in the final quarter of the year, returning almost 2% as interest rates (measured by the 10-year U.S. Treasury yield) moved lower.
The U.S. economy continued to improve heading into the end of the year, with third quarter GDP growth revised higher to 5% and unemployment gradually heading lower. These factors helped the Fed ultimately decide to stay on track with its plan to end the Quantitative Easing program. In what seems a continual waiting game, we still don’t know when interest rates will finally rise. The Fed has simply announced that it will be “patient” as it considers the timing of interest rate hikes in 2015.
Economic growth continued to languish abroad, and central bank action (or inaction) made headlines. Investors continue to speculate that the European Central Bank will embark on a new asset purchasing program in 2015 in an effort to combat deflation and spur growth in the Eurozone. Two unexpected announcements came from Asian central banks. The Bank of Japan announced an increase in the amount of its monthly asset purchases, while the Peoples Bank of China cut interest rates on loans and deposits. These actions were positively received and resulted in stock price increases in each of the respective markets.
In this newsletter, we recap 2014 results across global investment categories and review the effects on client portfolios. In each area we will discuss what worked and what didn’t work to provide perspectives on our strategic positioning.
The Mighty Dollar
There was no shortage of interesting economic and political events across the globe that impacted 2014 stock and bond returns. In the interest of coherence and brevity, we will focus on one thing that drove results across nearly all investment categories: A strengthening U.S. Dollar.
The dollar appreciated 11% against other global currencies in 2014. Currency strength and weakness moves in cycles, but the longer-term trend has been for a weakening dollar in the global economy. (See chart to right.) The recent rise of the dollar is not as monumental as some reports in the media may suggest, and last year’s rise does not necessarily indicate that the dollar will permanently buck (pardon the pun) the longer-term trend. With this context, let’s discuss 2014 results.
The U.S. economy expanded at a faster rate than analysts expected, and improvements in unemployment helped propel U.S. market gains. U.S. large stocks ended the year with another double digit return, showing resiliency throughout the year. Small companies finished modestly positive, but did not deliver nearly as strong of a performance as the 39% that they provided in 2013.
Outside the U.S., the picture was less glowing. Growth across the Eurozone remained anemic, with some countries experiencing negative growth. Emerging market stocks suffered from diminished growth expectations and a corresponding precipitous fall in global commodity prices. (Many emerging market companies export commodities and therefore benefit from rising prices.)
It is interesting to note that although foreign market returns were negative for you as a U.S. investor, the returns were not negative in the native currencies. (In fact, in the local currencies, foreign market returns were actually better than U.S. Small Cap returns.) The rising dollar detracted a full 10.8% from foreign developed stock returns and 7.3% from emerging market stocks.
What worked: U.S. Stock Overweight. Due to a variety of factors (including consistency of returns), we weight U.S. exposure at 70% of client stock portfolios, which is considerably higher than the 52% share that U.S. companies have of overall global market capitalization. Having this strategic overweight paid off in 2014.
What didn’t work: U.S. Small Company Overweight and Foreign Diversification. Small companies tend to outperform large companies by a meaningful margin over long periods of time. With this in mind, we weight U.S. small companies at twice the level they represent in the U.S. stock market. With large stocks outperforming small stocks in 2014, the small stock overweight worked against returns. Foreign diversification did not add performance benefits in 2014 either, since all foreign categories provided negative returns.
The purpose of holding non-traditional assets in the portfolio is to gain exposure to investments that are unlike stocks and traditional bonds. As such, we include emerging market bonds, high yield bonds, and commodities to name a few. Performance was mildly positive across most categories, but oil prices dropping by almost 50% had an adverse affect on the performance of the entire asset class.
What worked: The commodity strategy that Paracle utilizes fell less than half as much as the index, since it is strategically weighted quite differently than the index. Specifically, it has a 25% exposure to oil and gas versus nearly 70% oil and gas exposure in the S&P GSCI Commodity Index.
What didn’t work: Our goal for this asset category is to beat inflation by 3% over time. Inflation came in at 0.8% in 2014, creating a hurdle of 3.8%. On this basis, the entire category fell short of the goal in 2014. However, removing commodities from the equation results in returns that average around 3% for the other strategies, which is not terribly far off the mark.
In the bond markets, 2014 rhymed with the themes of the last several years. At the beginning of the year many pundits declared that interest rates would rise rapidly, but they didn’t rise. While expectations around Federal Reserve policy did cause short term rates to move higher, longer term rates fell as investors sought the safety of U.S. dollar assets amid a weak global economy. Rates (measured by the 10-year U.S. Treasury yield) started 2014 around 3.0% and actually fell during the year, ending at 2.2%. As a result, bond markets fared well for the year and were up 6.0%. Once again, it didn’t pay to predict the market.
