First Quarter Market Perspective
Teetering and Tottering: Equities, Bonds, Currencies and Commodities
With investors seemingly oscillating between optimism and pessimism and greed and fear, the first quarter of 2015 followed suit with the third and fourth quarters of 2014. After finishing up 13.5% in 2014, the S&P 500 advanced a paltry 1% during this year’s first quarter, underperforming global equities, which gained 2.3% in U.S. dollar terms. This performance occurred despite the continued strengthening of the U.S. dollar relative to most international currencies during the quarter. In fact, in local currency terms all of the major international indices delivered significantly higher returns than U.S. indices.
The best performing broad asset classes during the quarter came in the international markets. Developed large cap international equities (MSCI EAFE Index) gained 4.9% in U.S. dollar terms, while the MSCI Small Cap Index returned 5.6%, despite the Euro depreciating by 11.2% and the British Pound depreciating by 4.8% during the quarter. REITs, U.S. Small Caps and Emerging Markets also performed well during the quarter, with REITs gaining 4.7%, while U.S. Small Caps returned 4.3% and Emerging Markets gained 2.2%. With oil prices continuing to struggle during the quarter, commodities and Master Limited Partnerships (MLPs focused on energy infrastructure) continued to slide, down 11.2% and 5.2%, respectively. The bond yield curve was relatively stable during the quarter, generating modest positive performance across bond indices. Long-term interest rates in the U.S. and overseas continued to decline alongside easing inflation pressures, which was positive for bonds. And municipal bonds continued to perform well with attractive yields and default levels that have returned to pre-2008 averages.
Table 1 below details how some of the major market indices performed during the quarter, as well as their annualized, trailing total returns.
Major Index and Currency Performance
|Annualized Trailing Total Return||Equities||Q1||1YR||3YR||5YR||10YR|
|S&P 500 TR||1.0||12.7||16.1||14.5||8.0|
|Russell 2000 TR||4.3||8.2||16.3||14.6||8.8|
|MSCI EAFE NR||4.9||(0.9)||9.0||6.2||5.0|
|MSCI Emerging Markets NR||2.2||0.4||0.3||1.8||8.5|
|MSCIAll Country World Index NR||2.3||5.4||10.8||9.0||6.4|
|Barclays US Aggregate Bond TR||1.6||5.7||3.1||4.4||4.9|
|Barclays Municipal TR||1.0||6.6||4.1||5.1||4.9|
|Barclays High Yield Muni TR||1.1||8.7||6.8||7.8||5.4|
|Euro (EUR vs. USD)||(11.2)||(22.1)||(6.9)||(4.5)||(1.9)|
|Pound (GBP vs. USD)||(4.8)||(40.3)||(16.9)||(8.0)||(7.5)|
|Yen (JPY vs. USD)||(0.0)||(14.1)||(11.8)||(4.9)||(1.1)|
|S&P GS Commodity Index TR||(8.2)||(40.3)||(16.9)||(8.0)||(7.5)|
|Wilshire Global Real Estate Securities Index TR||4.7||18.6||13.5||14.3||8.6|
|Alerian MLP TR||(5.2)||(2.5)||9.2||13.7||13.0|
Metering In: Stimulus in Europe
As many expected, the European Central Bank (ECB) unveiled a massive program in January designed to stimulate growth in the Eurozone by purchasing €1.1 trillion of bonds issued by Eurobased central governments, agencies and other institutions. The asset purchases will be made in the secondary market at a pace of €60 billion per month through at least September of 2016. The expectation is that selling institutions will use the proceeds to purchase other assets and extend credit to the real economy. While different in form than the various quantitative easing (QE) measures in the U.S., the ECB’s asset purchase program is expected to provide monetary stimulus to the Eurozone by holding down the prevailing interest rates and resulting borrowing costs to businesses and consumers. The goal is to support investment and consumption, and ultimately contribute to increasing growth and an inflation rate closer to the ECB’s target of 2%. As we expected, despite putting significant pressure on the value of the Euro, equity markets throughout the developed countries in Europe cheered this move.
