Each January we revisit the year behind us and review what worked well and what didn’t work as well. To set the stage for this year’s conversation, many of the global concerns and challenges of 2014 carried over into 2015 and took markets lower. In fact, a CNN Money study determined that nearly 70% of all investors lost money in 2015. Further, they determined that the only people who did not lose money either: 1) held cash, or 2) took on excessive risk by concentrating their investments in a few individual stocks.1 In other words, the only people who did not experience loss were those who took no risk or those who took massive risk but got lucky. Investors lost money if they were positioned for long-term growth (i.e. not held in cash) and were well diversified (i.e. not positioned in just a few individual stocks). In this environment, it should not be a surprise that most of our client portfolios were down slightly for the year.
2015 IN REVIEW
Let’s begin our discussion of 2015 by recapping what we had anticipated as stated in the closing of our 2014 recap:
- 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.
- Benefits of Lower Oil Prices. Lower oil prices will benefit both businesses and consumers… with more discretionary money to spend, the stable economic picture for the U.S. could continue to improve.
Both of these things came to fruition. Unfortunately volatility resulted due to concerns surrounding China’s economic slowdown as well as speculation regarding when the Federal Reserve would finally raise interest rates. On the positive side, the U.S. and other developed countries’ economies continued to steadily improve, in part boosted by low energy prices. Overall though, the mixed bag of positives and negatives created anxiety in financial markets that resulted in a year that felt dislocated. Let’s dig into various areas in greater detail and discuss their impact on your investment results.
Global Stocks – For the first time since 2011, global equities declined in 2015. Following is perspective on the various global stock market categories.
U.S. Stocks. Relative to the global benchmark, our portfolio is overweight to U.S. stocks (i.e. U.S. stocks comprise 54% of the global benchmark compared to 70% of our portfolio). This contributed to returns in 2015, as U.S. large stocks were one of the few positive performing categories.
Our strategic allocation to U.S. small companies detracted from returns in 2015 as they underperformed relative to U.S. large companies. Oddly, with an improving domestic economy and questions about growth abroad (where many U.S. large multinational companies generate revenue), U.S. small companies, which generate most of their revenue domestically, struggled. We expect these smaller companies to provide a higher return than large companies over time and for that reason maintain an overweight to the category.
Developed Foreign Stocks. In developed markets outside of the U.S., we are underweight large companies relative to the global benchmark, which is largely a product of our decision to hold a larger amount of U.S. assets to control risk, as well as our desire to overweight other categories that we believe will provide more growth over time. This underweight contributed positively to 2015 results, as foreign large companies turned in a negative return. (It is interesting to note though that returns for foreign large companies were actually positive in terms of their local currencies and were only negative due to the continued appreciation of the U.S. dollar, a theme that carried from 2014 into 2015.)
Alternatively, our portfolio overweight to small foreign stocks paid off well, since this was the highest performing stock category in 2015, even in the face of a strong U.S. dollar. As you may recall, these small stocks drew down less than their larger counterparts in the summer’s correction, and in the final part of the year they provided significantly greater returns than larger stocks. The prevalence of this positive performance dynamic is one of the reasons why we have a relatively high strategic weight to small foreign stocks in the portfolio.
Emerging Market Stocks. Emerging market stocks provided a disappointing result, and several years of negative returns have brought even the five-year category returns into negative territory. The negative news cycle coming out of China is driving nearterm results across all emerging market investments even though China’s downturn should have little impact on many emerging market countries. (See more on this below in our discussion of China.) The financial media has stoked investor anxiety with tales of doom painted across all emerging countries, but the long-term thesis of capitalizing on the growing consumer class in these countries remains unchanged. As is often the case when negative sentiment prevails, there are meaningful opportunities to purchase strong companies at lower prices.
Bonds. Bonds were a safe haven for 2015 and managed to earn slightly positive returns, even in spite of the Fed’s decision to begin raising rates. The lack of drama in the bond markets likely reflects investors’ collective expectation that yields would naturally start to rise as a result of improving economic fundamentals. Regardless, intermediate taxable bonds provided returns at a similar level to defensively oriented short-term bonds, which supports our strategic decision to maintain exposure to intermediate bonds rather than to tactically shift the portfolio’s maturity back and forth in anticipation of interest rate cycles. Intermediate municipal bonds provided even better returns than taxable bonds as a result of the improving financial situation of many municipalities.
Non-traditional. All of our non-traditional investment categories declined in 2015, underperforming both global equities and bonds. Both emerging market bonds and commodities lost more than other categories given their perceived dependence on China’s situation and the falling price of oil. Weakness in oil prices also had an impact on the energy sector of the high yield bond market as investors questioned whether the historically low default rates of energy companies would hold true in the current environment.
