QUARTERLY MARKET UPDATE January 2015
ASSET CLASS PERFORMANCE Equity Markets - After demonstrating considerable weakness to begin the fourth quarter of 2014, domestic large cap equity markets rebounded strongly to end the year with double digit returns. The S&P 500 Index, the Dow Jones Industrial Average and the Nasdaq Composite all added approximately another five percent to their total returns, with utilities and real estate attributing the majority of the results. Small capitalization stocks underperformed YTD, though they rallied from negative territory to post positive results by year end. Both developed and developing (emerging markets) international equities continued their significant underperformance relative to the US indexes, posting negative results for both the final quarter and the full year of 2014.
Fixed Income Markets - Domestic fixed income markets continued their slow but steady production of low single digit returns over the fourth quarter of last year. Both Corporate and Government debt securities experienced price increases promoted through the ongoing flattening of the yield curve. High yield corporate bonds bucked that trend as credit spreads tightened. Emerging market debt continued its underperformance relative to domestic sectors as US Dollar strength persisted, registering negative returns for the year.
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CAPITAL MARKETS OVERVIEW Key Economic Theme - Flattening Yield Curve
In December 2008, the US Federal Reserve (the Fed) cut the Federal Funds rate to its current target range of 0 – 0.25%, essentially reducing the rate at which banks lend to one another to zero. A significant piece of the Fed’s economic growth management strategy since then has been forward guidance regarding this rate, fearing that any sudden, unexpected adjustments to its language might cause adverse movements in both bond and equity markets. Through this emphasis on verbal sensitivity, the Fed’s word selection and phrasing choices have become as important as the actual changes in policy. The Fed doesn’t need to raise rates; merely to hint that it might consider doing so is indistinguishable from enactment of policy. Take the proposed rate hikes in April of 2013, the so called taper tantrum. Through its guidance, the Fed produced an immediate change in interest rates as the market rapidly repositioned for the forthcoming policy the language implied. The resulting higher interest rates and stronger dollar produced changes in the economy that arguably muted the already feeble recovery. Suddenly higher interest rates encouraged softness in the mortgage market and supported economic weakness that most likely contributed to negative Gross Domestic Product (GDP) growth in the first quarter of 2014. The Fed’s hint at possibly tightening its policy produced the same reaction an immediate rate hike would have. Today, having telegraphed impending higher rates resultant from assured future growth, questions surrounding the Fed’s course now exist. With almost everyone positioned for higher rates, the market has moved in the opposite direction. Long term Treasury rates are set by the market and have strayed considerably from the Fed’s preferred path with both inflation and growth expectations sliding. Bond yields are in a free fall along with inflation and growth expectations as traders unwind the trade the Fed’s language told them would be profitable. If the Fed feels compelled to follow through with the rate hikes they say are coming, the bond market is predicting the result will be lower inflation and more importantly lower growth.
QUARTERLY MARKET UPDATE January 2015 | Page Three Domestic stocks have been the last asset class to persist in the belief that an increase in interest rates by the Fed is solidly predicated on continuing and accelerating growth. Evidenced by increased volatility, even that may have started to change recently as the drop in oil prices has become too large to blame on supply issues alone. While some investors remain convinced that the US economy can decouple from emerging global concerns, there exist reasons for apprehension. The US economy, despite the 5% third quarter 2014 GDP growth, is still weak when looked at from a longer term perspective; the growth trajectory has been fixed in a 2 – 2.5% annualized range since 2010 (including the Q3 print). Additionally, economic reports continue to be of the same lackluster nature we’ve become accustomed to. The employment report was somewhat stronger than expected at 252,000 new jobs (and with upward revisions for previous months) but included many of the usual caveats. Hourly earnings fell and the workweek was unchanged; incomes are not improving much faster than inflation. The unemployment rate fell to 5.6% but that was at least partially due to another drop in the participation rate. Domestic auto sales registered lower than expected and down from last month (with the number of people missing payments increasing) but still remain fairly elevated. Factory orders fell and are now down year over year. The ISM services index was less than expected but still in growth territory at 56.2. Mortgage applications continued to fall, down over 9%, and jobless claims were slightly higher than expected but still fairly healthy. The fact is that the economic figures have fluctuated around this slow growth path for a long time and the recent data doesn’t change that. We have gone through periods of disappointing data over the last few years only to have the data turn higher and push stocks higher along with it. What is interesting is that weak data hasn’t produced much in the way of downside in stocks while positive data has continued to push markets higher. The response to incoming economic reports has been decidedly asymmetrically positive for investors. There does seem to be something a bit different about this latest rise in volatility, though, as some of the market based indicators are exhibiting cautionary signals that have been heretofore not present. An obvious example is the drop in Treasury note and bond yields generally over the last year. 10 year Treasury yields are again below 2%, reflecting an ongoing reduction in inflation expectations. That drop in inflation expectations over the last year has been aided by falling commodity prices with crude oil only the latest to participate on the downside. However, taken alone, falling inflation expectations by themselves are not necessarily a cause for concern. Of greater significance has been the flattening of the yield curve as long term rates (20+ years) have fallen faster than intermediate term rates (7-10 years). In the past, a flattening at the long end of the curve has been a warning that the Fed has gone too far in hiking rates and that economic growth is waning. Having it occur when the Fed hasn’t yet even begun to raise rates is unsettling. Continuing with this theme, credit spreads have been widening, with the lowest rated bonds performing the worst. CCC bonds (highest credit risk) have seen spreads move from a low of 6.3% in June of last year to near 10% recently. BBB bonds, the low end of investment grade, have seen a similar percentage rise from 1.4% in July of last year to a recent 2%. Even AAA bond spreads have risen, though only from 0.5% to 0.65% recently. Any one of these bond market indicators taken in insolation or the flattening yield curve and widening credit spreads (not to mention falling TIPS yields) might not necessarily mean much. But when they are moving in the wrong direction simultaneously, it signals stress and historically has provided an atmosphere beneficial for diligent risk management. Other indications of strain are evident in currency markets as well. The rising dollar is positive for the US economy in the long run, yet in a world where the US dollar remains the primary currency, a sustained increase in its value can lead to problems
