Investor Discussions - Q1|2015 Commentary
Wealth & Pension Services Group
Matt B. Bailey, CFA - Portfolio Manager
As expected, 2015 started out with an increase in volatility across all asset classes. Global stocks experienced many large intraday moves, interest rates tested historic lows, and commodities faced continued headwinds. The global economic landscape showed signs of improvement, as U.S. unemployment continued to decline, many European economic indicators started pointing towards growth, and Japan managed to pull itself out of a small recession. Overall, the global markets remained resilient but are likely to continue exhibiting increased levels of volatility.
During the first quarter, the U.S. economy remained on track. Final Q4 GDP came in at an annualized rate of 2.2%, as seen on chart 1, and continues to grind ahead. The current economic cycle has been labeled as the “Plow Horse Economy” by economist Brian Westbury, a fitting description of the slow but progressive growth the U.S. has experienced during the last 6 years.
U.S. employment data continued to disappoint naysayers who claim the economy is weak. The March unemployment report printed a new low of 5.5% (chart 2). This new cycle low was achieved in light of energy related jobs cuts linked to lower oil prices. In addition, the underemployment rate continued to make new cycle lows and now stands at 11.0%.
Inflation, as reported by the Consumer Price Index (CPI), also continued lower during the quarter. In fact, the latest year-over-year reading was negative for the first time in a few years (chart 3). This is important because it hints at deflation which can be bad for an economy’s future growth prospects. Even so, it’s more likely that the recent deflationary data was linked to falling energy prices and not indicative of weak economic growth.
We remain optimistic about the U.S. economy and see the prospects of deflation as being slim. Excluding food and energy, prices actually increased over the last year. We do see the potential for weak near-term economic data, specifically GDP. Harsh winter weather, recent strikes at west coast ports and the strong U.S. dollar all likely played a part. With that being said, we believe the weakness will be temporary and think factors such as lower energy prices will stimulate growth. Lastly, many key economic indicators remain positive, suggesting that future growth prospects of the U.S. economy are intact.
Outside the U.S., the economic data remains mixed but appears to be turning positive. The Citi Economic Surprise Index for Europe has recently shown signs of stabilization. This indicator compares economic data releases relative to consensus estimates for specific regions. The latest data hints that economic momentum may be turning positive within the euro zone. Chart 4 illustrates European GDP and manufacturing data going back to 1999 and shows that both GDP and manufacturing have seen an uptick in recent quarters.
In addition, the European Central Bank (ECB) recently announced that it will soon begin a full-scale quantitative easing (QE) program. The program will be similar to the Federal Reserve's seen within the US. The plan is for the ECB to buy bonds on the open market in an attempt to keep interest rates low and stimulate euro zone growth. This program, coupled with a weak euro, has the potential to get European growth on track.
Japan is another area displaying signs of positive growth. Chart 5 shows the recent strength their economy has experienced after going through a short recessionary period. Japan has been battling deflation for over 20 years and hopes to see real growth soon. The Bank of Japan (BOJ) is currently using every lever available in an attempt to stimulate their economy.
The emerging markets (EM) and frontier markets (FM) have remained a divided group. The recent drop in energy prices has created both headwinds (exporters) and tailwinds (importers). Lower energy prices should have a net positive effect on these markets, as most of them are net importers. Even so, investor sentiment remains negative on both for now. This is a key factor because foreign capital inflows play an integral part in keeping these economies afloat. Looking forward, lower energy prices and European growth should help these areas.
During the quarter, U.S. stocks continued their move higher but did so with a strong dose of volatility. The S&P 500 index (large caps) and Russell 2000 index (small caps) finished up 0.95% and 4.32%, respectively. Small caps were a notable leader, hinting that the investor appetite for risk has increased. Small cap stocks tend to be more volatile than large caps and provide a good risk barometer. Small caps also tend to perform well during periods of U.S. dollar strength, which we are experiencing at the moment. This outperformance is due to more than 80% of their revenues coming from within our borders, compared to just 67% for large cap companies.
Within the S&P 500 index, the dispersion amongst the different sectors continues to be wide. Chart 6 shows the S&P 500 sector returns for the first quarter and 2014. Health care continued to exhibit the positive momentum seen during 2014 and led all sectors. Although energy was down during Q1, sentiment towards the space appears to be turning positive. Also, analysis of the current business cycle suggests that we are nearing the mid to later stages. During these stages, energy has previously performed well and may be an attractive area to invest.
