Fourth Quarter Market Perspective
Financial markets ended 2014 in similar form and fashion to the way they started the year: whipsawing back-and-forth between risk-on and risk-off. The S&P 500 appreciated +4.9% during the quarter, but overall global equities advanced a scant +0.4%. Much of the performance differential between US and international equities resulted from a strengthening U.S. dollar. In fact, in local currency terms the MSCI EAFE and MSCI EM indices delivered positive returns during the quarter. However, in U.S. dollar terms the story was quite different, with the indices closing down -3.6% and -4.5%, respectively.
The clear winners during the quarter were US Small Caps, coming off big losses during Q3, 2014, and REITs, gaining +9.7% and +9.0%, respectively. With oil prices plunging, commodities were the clear loser during the quarter, finishing down -27.7%. MLPs (energy infrastructure) also struggled during the quarter, losing -12.3%, but still finished the year in positive territory. The bond yield curve continued to both fall and flatten during the quarter, generating positive performance across virtually all bond indices, and contributing to REIT performance by making REIT yields more attractive. 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||Q4||YTD||3YR||5YR||10YR|
|S&P 500 TR||4.9||13.7||20.4||15.5||7.7|
|Russell 2000 TR||9.7||4.9||19.2||15.6||7.8|
|MSCI EAFE NR||(3.6)||(4.9)||11.1||5.3||4.4|
|MSCI Emerging Markets NR||(4.5)||(2.2)||4.0||1.8||8.4|
|MSCI Emerging Markets NR||0.4||4.2||14.1||9.2||6.1|
|Barclays US Aggregate Bond TR||1.8||6.0||2.7||4.5||4.7|
|Barclays Municipal TR||1.4||9.1||4.3||5.2||4.7|
|Barclays High Yield Muni TR||1.2||1..8||8.3||8.4||5.5|
|Euro (EUR vs. USD)||-4.2||-12.2||-2.3||-3.4||-1.2|
|Pound (GBP vs. USD)||-3.8||-5.9||0.1||-0.7||-2.1|
|Yen (JPY vs. USD)||-8.5||-12.3||-13.8||-4.9||-1.6|
|S&P GS Commodity Index TR||(27.7)||(33.1)||(12.9)||(6.5)||(4.8)|
|Wilshire Global Real Estate Securities Index TR||9.0||20.3||16.6||14.4||7.6|
|Alerian MLP TR||(12.3)||4.8||11.9||16.7||13.8|
Hold On To Your Hats! It’s Going To Be a Bumpy Ride!
For several months, we have been cautioning investors to expect more volatility going forward than we have experienced in the past several years. That’s primarily because we believe virtually every asset class is currently somewhere between fully valued to overvalued. That’s not to say we’re expecting a sharp correction or an extended bear market anytime soon, but we do believe higher valuations today imply a more challenging return environment in the future. Moreover, when valuations are stretched, undesirable setbacks can create acute disappointment, which in turn increases market volatility. We are not the only ones cautioning investors in this regard. In November, Fed Chairwoman Janet Yellen and William Dudley (President of the New York Fed) both warned that as the Fed prepares to raise interest rates the markets may become more volatile. Recognizing this prospect, Yellen said the Fed “will strive to clearly and transparently communicate its monetary policy strategy in order to minimize the likelihood of surprises that could disrupt financial markets, both at home and around the world.” Regardless, Dudley acknowledged the “shift in [the Fed’s] policy will undoubtedly be accompanied by some degree of market turbulence.”
Another concern is the recent plunge in oil prices, which could further exacerbate volatility in global equity portfolios. Although there are many long-term positives associated with cheaper energy, in the near-term, a price drop of this magnitude is potentially destabilizing, particularly for countries that are net energy exporters. Case in point is Russia, which derives roughly half of its federal revenue from energy exports. Even though Aspiriant portfolios have only a small direct exposure to places like Russia (~1.0%), we are cognizant that Russia’s financial and economic challenges can reverberate through global capital markets as investors substantially re-price Russian financial assets and the ruble.
US Economy Posts Strong Results
The U.S. economy broadly improved during the fourth quarter as growth and labor markets posted strong results. According to the Bureau of Economic Analysis, real GDP (nominal GDP adjusted for inflation) increased at an annual rate of 5.0% during the third quarter of 2014. The big acceleration in the percent change in GDP reflected an upturn in federal spending and personal consumption expenditures, which were partially offset by a downturn in inventory, exports, state/local spending, and residential/nonresidential investment. Additionally, the Bureau of Labor Statistics reported the national unemployment rate fell to 5.6% in December, the lowest level since June 2008 when the Global Financial Crisis was gathering steam. Lower unemployment generally leads to increased spending, which in turn helps support future growth. Unfortunately, so far, the falling unemployment rate has not delivered the increase in wages seen in most periods of improving employment.
Meanwhile, inflation remains subdued at-best and catatonic at-worst. Price gains have generally undershot the Fed’s policy target of 2% over the past few years. In fact, the annualized inflation rate slid to a meager 1.3% in November from 1.7% in the previous three months, representing the biggest month-over-month decline in six years. The primary catalyst of the decrease was plummeting energy costs, especially oil, which was equally responsible for the selloff in commodities. The Treasury yield curve fell and flattened during the year, reflecting the market’s expectation that inflation will likely remain low for some time. In fact, as a point of reference, the U.S. ten-year bond interest rate started the year at 3% and finished at 2% (and we believe it could fall further as investors seek safety). Decreasing interest rates are a tailwind for equity and fixed income returns alike, which is what we experienced in 2014. On the other hand, the challenge when rates are low is finding investments offering an acceptable yield and/or expected return for the amount of risk being taken.