Over the next few days, Mario Draghi, President of the ECB, is expected to announce the ECB has met its target of purchasing €60 billion worth of debt during the month of March. Recently Draghi noted “more accommodative monetary policy is being translated into better credit conditions, which is not something we have seen before.” The monetary stimulus coupled with a depreciating currency and falling oil prices combined to deliver some encouraging developments in European business surveys and consumption data. This, in turn, led to the very strong local market performance for most European equities during the quarter. Although Eurozone interest rates are already very low and in some cases negative, the ECB’s Governing Council has argued that full implementation of its QE plan nevertheless is still required to achieve the recovery in GDP growth and inflation envisioned by the Bank. Otherwise, Eurozone growth would likely be too slow to soak up spare capacity in the economy and mitigate the threat of deflation. The ECB’s strong commitment here should continue to provide ongoing support for international equities.
From 2011 through mid-2014, we recommended clients maintain a significant underweight to developed market international equities. However, after analyzing the relative attractiveness of European equities and anticipating the ECB’s enactment of a QE program, we recommended clients increase their holdings of developed market international equities. While the markets have been volatile over the past three quarters and one of our manager’s strategies has been adversely impacted by falling energy prices and muted growth in emerging markets, this decision seems to be playing out well for our client portfolios this year. And while it’s far too early to judge our results, we continue to feel confident that this positioning will serve clients well in the years to come.
Petering Out: Strength of the US Recovery
The strength of the recovery in the U.S. appears to be slowing as both growth and labor markets have posted lackluster results. The Federal Reserve painted an uninspiring picture in their latest economic assessment, calling growth overall “slight” or “moderate” across most of the country. According to the latest Beige Book, manufacturing has been weak along with mixed sales. The report is generating sharply diminished growth expectations, with the Atlanta Fed estimating growth of only .2% in Q1 2015. According to the Bureau of Economic Analysis, real GDP (nominal GDP adjusted for inflation) increased at an annual rate of 2.2% during the fourth quarter of 2014 (compared with an annual rate of 5.5% during the third quarter). Although U.S. growth seems to have come to a halt in the past three months, the primary catalyst of the subdued growth is related to the plummeting costs of oil/ gasoline, which hurts the earnings and prospects of energy companies. And so far, we’ve not seen much of an offsetting boost in consumer consumption. The very harsh winter that impacted much of the Northeast was another factor that tamped down growth.
Of course, economic growth in 2014 also started with a weak -2.1% real GDP “growth” in the first quarter. However, the difference in 2015 is that the strong dollar makes for very difficult conditions that lessen the likelihood we’ll see a surge in the economy like we saw during the second and third quarters of 2014. Right now, it appears that the drag on growth coming from the strong dollar will have a stronger impact than the potential boost provided by lower energy costs to consumers.
The Bureau of Labor Statistics (BLS) reported the national unemployment rate was 5.5% in March, with the number of unemployed persons little changed at 8.6 million. Lower unemployment generally leads to increased consumer spending, which in turn helps support future growth. However, thus far, lower unemployment has not generated increases in consumption, spending or wages. In fact, to the contrary, the BLS reported that the inflation rate, as measured by the year-over-year change in the Consumer Price Index (CPI), was flat for February 2015. Over the past few years, CPI has generally fallen short of the Federal Reserve’s target of 2% for inflation. To put the current rate into context, inflation averaged 3.3% over the past 100 years. In the past 45 years since 1970, the annual inflation rate has been less than 1.5% only once, which was during the Global Financial Crisis when we briefly experienced deflation of -0.4%.1
Early signs of the slowdown were reflected by the Treasury Department’s announcement that the U.S. budget deficit widened during the first half of the 2015 fiscal year (which runs from October 1 through September 30). That widening ended a six-year-streak of narrowing the deficit since the trough of the financial crisis in March 2009. During the last six months, the deficit rose to $439 billion with federal receipts rising 7% to $1.42 trillion and outlays also rising 7% to $1.86 trillion.
