Global growth acceleration should continue in 2015 but intermediate term (2-5 years) growth potential is declining.
- UNITED STATES – Fundamentals continue to improve in a longer but less robust business cycle expansion
- EUROPE – The nascent economic recovery has stalled but leading indicators are picking up
- JAPAN – The economic plan in place is the right prescription for increasing GDP (Gross Domestic Product) and combating deflation
- EMERGING MARKETS (EM) – Led by economic prospects in China and India, the regions continue to be a long term global growth driver and not a systematic risk despite a short term slowdown in growth
Improving macroeconomics bode well for a balanced portfolio with a modest overweight to equities vs. fixed income & alternative investments.
- EQUITY INVESTMENTS - Maintaining current preferences for Foreign Developed and Emerging Markets as well as Value over Growth and Large Cap over Small Cap in all regions
- FIXED INCOME INVESTMENTS - Continue to prefer increased exposure to actively managed opportunistic areas
- ALTERNATIVE INVESTMENTS - Remain committed to alternative assets that have lower correlation to equity and fixed income, increase portfolio diversification, and can protect against unexpected inflation
Market Performance Commentary
The theory of globalization has promised a higher long-term economic growth rate as far back as we can remember. Since the “Great Recession” six years ago, global economic development across major regions has more or less been in sync. However today, the global recovery is still a recovery but it is now weaker, more U.S. driven, and continues to rely on extraordinary monetary policy support, especially in Europe and Japan.
Global leading economic indicators suggest continued growth, but under the surface regional differences are pronounced.
In 2015, the economic and capital market divergences between countries and across regions may become more pronounced over time as the respective monetary policy regimes prescribed by central banks around the world become divorced from one another. As an example both the U.S. and the U.K. may (and we do stress the word “may”!) raise interest rates (a form of monetary tightening) while Europe, Japan, and China could remain much more accommodating at the margin.
Equity market returns in 2014 also fell along regional biases: the MSCI All Country World Index, a global stock market index, was up only 3.8% while the Russell 1000 Index, a stock market index made up of the largest 1,000 companies in the U.S., was up 13.2%. Given U.S. stocks make up about 50% of the total global market capitalization, it is not that difficult to surmise that stocks outside the U.S. performed relatively poorly in 2014. As such, the MSCI World ex USA Index, a stock market index made up of companies in foreign developed markets, was down 4.3%.
That said, additional equity market gains in the U.S. could be tough from these levels while equities in the rest of world may benefit from continued monetary policy accommodation and – just maybe – positive economic data surprises compared to extremely pessimistic expectations, especially in Europe.
Overall fixed income performance was solid in 2014, up around 6%, as measured by the Barclays US Aggregate Bond Index. However much of that performance was driven by strong moves in U.S. Treasury securities, especially longer-dated bonds (i.e. beyond a 10-year maturity date). As we mentioned last quarter, given the anxiety around a downshift in global economic growth and continued geopolitical risk, interest rates remain low relative to the year ago period; the 10-year U.S. Treasury bond yield is around 2% today vs. 3% in January of 2014.
Global Growth Accelerating, Driven by the U.S.
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 helps frame our portfolio asset allocation decisions.
Global growth is expected to be around 3.5% in 2015 vs. 3.1% in 2014 and will continue to rely on extraordinary monetary policy support in Europe and Japan. Economic and monetary policy developments have not fundamentally changed since 2014, but they have become further accentuated as deflationary fears have resurfaced. Oil prices will likely stay subdued in 1H15 allowing most developed and emerging market economies to benefit.
The U.S. is the one major economy which has remained on script: the labor market continues to improve, the economy is growing at a decent pace, and the oil price drop is likely to boost consumption. As a result, the Federal Reserve Bank is setting the stage for interest rate hikes in the future. However, in a nod to worries about global growth, we would expect a slower and milder interest rate hiking cycle compared to cycles in the past.
U.S. leading economic indicators still suggest positive economic momentum and a chance that the economy may finally shift into a self-sustaining second gear (i.e. 2.5-3.0% GDP growth; Gross Domestic Product) with solid employment growth supporting consumer and corporate spending. Consumer spending should pick up in 2015 due to lower oil prices, wage gains, and the wealth effect but overall growth may stay below 3% for the year as business investment spending is running close to its five-year average, and residential investment spending has flattened in recent quarters.
Overall, the U.S. appears to be reasserting its traditional role as leader of the global business cycle with prospects for economic growth acceleration compared to the rest of the world and the next recession (defined as two consecutive quarters of negative GDP) appears to be a ways away. As a reminder, business cycle expansions do not die of old age, but rather are killed by monetary policy. We still believe a sustained but mild business cycle expansion can continue considering employment and inflation are below the Fed’s targets. Furthermore, every business cycle downturn over the last century (save 1930’s and 1981) came after the output gap went positive and unemployment fell to below average levels; the former is negative and the latter is above average.
GDP growth in 2014 was a disappointment and the economy still lacks robust and important growth drivers. Consumption remains anemic as a result of weak wage growth, tax increases, and a high savings rate to reduce the household debt overhang. Fixed capital investment has started to turn up after a long decline but remains low as a percentage of GDP. With a relatively weaker currency these days, external trade has been a modest support to growth so far.
