Key Points


  • UNITED STATES - Fundamentals are improving in a longer but less robust business cycle expansion 
  • EUROPE - Slowly but surely exiting recession despite choppy economic data and deflationary scares
  • JAPAN - The economic plan in place is the right prescription for increasing GDP (Gross Domestic Product) and combating deflation
  • CHINA - Engineering a deceleration through a normalization of the “internal investment vs. consumer consumption” tradeoff and positive economic reform
  • EMERGING MARKETS - Continue to be a long term global growth driver and not a systematic risk despite a short term slowdown and turbulence



The equity market’s performance in the first quarter was volatile but finished modestly higher. The MSCI All Country World Index was up 1.3% during the quarter and 17.1% for the trailing twelve months. However the index was down almost 6% year-to-date in the beginning of February due to broad based worries about the impact of a brutal winter on the U.S. economy and economic growth in Emerging Markets, especially China and the “Fragile Five” (Brazil, Indonesia, India, Turkey, and South Africa). Presently, Emerging Markets are stable, but new worries over the ongoing geopolitical tension between Ukraine and Russia continue to keep investors on edge.

Another investment headwind that is now being contemplated is the future normalization of U.S. interest rates - with better economic growth come higher interest rates. The last time the Federal Reserve Bank raised interest rates was June 29, 2006...a distant memory in most investors’ minds after eight years of extremely accommodative monetary policy. According to comments Fed Chairwoman Janet Yellen made in March, mid-2015 might be the next time the Fed raises short term interest rates, depending on the levels of unemployment and inflation in conjunction with economic growth. The Fed will have patience in order to insure adequate employment and a zero chance of debilitating deflation.

Many investors are drawing comparisons to the “1994” and “2004” periods back when the Fed initiated interest rate tightening cycles and caused equity markets to fall an average of 8-9% during each episode. In each of those time periods, the run up to the first rate hike was lead by “value” stocks while high growth stocks underperformed; in the ensuing selloffs, value stocks outperformed as well. Investors, using the same playbook today, are selling high growth, richly valued technology and biotechnology stocks, which have underperformed since Yellen’s comments in March. The “1994” and “2004” episodes did have a happy ending as equity losses were more than fully recovered later in the following years as investors ultimately realized higher rates came with more than commensurate economic growth.      

As a result of the equity volatility during the quarter, fixed income performance was solid: the Barclays US Aggregate Bond Index was up 1.8% for quarter and -0.1% for the trailing twelve months. As we mentioned last quarter, the reversal in market performance is a great reminder of the importance and benefits of asset allocation and portfolio diversification.


We monitor a focused set of global leading economic indicators that cut through the economic noise and short-term anxiety in order to continually gauge our position in the business cycle. Our quarterly review of the economic trends in key geographic regions based on these indicators and framing our portfolio asset allocation decisions generally have remained the same:   


Despite financial punditry to the contrary, the Fed created financial and monetary conditions to stimulate growth and stem financial system failure (QE1), prevent deflation (QE2), and, most recently, to offset severe fiscal tightening (QE3). It has been successful so far as leading economic indicators suggest economic momentum is positive though recent weather-induced (or otherwise) weakness is a concern. The next recession continues to appear to be far off, and a sustained but mild business cycle expansion may continue considering still high unemployment, low inflation, and a Fed supporting the business cycle. It is extremely rare to enter a recession when we do not have direct monetary tightening: out of 19 recessions since the inception of the Fed Reserve Bank, there has been only one (1945, due to fiscal WWII demobilization) that was not associated with direct monetary tightening. 


Slowly but surely the continent is exiting recession despite choppy economic data and deflationary scares. The region is emerging from its 18-month recession and leading economic indicators suggest economic momentum is present. Add potential help from the European Central Bank in the form of increased monetary accommodation, and the economy will get the support it needs until it is fully healed.


“Abenomics,” the economic plan underway in Japan is the right prescription for improving the economy and combating deflation. The prescription calls for aggressive monetary stimulus, increased public infrastructure spending, and currency devaluation to make exports more attractive; leading economic indicators continue to point in the right direction. Monetary and financial conditions remain easy and, as a result, bank lending is finally improving and providing growth capital to the economy. Long term forward corporate profit estimates and inflation are picking up, but a weaker currency has not resulted in increased exports over the last two quarters, and it is something we are watching closely. 


By engineering an economic deceleration through the normalization of government investment vs. consumer consumption tradeoff and positive economic reform, the country has so far averted a hard landing during the recent global slowdown and now appears to be free of a major financial crisis. Recent fears around ongoing economic reforms in its transition to a more market-oriented and balanced (investment vs. consumption) economy are valid in our opinion. Economic news flow has been poor and leading economic indicators are sending worrying signs about intermediate term (2-5 years) economic growth, which can pose difficulties for the government in maintaining the momentum of economic reforms in 2014 and beyond. In contrast to the rest of the world but appropriate for its business cycle and economic evolution, monetary and financial conditions have tightened. 


We believe the Emerging Markets do not pose a systematic risk and will remain a driver of long term global growth despite a short term growth slowdown and turbulence. Emerging markets should account for 70% of global growth through the end of the decade given the aggregate demographic and productivity improvement profile. All major developed economies are moving in the right economic direction for the first time in a long time, and, despite recent turbulence, this should ultimately benefit emerging markets in general as they are commodity and industrial manufacturing export oriented. However, as emerging markets continue to adjust sovereign balance sheets as a consequence of depreciating currencies, inflation concerns, and higher global interest rates, a downshift in short term growth is expected.

Remain Overweight Equities vs. Fixed Income

Our asset allocation positioning remains overweight equities vs. fixed income. Equities in aggregate today are fairly valued relative to our forward growth projections in an improving global macroeconomic scenario, but they are still inexpensive vs. fixed income. We are disciplined in our asset allocation methodology and will only choose attractive investment opportunities that meet our rigorous valuation criteria. 


We continue to reposition our overall global equity allocation based on both our macroeconomic outlook and the relative valuation opportunities in the asset class measured by price-to-earnings (P/E), price-to-book value (P/B), price-to-cash flow (P/CF), forward earnings growth projections, and returns on invested capital. 

Fixed Income

We continue to be mindful that an improving economy, over time, leads to an increased level of employment; more jobs = more wages = more spending on goods and services = more inflation. The perceived outcome of this relationship will cause interest rates to go up, not down. In order to protect our fixed income portfolio in this environment, we continue to prefer lower portfolio duration and increased exposure to opportunistic areas such as floating rate, high yield, and convertible bonds.  


We remain committed to alternative assets such as Hedge Fund Trading Strategies, Commodities, and Real Estate that have lower correlation to equity and fixed income, increase portfolio diversification, and may help protect against inflation. 

The portfolio changes outlined above will vary based on the individual investment objectives of your financial plan. As always, we very much appreciate the trust and confidence you place in our firm. We value that trust every day and will continuously strive to retain it. Please do not hesitate to contact your advisor for any questions or service needs.

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