Although we are just entering first quarter earnings season, consensus expectations among equity analysts indicate consolidated earnings across the S&P 500 companies fell by 2.9% in Q1 2015 and will likely fall an additional 0.85% in Q2 2015.2 The last quarterly decline in earnings occurred in 2009, coinciding with the end of the recession. Although analysts expect earnings to recover during the second half of the year, we generally believe their estimates may prove overly optimistic. Indeed, we have been concerned about the sustainability of elevated earnings and valuations for quite some time.
One potential justification for continued elevated valuations is the Federal Reserve’s dovish policy stance. The continued low interest rate environment helps support equity valuations, causing earnings and dividend yields to continue to look attractive compared with bond yields. On the other hand, some of the expected increase in market volatility may be based on anticipated future Federal Reserve actions. While the Federal Reserve’s economic data has shown softening in the economy, the Fed did remove the word “patient” from the March statement. It’s possible the Federal Reserve may begin raising interest rates as early as June 2015, but with growth slowing many markets participants now think the Fed will wait until September. In any event, we expect the Federal Reserve to increase interest rates at a measured pace. We won’t be surprised to see an initial adverse reaction to an interest rate hike in both the equity and fixed income markets, but history demonstrates that each of these markets tends to rebound later in a cycle of rising rates. That said, just as volatility increased a few years ago when the Federal Reserve started to discuss the end of QE; we believe investors should expect volatility during future Federal Reserve announcements.
Generally speaking, there are two ways to correct overvalued stocks. Either companies naturally grow into their valuations with lower price growth than earnings growth or the stock prices fall. Up to this point, we have been leaning toward the former being the more likely course of adjustment with increased levels of volatility as companies eventually grow into their valuations. However, given the recent weakness in GDP growth and earnings, we believe the probability of a market correction of at least 10% has increased and may be in the cards. The good news is that historically, market corrections have only lasted two months or less. We don’t think investors should fear corrections as they are a natural part of the markets; however, we should be aware of the potential and act systematically before, during and after these events by engaging in disciplined rebalancing and employing dollar-cost averaging strategies when deploying large sums of cash in portfolios.
1 Source: U.S. Bureau of Labor Statistics and Aspiriant.
2 Source: Thomson Reuters I/B/E/S.
Important disclosures: Past performance is no guarantee of future performance. All investments can lose value. Indices are unmanaged and it is impossible to invest directly in an index. The volatility of any index may be materially different than that of a model.
Equities. S&P 500 is a market-capitalization weighted index that includes the 500 most widely held companies chosen with respect to market size, liquidity, and industry. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It is a subset of the Russell 3000 Index representing approximately 10% of the total market capitalization of that index. It includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership. The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. The MSCI ACWI Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets.
Fixed Income.The Barclays U.S. Aggregate Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities. These major sectors are subdivided into more specific indices that are calculated and reported on a regular basis. The Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index has four main sectors: general obligation bonds, revenue bonds, insured bonds, and prerefunded bonds. The Barclays High Yield Municipal Bond Index is an unmanaged index composed of municipal bonds rated below BBB/Baa.
Real Assets. S&P GSCI: The S&P GSCI© is a composite index of commodity sector returns representing an unleveraged, long-only investment in commodity futures that is broadly diversified across the spectrum of commodities. The returns are calculated on a fully collateralized basis with full reinvestment. Wilshire Global RESI is a broad measure of the performance of publicly traded global real estate securities, such as Real Estate Investment Trusts (REITs) and Real Estate Operating Companies (REOCs). The index is capitalization-weighted. The Alerian MLP Index is a gauge of large and mid-cap energy Master Limited Partnerships (MLPs). The float-adjusted, capitalization-weighted index includes 50 prominent companies and captures approximately 75% of the available market capitalization.