What worked: Maintaining a strategic allocation to intermediate term bonds
What didn’t work: Nothing to note.
As we review recent financial literature and receive client questions, a few specific themes emerge. We will discuss a few common questions here, and if you have further questions, please reach out to us.
Should we invest more in U.S. stocks and abandon foreign stocks? We don’t recommend it. (Interestingly, we also received the converse question from a few contrarian-minded clients: Should we increase our foreign stock targets since they have underperformed for a few years?)
U.S. stocks have outperformed foreign stocks for the fourth time in the past five years. For context though, consider that recent U.S. market performance has largely been the result of a knee jerk away from negative events elsewhere in the world. Europe is likely slipping into another recession, and questions linger around slowing economic growth rates in emerging market countries. By comparison, the U.S. appears to be a relatively good place to invest. It’s easy to forget that even in 2014 there were U.S. stock market sell-offs and many news stories centered on negative headwinds for U.S. growth, including:
- Anxiety that the end of the Federal Reserve’s asset purchasing program could depress the economy.
- Observations that the unemployment rate has been incredibly stubborn to recede, and the stated rate doesn’t even truly capture the extent of underemployment in the economy,
- Concern that a lack of investment by U.S. companies into their own businesses could threaten their future competitiveness in the global marketplace. (Record levels of excess cash on corporate balance sheets have widely been used to buy back shares or to pay dividends rather than to invest back into the companies.)
- Frustration that ongoing stalemates in Washington are detrimental to good decisions for our country’s future strength.
We believe it makes sense to retain a strategic overweight to U.S. stocks relative to their foreign counterparts. Why? First, most of our clients will retire in the U.S., and it is therefore important to ensure that their wealth growth in U.S. dollars exceeds the rate of growth and inflation within the United States. Investing in U.S. stocks is a practical way to accomplish this. Second, U.S. markets have historically experienced more consistency and smaller sell-offs than other global equity asset classes (even in 2008). Finally, the U.S. maintains a higher level of productivity than foreign countries do.
We are not able to see the future, and we are certainly not forecasting the demise of U.S. financial success, but suffice it to say that if history repeats itself, then U.S. stocks will likely not remain the market darling indefinitely. The illustration to the right demonstrates how inconsistent investment category performance is from year to year.
The cyclical nature of markets can result in periods of time where diversification does not seem to provide benefits. Frustration with this can tempt investors to allocate more assets to categories that have performed well recently, only to find that these same categories underperform in the subsequent period. A longer-term perspective helps an investor keep their vision unclouded by recent performance. Foreign stocks can be expected to outperform at times in future years, and continuing to own these investments will help to smooth overall returns and therefore achieve a better compound growth rate over time. Alternatively, viewing foreign investments from a simpler perspective, limiting oneself to the domestic U.S. market results in missing out on compelling investment opportunities abroad, which comprise over half of the world’s investment opportunity set.
Should we maintain commitment to Non-Traditional investments, especially commodities?
The case for having exposure to commodities in the investment portfolio remains unchanged. There are diversification benefits to holding commodities because commodities often move in the opposite direction of stocks and bonds. This can provide protection from swings in stock and bond markets and affords rebalancing opportunities. Commodities also serve to provide a long-term inflation hedge. Commodity prices rise alongside the ever-growing prices of goods and services. By owning commodity investments, an investor can participate in the rising prices and help maintain their purchasing power over time.
What to Expect in 2015
Although we can never see with perfect clarity exactly what will happen in the near term, as we head into a new year, here are a few themes to consider:
- Higher Volatility. In any given year, it is not surprising to see stock markets rise and fall. Stock markets have ended in positive territory for the last six years. Historically, it is normal to have a negative year one out of four years, so it is natural to expect that 2015 could end negatively. The market roller coaster can drop at any time, so it always makes sense to fasten your seat belt and be ready to stay in your seat. It’s OK to scream. That’s normal. History has taught us that what goes down, does comes up. Eventually. Not always as quickly as one would like. As a reminder, always keep in view our approach of focusing carefully on cash needs. This helps protect your lifestyle because we have confidence that you won’t need to utilize the assets that are invested in global stocks for at least 10 years.
- Benefits of Lower Oil Prices. Lower oil prices will benefit both businesses and consumers. Some economists expect nearly $1 trillion in savings across savings on gas and production costs, and the trickle down effect of this could be tremendous. Consumer spending accounts for roughly 70% of the U.S. economy; and with more discretionary money to spend, the stable economic picture for the U.S. could continue to improve.
We hope you find these perspectives helpful and are happy to discuss any aspects for which you want greater detail.