The region may remain the weakest major economy in 2015 with expected GDP growth of only 1.1%, but inflation should stay far below the European Central Bank (ECB) mandate of 2% for the foreseeable future with expectations of 0.6% in 2015 and around 1% in 2016. Secular deflationary trends in the services sector, limited pricing power by businesses, light cost pressures from labor, and the recent decline in oil prices should exert more deflationary pressure.
However, leading economic indicators are picking up but the future of both economic growth and inflation relies heavily on decisive incremental monetary policy (e.g. “QE”: Quantitative Easing) and a weak currency in order to increase inflation expectations. While still weak, Europe may be able to provide upside surprises vs. very pessimistic expectations.
The economic plan AKA “Abenomics” could be the right prescription for increasing GDP and combating deflation. Economic data was disappointing in 2014, with the economy officially entering a recession last quarter; however the contraction was due to a sharp inventory swing and final demand grew at 1.5% annualized, which is stellar.
The economy is expected to grow 1.1% this year, exceeding potential, helped by the Bank of Japan’s latest round of extraordinary monetary stimulus (more “QE”). The weaker currency and lower interest rates should push up consumer spending, supported by wealth effects and higher wages (as corporate profits pick up due to further currency depreciation). 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 yet to materially increase exports.
Led by China’s economic growth prospects, emerging markets are a long term global growth driver and not a systematic risk despite a short term growth slowdown and turbulence. China is engineering a deceleration through a normalization of the investment/consumption tradeoff and positive economic reform. The country averted a hard landing during the global slowdown but leading economic indicators are still lackluster. While free of a major financial crisis so far, the country’s transition to a more market-oriented and balanced (investment vs. consumption) economy is proceeding as planned.
China’s economy is expected to slow to 7% growth this year, due to a further correction in the property sector, slowing manufacturing investment growth and moderate export growth. These effects may be offset by the government’s acceleration of new infrastructure projects announced in 2014, lower oil prices, easier monetary policy, and stable consumption growth. Even as the economy slows, it should still remain a major contributor to world growth.
Outside of China, demographics and a catch up in productivity should drive emerging markets to around 70% of global growth through the end of the decade. Emerging markets continue to adjust sovereign balance sheets as a consequence of depreciating currencies, inflation concerns, and higher global interest rates resulting in a short term growth downshift.
Finally, India should be a bright spot in 2015 with economic growth likely to be considerably stronger than 2014. Policy initiatives from the Modi government should boost activity and the fall in oil prices is a big positive.
Remain Overweight Equities vs. Fixed Income
We are disciplined in our asset allocation methodology and will only choose attractive investment opportunities that meet our rigorous asset class evaluation criteria (made up of qualitative assessments of valuation and momentum).
Improving global macroeconomics bode well for a balanced portfolio with a modest overweight to equities vs. fixed income; alternative assets are necessary for non-correlated risk-adjusted performance and protection against unanticipated inflation:
- Long-term expected returns on equities could be well above those on fixed income as the “equity risk premium” remains large and persistent and the 30-year bull market in fixed income comes to an end.
- Equity and fixed income valuations are much lower for markets and sectors outside the U.S. as investors continue to price in a high risk premium and very pessimistic assumptions on earnings growth; both of these factors should fade somewhat this year.
- Increasingly higher global stock valuations and a still-strong demand for safer fixed income assets call for maintaining a relatively balanced portfolio between equities, fixed income, and alternatives with only a modest overweight in equities.
Within the U.S. Equity sector, we see modest upside potential as valuations remain higher than historical averages against accelerating earnings growth. The biggest challenge comes from persistently bullish sentiment. We continue to believe that long-term U.S. Equity returns may lag Foreign Developed equity.
In the Foreign Developed equity sector, we note European equities are valued favorably and should benefit from the ECB’s efforts to reflate the economy, better economic data surprises, and improved earnings growth. Japanese equity valuations are very low, and corporate behavior is changing, with a clear improvement in profit margins.
The depressed sentiment in the Emerging Market equity sector during 2014 has lifted some and so has the outsized relative valuation attraction vs. developed equities. However the sector is still attractive on a relative valuation basis.
Improving economy and eventually rising interest rates calls for lower overall portfolio duration and moderate exposure to opportunistic areas. Fixed income assets have been very resilient in the face of Fed “QE” reductions and prospective interest rate hikes; but markets may be too complacent about the timing and speed of the Fed tightening cycle and the coming end of the 30-year bull market in fixed income.
We still prefer “opportunistic” areas overall and full allocation to proven fixed income managers with a broad mandate targeting opportunistic investments such as floating interest rate, senior bank loans, high yield/junk-rated, convertible bonds, and preferred stock.
We remain committed to alternative assets such as Hedge Fund Trading Strategies and “real assets” (such as Commodities, Infrastructure, Natural Resources, and Real Estate) that have lower correlation to equity and fixed income, increase portfolio diversification, and may help protect against rising inflation.
The portfolio profiles 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.