Amy Magnotta, CFA, Senior Investment Manager, Brinker Capital
Despite geopolitical tensions in Russia and the Middle East, the end of the Federal Reserve’s quantitative easing program, weakness in growth abroad, and a significant decline in oil prices, U.S. large cap equities posted solid double-digit gains in 2014. International equity markets lagged U.S. markets, and the spread was exacerbated by the major strength in the U.S. dollar. Despite consensus calling for higher interest rates in 2014, yields fell, helping long-term Treasuries deliver outsized returns of more than 25%. The weakness in energy prices weighed on markets in the fourth quarter, with crude oil prices falling by almost 50%, the type of move we last saw in 2008. However, it wasn’t enough to prevent the S&P 500 from hitting all-time highs again in December. Volatility remained relatively low throughout the year. We did not see more than three consecutive down days for the S&P 500, the fewest on record (Source: Ned Davis Research).
In the U.S., the technology and healthcare sectors were the largest contributors to the S&P 500 return; however, utilities posted the biggest return, gaining more than 28%. Large caps significantly outperformed small caps for the year, despite a big fourth quarter for small caps. The spread between the large cap Russell 1000 Index and small cap Russell 2000 Index was 760 basis points. Growth outperformed value in large caps and small caps, but value outperformed in mid caps due to the strong performance of REITs.
U.S. equities outperformed the rest of the world in 2014. The S&P 500 Index led the MSCI EAFE Index by more than 1,800 basis points, the widest gap since 1997. In local terms, international developed markets were positive, but the strength of the dollar pushed returns negative for U.S. investors. Emerging markets led developed international markets, but results were mixed. Strength in India and China was offset by weakness in Brazil and Russia.
As the Fed continued to taper bond purchases and eventually end quantitative easing in the fourth quarter, expectations were for interest rates to move higher. We experienced the opposite; the yield on the 10-year U.S. Treasury note fell 80 basis points during the year, from 3.0% to 2.2%. Despite a pick-up in economic growth, inflation expectations moved lower. In addition, U.S. sovereign yields still look attractive relative to the rest of the developed world. As a result of the move lower in rates, duration outperformed credit within fixed income. All sectors delivered positive returns for the year, including high-yield credit, which sold off significantly in the fourth quarter due to its meaningful exposure to energy credits.
Our macro outlook remains unchanged. When weighing the positives and the risks, we continue to believe the balance is shifted in favor of the positives over the intermediate term and the global macro backdrop is constructive for risk assets. As a result our strategic portfolios are positioned with an overweight to overall risk. A number of factors should support the economy and markets over the intermediate term.
- Global monetary policy accommodation: We anticipate the Fed beginning to raise rates in mid-2015, but at a measured pace as inflation remains contained. The ECB is expected to take even more aggressive action to support the European economy, and the Bank of Japan’s aggressive easing program continues.
- Pickup in U.S. growth: Economic growth improved in the second half of 2014. A combination of strengthening labor markets and lower oil prices are likely to provide the stimulus for stronger-than-expected economic growth.
- Inflation tame: Inflation in the U.S. remains below the Fed’s 2% target, and inflation expectations have been falling. Outside the U.S., deflationary pressures are rising.
- U.S. companies remain in solid shape: U.S. companies have solid balance sheets that are flush with cash. Earnings growth has been solid and margins have been resilient.
- Less uncertainty in Washington: After serving as a major uncertainty over the last few years, Washington has done little damage so far this year. Government spending will shift to a contributor to GDP growth in 2015 after years of fiscal drag.
- Lower energy prices help consumer: Lower energy prices should benefit the consumer who will now have more disposable income.
However, risks facing the economy and markets remain, including:
- Timing/impact of Fed tightening: QE ended without a major impact, so concern has shifted to the timing of the Fed’s first interest rate hike. While economic growth has picked up and the labor market has shown steady improvement, inflation measures and inflation expectations remain contained, which should provide the Fed more runway.
- Slower global growth; deflationary pressures: While growth in the U.S. has picked up, growth outside the U.S. is decidedly weaker. The Eurozone is flirting with recession, and Japan is struggling to create real growth, while both are also facing deflationary pressures. Growth in emerging economies has slowed as well.
- Geopolitical risks: The geopolitical impact of the significant drop in oil prices, as well as issues in the Middle East and Russia, could cause short-term volatility.
- Significantly lower oil prices destabilizes global economy: While lower oil prices benefit consumers, significantly lower oil prices for a meaningful period of time are not only negative for the earnings of energy companies, but could put pressure on oil dependent countries, as well as impact the shale revolution in the U.S.
While valuations are close to long-term averages, investor sentiment is in neutral territory, the trend is still positive, and the macro backdrop leans favorable, so we remain positive on equities. In addition, seasonality and the election cycle are in our favor. The fourth quarter tends to be bullish for equities, as well as the 12-month period following mid-term elections. However, we expect higher levels of volatility in 2015.
Our portfolios are positioned to take advantage of continued strength in risk assets, and we continue to emphasize high-conviction opportunities within asset classes, as well as strategies that can exploit market inefficiencies.
||Quality bias; overweight vs. Intl
||Benefit from higher volatility
||Oil stabilizes in 2H15
||Later in cycle
Source: Brinker Capital
Views expressed are for informational purposes only. Holdings subject to change. Not all asset classes referenced in this material may be represented in your portfolio. All investments involve risk including loss of principal. Fixed income investments are subject to interest rate and credit risk. Foreign securities involve additional risks, including foreign currency changes, political risks, foreign taxes, and different methods of accounting and financial reporting. Past performance is not a guarantee of similar future results. An investor cannot invest directly in an index.