Dear Client:

2014 Review

The U.S. stock market posted its third consecutive annual gain in 2014, overcoming headline news events of global recession fears emanating from Europe and emerging markets, Russian military maneuvers on the Ukraine border, and a potential Ebola epidemic among many others. This was a welcome result based on our concern in early 2014 over the potential negative impact of the cessation of quantitative easing by the Federal Reserve (Fed) on the financial markets. The increased volatility we anticipated manifested itself at times throughout the year, depending on market capitalization, currency exposure or fear of deflation.

Equity Markets’ Returns in Local Currency and U.S. Dollar Terms

The S&P sector returns varied significantly at year-end, and even within the year. The Energy sector led the market through June with a 13% gain, before reversing course to end the year with a 7.8% loss following a 50% collapse in the price of crude, which continues making new post-recession lows. Telecom was also a laggard rising 3% for the year, while the best sectors were Utilities and Healthcare which posted gains of 29% and 25%, respectively. Our relative underweight in Energy and Telecom helped performance, as did our exposure to Healthcare which is well represented in client portfolios.

The International equity markets largely benefitted from excess global liquidity with most countries rising in local currency terms. In U.S. Dollar terms, however, many countries had negative returns for 2014 because of the magnitude of the U.S. Dollar appreciation versus their respective currencies. Japan, for example, rose 9.8%, assisted by stimulus from the Bank of Japan, but fell 3.7% on a dollar basis because of the sharp depreciation in Yen. Likewise, the German DAX gained 2.8%, but lost 9.8% in dollar terms due to the relative decline of the Euro currency.

After rising only 0.1% in the first quarter, U.S. GDP rebounded more than expected with gains of 4.6% and 5% in the second and third quarters respectively. This is a significant improvement over 2.4% annual growth from 2010 through 2013. Moreover, consumption grew 3.2% in the latest release versus the 1.9% annual average since 2010.

As we await results of the final quarter, economists have revised their full-year 2014 U.S. GDP estimate to 2.3%, compared to 3% at the beginning of the year. The consensus for 2015 is for 3% GDP growth while the Fed is estimating a range of 3 – 3.2%. We note that both the Fed and the consensus have been overly optimistic for each of the past five years. A noticeable change is that the outlook for global GDP is now less than that of the U.S. based primarily on the slowdown in China and the Eurozone. For 2015, the World Bank is estimating 2.8% GDP for the global economy.

The further decline of long-term interest rates in the U.S. throughout 2014 came as a surprise to most investors. The 10-year treasury yield fell gradually from 3.0% at the beginning of the year to around 2.0% at year-end. Meanwhile, the Fed exited smoothly its purchase program of U.S. Treasury bonds and mortgage securities, known as quantitative easing 3 (QE3), without disrupting financial markets. New additional demand for US treasuries came from foreign investors driven by weak economic growth, the concern of deflation, and excess liquidity in their home countries.

At the start of 2015 the outlook for interest rates is split: The Fed consensus is to raise short-term rates four times to a total of around 1.1% by year-end while market participants can see, at best, two rate hikes totaling around 0.6%. The market concern stems from low global inflation intensified by the recent fall in oil prices. Indeed, inflation in the major developed economies (US, Euro zone, Japan, UK) and also in China declined in recent quarters (see chart 1). Germany, one of the countries with the lowest inflation, actually has negative short-term interest rates, a burden for this nation of savers. Some of those savers turned to Noesis during 2014.

Chart 1 – Global Inflation Trend

The Fed, on the other hand, emphasizes the strength of the U.S. economy, in particular the improving labor market and consistently growing payrolls throughout the past year. It considers energy prices as transitory and thus excludes them from its projections of long-term inflation.

Wage growth while averaging 2.0% is well controlled and does not add any upward pressure to inflation yet. Thus, it is difficult for us to see any meaningful interest rate increase in the coming year and we continue to view the bond market as unattractive, particularly in relation to the equity market. Stocks offer an earnings yield of 1.4% above the 10-year treasury yield (see chart 2). While this spread is below its long-term average, it still offers a decent premium for equities.

Chart 2 – Spread between S&P 500 earnings yield and 10-year Treasury yield

In our fixed income investment, we are looking for yield alternatives without taking too much risk of principal. We continue to use high-dividend paying equities supported by sustainable growth potential, investments in niche sectors such as master limited partnerships, and structured securities based on companies with solid fundamentals. The recent weakness in high yield corporate bonds returned the valuation of this sector back to its long-term average, thus offering opportunity for a small allocation. In general, we recommend an equity-overweight in balanced portfolios.
 
2015 Outlook

We anticipate the continuation of several themes from 2014 in the new year; namely a strong dollar, market volatility, low inflation, attractive earnings growth, and expansion of the earnings multiple. The dollar strengthened as the Fed ended its quantitative easing program while other central banks, especially Japan, maintained an accommodative stance. The dollar strength led to increased volatility within the equity market in 2014. We feel much of the dollar appreciation has run its course but that it will likely maintain this level with a stronger bias. Another strong dollar impact is that inflation remains subdued. Through November, the Consumer Price Index (CPI) is 1.3% year-over-year, and the Producer Price Index (PPI) is up 1.4%. Wage pressure is also muted with average hourly earnings rising 1.7% year-over-year through December. As for earnings, the S&P 500 is estimated to grow at 9.4% in 2015. Given our outlook for earnings growth, relative economic and political stability, and excess global liquidity we expect the U.S. equity market to rise. We recognize the probability of greater volatility centered around Fed interest rate meetings and decisions, which will also likely impact global equity markets.

We are cognizant of the risks and opportunities of investing in international markets, which currently trade at lower multiples than the U.S., and continue to monitor their relative attractiveness. Our stance is to maintain an invested position over the course of this year, with little regard to short-term selloffs or fluctuations.

Thank you for the opportunity to serve you and for the referrals you gave us in 2014. Noesis continues to grow at a consistent and measured pace, allowing us to reinvest into our client service processes and research.  Please contact us if you have any questions or comments.

 

Sincerely,
Noesis Research Team

 

Form ADV is available upon request