Oil: Fueling a Global Engine2
In our opinion, the price of oil (or energy more broadly) is perhaps the most important data series across any of the financial markets. Developed nations around the planet consume enormous amounts of energy and they deploy significant amounts of capital/income to keep their motors/lights on. So, more than any other input to global growth, oil prices affect the free cash flow and financial health of governments, businesses and individual consumers. Appreciating this reality is extremely important to understanding the impact oil has on asset classes and investment portfolios.
Historically, the global supply of oil has been artificially constrained by OPEC, but demand has continued to soar. As a result, the prevailing price has been higher than what arguably would have been the true equilibrium price in a free market. However, over the past several years, fracking technology (which was developed ~20 years ago) finally became economically and politically tolerable. That positive supply development transformed the United States from being a net importer of natural gas into a net exporter and has simultaneously reduced its crude oil imports. Concurrently, global growth has slowed and softened demand for energy. Equally important, technological advances in fuel efficiency and/or resource replacement have dramatically improved. Combined, all these factors have led to a slow, but steady, decline in per capita oil consumption, which, in turn, could contribute to a slow, but steady decline in the real price of oil as the market searches for a new supply/demand equilibrium (or long-term average price). Nevertheless, that doesn’t explain the wild ride we experienced in 2014, with oil ending the year down ~45%! For many, the pace and magnitude of recent oil price declines has been unnerving and feels potentially destabilizing.
So, what happened? We believe the recent downward price action reflects “channel stuffing” as producers have been racing to have their crude oil fill both the onshore and offshore storage tanks around the world. The upshot is a supply channel overflowing with a glut of oil and nowhere to put it. Oil producers are literally “hitting the bid,” no matter how low the bid has gone. We believe that if the price movement is short-term in nature, investors shouldn’t be overly preoccupied because the impacts will likely offset in the future. However, if the price movement represents a more permanent adjustment, then portfolios should enjoy benefits over the long-term. The $64,000 dollar question we have been asking ourselves is: what is the long-term fair value price of oil?
Please stay tuned for a future Insight in which we attempt to answer that important question.
Over the past several quarters, we have expressed our concerns about prevailing valuation levels as well as our expectations for increased volatility going forward. Last summer, we completed our Capital Market Expectations and began revising portfolios based on our current views and the related investment decisions. In December, we wrote an Insight [^1] sharing our specific thoughts with clients. In short, we strongly believe prudent investors should reposition their portfolios to be more defensive. To us, this is clearly not a time to be grasping for every last dollar of return. Consequently, we are recommending that clients:
- Expect Less. Investors have earned solid appreciation in their portfolios since March 2009, but going forward we believe return expectations should be substantially more muted.
- Reduce Risk. Unlike March 2009, this is not a time to increase risk, and, in fact, we are recommending that clients reduce risk by:
- Eliminating/reducing leverage (e.g., durable margin)
- Adding/increasing fixed income exposure
- Adding/increasing defensive equities (e.g., risk-managed equities, and tilt to quality)
Significantly reducing US Small Cap equities
- Maintaining underweight to US Large Cap to fund an overweight to emerging markets
Of course, implementing portfolio changes creates an unavoidable timing element. During the initial rebalancing period, investors could certainly forgo some incremental return in one asset class and experience a drawdown in another asset class. Because we are not market timers we think it is very hard to predict the direction of those near-term impacts. Frankly, we don’t believe any investor has demonstrated persistent skill when it comes to market timing. Instead, we are long-term, value-oriented investors who tend not to get overly preoccupied with short-term results, whether good or bad. That’s because short-term portfolio effects tend to be inconsequential when it comes to evaluating a portfolio’s longer-term returns and risk-adjusted performance.
While the average American may not radiate optimism, the domestic equity market is showing signs of exuberance, or more likely a stretching for investment returns even with the attendant high valuations. While we do understand the US economy is performing better than most other countries…and believe this will remain the case throughout 2015…we also believe investors have already captured the lion’s share of investment returns from the current market cycle. Yes, there is certainly the risk we have reduced the domestic equity allocation (risk) early but we would rather forgo the last measure of returns than overstay our welcome. In our view, that risk is much smaller and more palatable than hanging around too long in this momentum-driven market. The concern of the market continuing to expect double digit earnings growth at this stage in the economic cycle is too great to ignore. It is the rational understanding that the investment market often leads the economy (the stocks outperform the businesses), not vice versa, which leads us to this conclusion.
Of course, we empathize with those who’ve experienced some difficult short-term results from a portfolio transition. We expect better results over time and trust you’ll agree that reducing risk in portfolios seems like the right decision in light of the increasing volatility we have seen to start 2015.
See our Insight on Capital Market Expectations written in December 2014.
Reference: The views expressed herein reflect Aspiriant’s opinions as of the date of this publication and are subject to change without notice. They do not represent investment advice. The perspectives were formed by a variety of sources, including data and information provided by the Office of Integrated and International Energy Analysis under the U.S. Energy Information Administration, which is part of the U.S. Department of Energy. For specific reference, please see the Office’s Annual Energy Outlook 2014.
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.