As with stocks, investors are selling off indiscriminately with broad generalizations, likely driven more by fear than logic. To illustrate, falling oil prices can be expected to harm the economies of countries that export oil, but it should actually have a positive effect on many other economies that rely on oil as an input to production. And in regard to oil prices themselves, the drop in prices isn’t a result of decreasing demand, as demand for oil actually increased last year. The drop in price is likely related to an oversupply of oil on the market today.
While we were disappointed to see the non-traditional asset category underperform both stock and bonds this year, we continue to believe that exposure to this area will provide benefits to patient, long-term investors.
PERSPECTIVES ON CHINA
China’s economic slowdown and the collapse of its stock market created last summer’s sell-off, but markets rebounded nicely by the end of the year as investors reset their sites on improving growth in the U.S. and Europe. However, anxiety has returned in the first weeks of 2016, and any discussion of recent events would be remiss without providing some basic perspectives on China.
Two things are readily apparent. First, it is a near certainty that China’s domestic investment markets have experienced a “bubble.” Periods of extreme overvaluation can occur from time to time in any market, and it is no surprise that a market that is heavily controlled by the government would experience some severe misallocations of investment capital. The second thing that is clear is that economic information coming out of China is not transparent. As a result, it is exceptionally difficult for anyone to make a clear evaluation of what is actually going on within China because the information coming out of China is not complete and is often distrusted as government propaganda.
Although it is sometimes difficult to decipher what is going on within China’s domestic markets, your direct investment exposure to these markets is minimal, comprising only 2.4% of the Paracle-managed stock portfolio. Our allocation is intentionally light to China due to the lack of transparency in Chinese investment markets and because we believe that there are much better investment opportunities in other emerging market countries that maintain capitalist investment markets, better transparency, and more favorable protections for foreign investors.
With this context in mind, the most important question for you is not with regard to what is going on within China’s domestic financial markets, but rather, exploring what impact China’s economic slowdown might have on the rest of the world’s economies. Let’s start close to home with the U.S. Our exports to China account for less than 1% of our total annual economic output. For comparison, domestic consumer spending accounts for 68% of our economic output. So, what we are buying from one another (which ironically may be manufactured in China) counts for a whole lot more than what China is importing from us. At essence, China relies on us to buy their goods, but we do not yet rely heavily on them to buy our goods.
Of course, while the direct relationship of our economic output to China is very limited, there are potential ripple effects in a global economy. Economists estimate these ripple effects by studying and quantifying China’s economic relationship with each country in the world and then running an algorithm to estimate where the waves of the ripple stop. One in-depth study by Deutsche Bank determined that “a 1% drop in China’s GDP and imports from the U.S. would reduce U.S. GDP by well under 0.1% based on direct and indirect trade linkages.” This same study went on to reach similar conclusions for other developed markets as well as for most emerging market countries. In fact, it concluded that the only countries that can expect meaningful economic deterioration as a result of China’s decline are those with especially close trading ties: Hong Kong, Taiwan, and India.
These dynamics are largely due to the fact that China remains a net exporter rather than an importer. More specifically, they import raw materials from emerging market countries as inputs to their manufacturing processes and for their own internal use, and they manufacture and export goods to developed markets. To simplify one side of the equation, since China is not buying much from developed markets, this means that sales for U.S. and developed foreign companies only diminish by a little bit if China slows down its buying. (There are limited exceptions to this, especially Japan and Australia.)
On the other side of the coin, China’s slowdown means that it may not purchase as many raw materials for its own internal building and expansion. While this reduced demand for raw materials will hurt the specific emerging countries that are selling them to China, it actually lowers the prices of these resources for everyone else around the world.
The core question is whether the negative loss in global sales to China outweighs the positives of cost savings on energy and raw materials. As already mentioned, most detailed analyses suggest that China’s downturn is not likely to affect economic recovery or growth in developed nations and will only have a meaningful impact on a small handful of emerging market countries.
WHAT TO EXPECT IN 2016
All of these rational things said, there’s no telling whether investors will continue to worry about China or not. And there is no dismissing the fact that apprehension about China is creating downward pressure in global stock markets. In fact, the correlation between the U.S. and Chinese stock markets has reached historically high levels. If investors continue to sell stocks as a result of anxiety and speculation, then 2016 could certainly be a volatile year.
As always, the future is uncertain and we will continue to take specific steps based on things that can be known with certainty. Taxes can be saved, portfolios can be rebalanced to take advantage of new opportunities, and we can continue to help you plan toward specific goals. In this vein of thinking, be sure to reach out to us with any questions you have.