Key Takeaways —
As the year came to an end, a handful of big-picture issues dominated the investment landscape: the plunging price of oil, positive economic indicators in the United States relative to most of the globe, and the ongoing influence of central banks (a key effect of which has been to bolster stocks and other risk assets).
Large-cap U.S. stocks continued their unusually strong and unbroken stretch of gains. The S&P 500 rose 14% and avoided even a modest 10% “correction” for the third year in a row.
Most other major stock markets fared poorly in 2014. Developed international stocks lost 5% and emerging-markets stocks dropped 2%. These returns reflect the significant headwind presented by the strengthening U.S. dollar. Again, relative to history, we have seen an unusually strong stretch of U.S. outperformance relative to foreign markets.
Contrary to the consensus, the 10-year Treasury yield declined further and bond prices rose. The core investment-grade bond index was up nearly 6% for the year and municipal bonds also fared well. Credit-sensitive sectors did well, but emerging market local debt lagged.
While our diversified portfolios participated in the strong U.S. stock returns, they faced several headwinds for the year including our investments in foreign stocks and our underweighting of core, investment-grade bonds. Our domestic large-cap equity managers, like most of their stock-picking peers, also struggled to keep pace with the broad stock market this year.
In terms of the investment environment, the U.S. economy looks to be in pretty good shape over the near term. Fed monetary policy remains something of a wild card, but based on the Fed’s words and actions, we would be surprised if it shocks the economy or markets with an unexpectedly strong interest-rate hike.
However, our assessment of the attractiveness of U.S. stocks is based on a longer-term (five-year) assessment of potential returns across a range of scenarios. That analysis indicates even though the U.S. economy is doing well, given the high valuation of U.S. stocks relative to the rest of the world, we are concerned that we are not going to be sufficiently compensated for risk.
Our view is that Europe offers higher return potential, reflecting the fact that we believe earnings are temporarily depressed, while valuations are reasonably attractive. However, we are not increasing our allocation to European or developed international stocks because we believe the deflation or stagnation risk in Europe is not yet adequately priced in.
Similarly, we remain optimistic about emerging markets’ long-term fundamentals and believe they are likely to outperform U.S. stocks over our five-year investment horizon, but have held off on increasing our exposure this quarter based on potential shorter-term downside risks and volatility.
On the fixed-income side, we continue to think that rates will be low and for longer than most think, although higher rates are likely over a multi-year investment horizon. As such, the majority of our fixed-income exposure remains in flexible and absolute-return-oriented bond funds.
As the year drew to a close, a handful of big-picture issues dominated the investment landscape: the plunging price of oil, positive economic indicators in the U.S. relative to most of the globe, and the ongoing influence of central banks (a key effect of which has been to bolster stocks and other risk assets). In the financial markets, the year saw strong gains for U.S. large-cap stocks and core bonds with lagging performance elsewhere.
Looking first at the investment environment, oil prices hit five-and-a-half-year lows in late December (falling 40% in the fourth quarter alone) as new sources of supply met with potentially slowing global demand. While a decline in oil prices is typically viewed as an unambiguously positive development for the global economy, the result this time around is different because of the rapidity of the plunge and the current fragile global economic environment. With deflation concerns already high in Europe in particular, the oil price decline was seen as intensifying the deflationary risks.
One offsetting factor that helped the markets regain their footing in the fourth quarter (as it has many times in the post-financial-crisis period) was the ongoing influence of central banks. Even as the Federal Reserve suggests it is on track to begin raising rates in the face of U.S. economic improvement, it once again soothed markets by reaffirming that it would continue to be patient in shifting its stance. Given the poor economic conditions that persist in Europe, investors continue to expect the European Central Bank to take a more meaningful step toward full quantitative easing (i.e., purchasing bonds and other assets with the aim of stimulating the economy). Central banks in Japan and China expanded their stimulative policy efforts over 2014. The takeaway is that even as the Fed may begin scaling back its support, there appears to be no shortage of supportive monetary policy globally At the same time, the fact that central banks continue to undertake (or contemplate) aggressive action provides a reminder of the broader economic risks we continue to navigate.
While our diversified portfolios participated in the strong U.S. stock returns, they faced several headwinds for the year including our investments in foreign stocks and our underweighting of core, investment-grade bonds. One of the biggest detractors to our portfolios’ overall performance in 2014 was the significant underperformance of our domestic large-cap equity managers. Key among the performance drivers that have broadly affected fund managers is the fact that many managers hold some non U.S. based multi-national companies and some amount of cash.
We think these factors have some explanatory validity, but they are external to our conviction level in the specific funds we own. Our ongoing due diligence and monitoring of our managers throughout the year confirmed our high conviction for the majority of individuals and teams we have selected for our portfolios.
Finally, when it comes to the financial markets, we think it’s worth putting recent results into the context of history. This has been an unusually long and strong period of positive performance for large-cap stocks. Since 1945 there have only been three other periods (out of 51 total) where the S&P 500 has had a longer streak of gains without at least a 10% correction, according to Ned Davis Research. In addition, over the past two years, the S&P 500 has outperformed both developed international and emerging-markets indexes by an unusually large margin relative to history. These observations don’t mean U.S. stocks are necessarily set to tumble in the near term, but we think this data does provide some perspective as an argument for global portfolio diversification and prudent risk management.