QUARTERLY MARKET UPDATE January 2015 | Page Three outside the US (i.e. developing markets). The buildup of dollar debt over the last few years means that a rising dollar can cause problems for the rest of the world as dollar debts become harder to service. It is also interesting that the recent rise of the dollar against other currencies has not been accompanied by a fall in the dollar price of gold. That would seem to signal an uncertainty component to its increase, not only a reflection of a strong US economy. One of the main concerns of the last few years, outside of sentiment and valuation issues, is that the US economy’s slow growth path provides less room for error. A shock that might have produced a modest impact when growth was closer to historical norms (3% or more) might now be sufficient to cause larger interference. Reviewing widening credit spreads, how much of recent growth has resulted from relaxed funding conditions in the low quality credit market? If we reduce funding for that segment of the economy, how much will it reduce growth? We can’t accurately quantify responses, yet our supposition is that contribution to growth from low rated credit has been significant in this cycle. Disruption to these markets would likely depress growth estimates. The market is exhibiting increased volatility in conjunction with inconsistent and suspect market internals. We would expect the volatility to continue until inconsistencies between equity and fixed income market expectations are more fully synchronized. There exists no way to determine in advance whether continued muted growth or accelerating growth will prevail in the near term, but a defensive investment stance is warranted until the answer is more clearly observable.
PORTFOLIO IMPACT - Traditional Assets
PORTFOLIO IMPACT - Alternative Assets
Stocks – Our sector positioning remains consistent with our aforementioned outlook, as we persist with over weights in healthcare, infrastructure, telecom and other yield generating equity sectors. These are largely defensive in nature, as price risk remains more acute to cyclical sectors if bond market behavior correctly predicts continued slow growth in the face of prospective interest rate increases. From a valuation perspective, international sectors continue to look more attractive than their domestic counterparts. We therefore continue with nearly half of our equity exposure weighted to world and international categories for those accounts where tactical management of asset class ranges is mandated.
Global Macro – The investment team has made a decision to devote, on average, half of its portfolio’s active risk to the currency strategy and half to the asset class/market strategy (equity & fixed Income). One reason for this significant allocation of the risk budget to currency is the large diversification benefit that a dynamically managed currency strategy is expected to provide to a top-down (macro) portfolio. In Equilibrium (longer-term, normal state), currencies have no correlation with assets and, therefore, should be expected to deliver performance that is generally uncorrelated with market strategies. Over shorter horizons, correlations between currencies and markets can be non-zero, but they tend to still be low relative to, say, the correlation of one equity market with another or one bond market with another. Additionally, one observes that there are large swings in currency prices (the non-normal distribution of exchange rate changes) over the short term but over the long term, those price swings are reduced dramatically. This gives the team more confidence in the value/price investment signals observed when they are dynamically managing their currencies. Lastly, the results indicate that exchange rates tend to revert to fundamental value over shorter time horizons than do asset classes/markets.
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PORTFOLIO IMPACT - Traditional Assets
PORTFOLIO IMPACT - Alternative Assets
Bonds – Long term fixed income instruments outperformed shorter duration securities in 2014, contrary to consensus. This was attributable to yield curve flattening caused by low inflation and growth expectations. While these conditions may remain present for the intermediate term, and long term bond outperformance could continue, valuation and acute interest rate sensitivity of long term bonds provide reticence to acquiring exposure from these levels. However, we continue to think bonds remain a crucial diversifier and will generate positive returns over the intermediate term while acknowledging the existence of interest rate risk to our fixed income position. We therefore are predisposed to short duration vehicles, favoring credit risk over interest rate risk. The goal is to garner stable risk adjusted returns, even if long dated bonds could outperform in the near term due to the uncertainty of the macro environment.
Absolute Return – U.S. Treasury rates declined once again in December after the Fed announced its plans to remain patient with respect to increasing the Federal funds rate. At the same time, yields for German Bunds approached historic lows as the market began to more-seriously consider stimulus in Europe, and, in Japan, JGB yields have declined further due to continued quantitative easing there; we expect these divergent central bank monetary policies to create trading opportunities. Our credit long/short sub advisers remain positioned for rising interest rates with long positions in floating rate bank loans and short positions in fixed rate high yield bonds; while that was a headwind in 2014 when rates declined, we think it is prudent as we head into 2015. We believe that equity long/short strategies may provide a compelling investment opportunity in 2015. The dynamics that support our view are the continued improvements to company fundamentals and our expectations for correlations between stocks to remain low as increased volatility may lead to higher dispersion. We therefore marginally added to the strategy allocation heading into 2015.
Copyright Š 2015 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor.
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Copyright Š 2015 Kern DeWenter Viere, Ltd. All Rights Reserved. Investment advisory services and fee-based planning offered through KDV Wealth Management, LLC, an SEC Registered Investment Advisor. Securities offered through ValMark Securities, Inc. Member FINRA, SIPC - 130 Springside Drive, Suite 300, Akron, Ohio 44333-2431, 1-800-765-5201. KDV Wealth Management, LLC, is a separate entity from ValMark Securities, Inc. and ValMark Advisers, Inc.