Happy New Year! A new year offers us all the opportunity to look back and make some sense of the year behind us.
In many ways, 2014 was a year dominated by headlines. Early in the year, a polar vortex swept across the U.S., and as a result, many expected slower economic growth. For the first time, a woman was appointed as chair of the Federal Reserve. Russia engaged in conflict with Ukraine and later annexed the region of Crimea. General Motors recalled millions of vehicles in order to fix faulty ignition switches. Home Depot got hacked. Ebola killed thousands in Africa. Ebola then found its way to the U.S., and markets panicked in response. Oil prices began a steep decline on Thanksgiving. Over the course of the year, U.S. unemployment went down to pre-recession levels. The Federal Reserve’s program, known as Quantitative Easing, officially came to a close. Sony then got hacked. North Korea’s internet went down. Somehow amidst it all, U.S. equity markets reached new highs on over 50 trading days throughout the year.
This was a continuation of the bull market which many believed to be well overdue for a correction. Throughout the year, stocks had largely been described as fairly valued or slightly expensive compared to historical valuations. Following a 2013, where major equity benchmarks rose over 30%, many investors sold off heavily at times during 2014 in reaction to the various headlines mentioned above. While market volatility itself did not make headlines, it still proved to be a force to be reckoned with in 2014.
2014 witnessed the proliferation of what some call the “V-bottom sell-off”. The V-bottom sell-off is the grandest of head fakes where the markets dive sharply only to quickly rebound. In 2013, we saw three sell-offs of roughly 3%. In 2014, we experienced two sell-offs of 4%, two more of 5%, and in the first half of October, we watched the S&P 500 plummet by 7.5%, only to end the month higher. We have now experienced ten V-bottom sell-offs of more than 3% since early 2013. That’s compared to a grand total of 38 in the prior 62 years combined. Interesting times for stock markets, indeed.
International markets offered little refuge in 2014. Geopolitical and fiscal issues held most developed and emerging markets countries down during the year. Eurozone countries continue to struggle with recession. The European Central Bank has talked a lot about monetary stimulus; however, they’ve done nothing more than cut interest rates so far. They’re expected to inject capital into their markets as early as Q1 of 2015; however, no true schedule of activities has been released. For the year, European markets were down about 2%.
The Bank of Japan committed to increasing their monetary stimulus on Halloween, and markets clearly welcomed the news, as most international markets went higher. Japan’s own stock market, the Nikkei 225, rallied about 5% on that day alone, and over the final two months of the year the Nikkei moved another 16% higher. The Shanghai Composite (China) was up 30% in the final two months of the year, and the Hang Seng was down about 1.5%. What’s clear is that monetary stimulus has been generally positive for the markets; however, the velocity at which markets have traded higher on the news of monetary stimulus is concerning.
Emerging markets experienced more volatility than domestic markets in 2014. Emerging market stocks fell 10% early in the year, then climbed 20% higher by about mid-year, and then retreated 15%, to finish slightly down for the year. Currency issues and low oil prices have impacted many emerging markets economies; however, one of the less worrisome bright spots abroad has been India. The elections in the spring of 2014 brought business-friendly leadership to power in India, the world’s largest democracy by the way, which is expected to help promote economic growth. India’s economy, demographics, and business environment offer a favorable outlook, and there are many emerging market companies which are similarly poised to grow. Investment selection continues to be the ever-important issue with these countries and markets.
The bond markets proved to be somewhat less volatile this year than they were in 2013. In May of 2013, we experienced the “Taper Tantrum,” when the Fed first announced plans to end the bond purchase program known as Quantitative Easing. Bond values dropped dramatically at that time. To a lesser degree, we witnessed bond market volatility in 2014, but it was primarily concentrated in the high yield sector. In 2014, two of the more major sell offs occurred in the late summer, as well as in October. Energy-related debt makes up about 15% of the high yield bond market, and when oil prices declined, concerns increased regarding potential defaults. The year ended with oil selling at roughly $53/barrel, so default concerns are probably not misplaced.
Many bond strategists have preached the importance of shortening durations in order to reduce interest rate risk. Low yields have pushed investors to seek out yield in other places – either by investing in longer maturity bonds or bonds with lower credit quality. Spreads between the 10-year Treasury and high yield bonds have widened; however, the greatest total returns have come from longer maturity, investment grade bonds. Still, the more prudent approach has been to shorten maturities on bond allocations to protect against the adverse effects of sharp moves in interest rates.
What, then, does all of this mean for 2015?
Let’s start by looking at the fundamental drivers which should influence economic growth. The U.S. is one of the healthier economies in spite of a large debt-to-GDP ratio. Inflation is presently not too high nor too low. The job front has improved. Retail sales are up. Auto sales and home sales have improved. As long as rates remain low, which is expected to persist for most of the year, the investment environment still favors assets like U.S. stocks and real estate. Forecasts put U.S. GDP in the neighborhood of 3%, and global growth is expected to be in the 3% range.
2015 may be the year in which interest rates actually rise. It feels like the consensus forecast for the past few years has been rising rates since rates couldn’t seem to go any lower. Diversification has been one way to find yield in this low interest rate environment, and duration management continues to be the most prudent means for mitigating interest rate risk.
Growth potential comes with a cost, and we will have to pay through patience as volatility will continue to test investors’ resolve. We look to history to help guide our outlook on valuations, volatility, and expected returns; however, we have to proceed with caution. It needs to be said again, that the recent unique and extraordinary monetary policy on display around the world is and has been a grand experiment in which investors are forced to participate. While the policies in the U.S. have been largely successful so far, the experiment goes on across the globe. We have seen the Dow go from 17,000 to 18,000 at a pace unseen by history. We saw similar results for Asian markets in late 2014. Oil will continue to dominate headlines, and headlines will continue to provoke volatility and cause some investors to overreact.
It seems very likely that the unknowable future will drive market volatility. The political decisions that have yet to be made, the social issues that have yet to be resolved, and dynamic fiscal policy changes will all cause markets to react to varying degrees.
We all need to be cognizant of the risks and challenges that we face. We are adapting to the ever-changing environment and remain at the ready to take a more defensive posture as market data changes. All investors have unique goals, time horizons, investment objectives and tolerance for uncertainty. We encourage you to revisit these issues with your advisor to either confirm your current course of action or to identify and discuss potential midcourse adjustments if necessary.