As the year drew to a close, a handful of big-picture issues dominated the investment landscape: the plunging price of oil, positive economic indicators in the U.S. relative to most of the globe, and the ongoing influence of central banks (a key effect of which has been to bolster stocks and other risk assets). In the financial markets, the year saw strong gains for U.S. large-cap stocks and core bonds with lagging performance elsewhere.
One offsetting factor that helped the markets regain their footing in the fourth quarter (as it has many times in the post-financial-crisis period) was the ongoing influence of central banks. Even as the Federal Reserve suggests it is on track to begin raising rates in the face of U.S. economic improvement, it once again soothed markets by reaffirming that it would continue to be “patient” in shifting its stance. Given the poor economic conditions that persist in Europe, investors continue to expect the European Central Bank to take a more meaningful step toward full quantitative easing (i.e., purchasing bonds and other assets with the aim of stimulating the economy). Central banks in Japan and China expanded their stimulative policy efforts over 2014. The takeaway is that even as the Fed may begin scaling back its support, there appears to be no shortage of supportive monetary policy globally. At the same time, the fact that central banks continue to undertake (or contemplate) aggressive action provides a reminder of the broader economic risks we continue to navigate.
Against this backdrop, the S&P 500 index gained almost 14% and, for the third year in a row, avoided even a modest 10% “correction.” On the other hand, U.S. small-cap stocks, dropped more than 13% from their summertime high through mid-October, and ended the year up 5%. Outside the United States, most major stock markets performed poorly. Developed international stocks lost 5% and emerging-markets stocks dropped 2% (based on MSCI EAFE and MSCI Emerging Markets indexes, respectively). These returns reflect the significant headwind presented by the strengthening U.S. dollar, which detracted from returns for dollar-based investors.
Contrary to the consensus coming into 2014, the 10-year Treasury yield declined and bond prices rose. The core investment-grade bond index was up 5.8% for the year and municipal bonds also fared well. Outside of core bonds, sectors such as high yield and floating-rate loans lagged.
Finally, we think it’s worth putting recent financial market results into the context of history. This has been an unusually long and strong period of positive performance for large-cap stocks. Since 1945 there have only been three other periods (out of 51 total) where the S&P 500 has had a longer streak of gains without at least a 10% correction, according to Ned Davis Research. In addition, over the past two years, the S&P 500 has outperformed both developed international and emerging-markets indexes by an unusually large margin relative to history. These observations don’t mean U.S. stocks are necessarily set to tumble in the near term, but we think this data does provide some perspective as an argument for global portfolio diversification and prudent risk management.
INVESTMENT STRATEGY & OUTLOOK
In terms of the investment environment, the U.S. economy looks to be in pretty good shape for the near term. There are several positives: the labor market continues to strengthen, inflation remains subdued, manufacturing indexes and other leading economic indicators are consistent with solid GDP growth, falling oil prices should boost consumer spending, and government fiscal policy is likely to become more of a growth tailwind than a headwind as the impact of past budget cuts rolls off.
In contrast to the United States, the Eurozone (ex-U.K.) continues to fight deflationary headwinds. The December year-over-year headline inflation number fell to negative 0.2%, real GDP growth is below 1%, and two-year government bond yields in Germany and France are actually negative, meaning investors are paying the government for the privilege of owning these bonds. Our view is that in Europe we are getting reasonable earnings (albeit with less growth) at attractive prices relative to US equities, which is why we have maintained our strategic weighting to international developed stocks.
There is a lot of negative news surrounding emerging markets stocks, such as slowing growth in China and other BRICs and the decline in emerging-markets currencies. Nevertheless, we remain optimistic about emerging markets’ long-term fundamentals and believe they are likely to outperform U.S. stocks over our five-year investment horizon. However, we are conscious of the shorter-term downside risk and volatility they pose. We have maintained a strategic allocation to emerging markets stocks via a diversified strategy and would look to marginally increase the exposure as we become
more constructive on the economic picture in China and other key countries.
From an asset class perspective, we believe investment grade bonds are likely to generate very low single-digit annualized returns in the near-term. Our very low return estimates are explained by the very low current yields and our expectations that interest rates will move higher over time, although the timing and magnitude are, of course, uncertain. As such, a material portion of our fixed income exposure remains in opportunistic, flexible, and absolute return oriented bond funds that we believe offer superior longer-term risk/reward profiles compared to core bonds.
Our allocation to alternative strategies has recently been disappointing however we think the decision to own them is prudent given risks to the economy and stock markets. The strategies we own are intended to generate long-term returns that are better than core bonds, with lower downside risk and volatility than stocks and relatively low correlation to stock and bond market indexes.
The last year was a challenging one for globally diversified portfolios, as any diversification away from U.S. equities or bonds detracted from overall returns. We believe this to be an anomaly, as six years of globally suppressed interest rates has compelled investors to take more equity risk to compensate for lower bond yields. There is little historical precedent for the sustainability of such a period, but it seems unlikely to continue indefinitely given elevated equity market valuations and that the Federal Reserve is on the precipice of raising short-term interest rates for the first time in over six years. Our positioning in client portfolios reflects this view, where we remain constructive on equities versus core bonds. In equities, we are positioned for a continued expansion in the U.S. but have a more cautious view on international developed given the strength of the U.S. dollar versus other currencies. In fixed income, we have slightly reduced our exposure to emerging market bonds and have kept the duration of the overall portfolio relatively low given the Fed is likely to increase short-term interest rates in 2015.
We appreciate your confidence and trust in us. As always, please feel free to contact us with any specific questions about this letter or any of the investments that we manage on your behalf.
This material is provided for informational purposes only and does not constitute an offer or solicitation by HFS, or its subsidiaries or affiliates, to invest in these indices or their constituent products. The data contained herein are from referenced sources which HFS believes to be reliable. This information discusses general market activity, industry or sector trends, or other broad-based economic, market or political conditions and should not be construed as research or investment advice. The views expressed are those of HFS. They are subject to change at any time. These views do not necessarily reflect the opinions of any other firm. Investing involves a high degree of risk, and all investors should carefully consider their investment objectives and the suitability of any investment. Past performance is not necessarily indicative of future results.