Developed international stocks made up some of the ground they lost during 2014 and finished Q1 strong. The STOXX Europe 50 index ended up 4.58%, while the Japanese Nikkei 225 index was up 10.04%. Much of this strong performance was likely due to the stabilization of the European and Japanese economies. Additionally, investor sentiment turned positive as the ECB and BOJ continue to use loose monetary policy. More impressive is the fact that the euro weakened against the dollar throughout the quarter. In local terms, European stocks were up much more. This is due to the effects of currency translation. When foreign currencies decline against the U.S. dollar, domestic investors receive lower returns on their international investments.
Emerging Market (EM) equities, as represented by the MSCI EM index, were up 2.24% during the quarter. The Frontier Markets, as represented by the MSCI FM Index, were down -1.5% during quarter. Investor sentiment remains negative on both of these markets for numerous reasons. They include: low energy prices, the potential for rising rates, and weak economic growth. Although negative sentiment has led to near-term weakness, it has also created attractive valuations. These low valuations may support new investment in the space as investors seek out value.
During the quarter, most bond indexes mimicked the stock market’s high level of volatility. The U.S. 10-yr Treasury index was not immune. It started the year at 2.17%, fell as low as 1.65%, and ended the quarter at 1.93%. This fickleness filtered through to the Barclays US Aggregate Bond Index which finished up only 1.61%. Riskier areas of the bond market were mixed. The Barclays Corporate High Yield Bond index ended the quarter up 2.52%, while the Barclays Global Aggregate ex-USD Bond index finished down -4.63%. Much of the weakness in the international bond market was attributable to the strong U.S. dollar.
Going forward, interest rates are likely to stabilize before moving higher over the next few quarters. Chart 7 shows the history of the U.S. 10-yr Treasury going back to 1965 and highlights the historic lows rates are at right now. Looking ahead, we think a few factors will lead to higher rates in the future. These include stronger global growth and the Federal Reserve tightening its current monetary policy.
Even with rates poised to move higher, it’s important to recognize the active role bonds play within portfolios. First, bonds offer a predictable source of income. This income can create a compounding effect on returns when reinvested over time. Second, bonds have tended to provide a less volatile return stream than stocks. Lastly, and most important, bonds offer uncorrelated returns. This can help increase portfolio diversification and reduce portfolio risk.
Chart 8 illustrates the difference between a “bad” year in stocks and “bad” year in bonds. It shows that bonds have tended to experience smaller drawdowns than stocks. It also shows that they have provided positive returns during negative periods in the stock market.
Outside of stocks and bonds, the commodity market continued to face headwinds. The U.S. dollar has been strengthening against most foreign currencies since last June. This has had a negative impact on many commodities as they have a strong inverse relationship. The Bloomberg Commodity Index finished the quarter down -5.94%, while the U.S. dollar index was up 8.34%.
Beyond the U.S. dollar, commodities have other obstacles. For instance, global energy continues to be oversupplied, even with prices falling to multi-year lows. Also, inflation has been non-existent during the current expansion. This has led many investors to pull money from the asset class (investors often allocate to commodities as a hedge against inflation). Looking forward, commodities will likely continue facing the current headwinds seen in the market.
The first quarter of 2015 provided global investors with a hint of the new normalcy. Volatility was rampant across all asset classes and is likely here to stay. With that being said, the markets remained strong and continued to climb higher. Furthermore, global economic data has been stabilizing and appears to be pointing towards near-term growth.
Looking ahead, stocks remain relatively more attractive than bonds and commodities, especially the U.S. and international developed stock markets (Europe and Japan). Within bonds, credit focused investments still make sense and should benefit from stronger economic data and rising rates. Lastly, commodities face significant headwinds which do not appear to be abating.
Finally, we want to stress the importance of taking a long-term approach to investing. We believe the markets are likely to continue exhibiting higher levels of volatility. This will require increased patience and portfolio diversification. Over the long term, diversification has proven to lower portfolio volatility and reduce risk. We are confident this time will be no different.
As always, please feel free to contact us with any questions you may have.
Matt B. Bailey, CFA, CMT
Source:Bloomberg.com, Citigroup, Morningstar Office, Goldman Sachs Asset Management, Fidelity Investments