The Case for Global Equity Exposure
(despite “everyone” knowing the United States is the place to be)
After another year of out-performance for U.S. stocks versus other markets—for the fourth time in the past five years versus developed international stocks, and the third time in the past four years versus emerging markets—we’re starting to hear more people question the benefit of investing outside the United States. This is an important question, and we acknowledge that owning foreign stocks has been an unsatisfying experience over the past couple of years. Moreover, given some of the current economic and geopolitical forces, it can appear likely to continue this way. So we feel it is worth spending a few paragraphs addressing the topic.
The first key point is to remember that equity markets and asset classes in general go through cycles and it is unwise to extrapolate recent performance trends far into the future (as we see many investors and commentators doing). Furthermore, investors often suffer from extreme overconfidence that they can predict these shifts and correctly time their buys and sells accordingly (data show actual investor returns lag indexes by hundreds of basis points due to timing errors). As an example, we were hearing this same question back in the late 1990s/early 2000s after U.S. stocks had a similar streak of outperformance. As shown in the chart above, in the market cycle that followed from 2002–2007, international stocks trumped U.S. stocks by a wide margin, and emerging markets did even better, outperforming the S&P 500 by more than 20 percentage points annualized. (Of course, toward the end of the latter period people were asking why they didn’t have more exposure to emerging markets only to see emerging markets meaningfully trail the U.S. market since then.)
Because markets move in cycles, there will always be periods when global diversification doesn’t appear to “work.” In our view as long-term investors, the case for global investing remains compelling and extends beyond the simple matter of capturing returns as market leadership rotates.
Broader Opportunity Sets
The most important reason to hold a globally diversified portfolio is to access a much broader investment opportunity set. In 1970, U.S. GDP accounted for 47% of the world’s total GDP. Today it is closer to 20%, while emerging markets now comprise roughly half the world’s total output. Likewise, in terms of stock market capitalization, in 1970 the U.S. market comprised 66% of the world’s total stock market value. By 2013 it had declined to roughly 49%, with emerging markets comprising 11%, and the remainder in developed international markets. In other words, businesses around the globe are launching, innovating, producing, and growing, and their stocks have the potential to do so as well. If an investor chooses to only invest in U.S. stocks, they are excluding themselves from over half of the world’s total investment opportunity set. Moreover, they are limiting their opportunity to invest in some of the world’s most attractive companies domiciled outside the United States.
A second important reason for owning a global stock portfolio is the benefit of diversification. A diversified global equity allocation should produce better longer-term risk-adjusted returns than any single country held in isolation. This has been the case historically as shown in the chart on the right, which extends back to 1970 when data for the developed international market index begins, and incorporates emerging markets starting in 1988 when their index returns became available. Looking at rolling 10-year periods, the global portfolio (comprised of 60% S&P 500 and 40% non-U.S. stocks) generated an average return of 12.5%, beating the S&P 500’s average return of 11.3%. (The results were similar using rolling five-year periods.) Moreover, the global portfolio beat the S&P 500 in 71% of the rolling 10-year periods (there are 420 such periods going back to 1970). Countries around the world are in different stages of their economic and market cycles, and at any given time one particular market can and will outperform others. Consistently predicting which market will outperform, and more importantly getting the short-term timing right, is impossible. If you concentrate your exposure in only one market—even if it’s the U.S. market—you run the risk of that market undergoing an extended period of underperformance that could have a lasting negative impact on your portfolio. And human nature is such that most people also won’t be able to stand being heavily invested in an underperforming market for too long. This discomfort may lead them to sell in disgust at low prices and chase the recent country market winners, probably just as those markets approach their highs for the cycle.
That is why diversification—consistently owning a variety of asset classes, strategies, and managers that should perform differently depending on the environment—enables us to create portfolios that should perform at least reasonably well across a wide range of possible scenarios and outcomes. But it takes discipline to be a long-term diversified investor, because you know you will own some asset classes that are laggards in any given year or even over multiple years, and with 20/20 hindsight it is easy to start questioning why you owned those particular assets in the first place.
In addition to our belief in the long-term benefits of investing globally, we also believe that valuation matters and is a key component of future market returns—after all, future returns are all that matter from this point forward. Valuation is the key driver in all of asset allocation decisions. Therefore, there are times when it makes sense to over- or underweight markets or asset classes to tilt the odds of success more in your favor. So today’s popular argument that Europe and Japan are economic basket cases and that emerging-markets companies face risks that U.S. companies don’t face, doesn’t necessarily mean there aren’t compelling investment opportunities in those markets. Whereas even if the United States is the strongest and most stable economy in the world, that doesn’t mean its stock market offers the best risk/return profile right now.
Our Asset Class Views Looking Ahead
In terms of the investment environment, the U.S. economy looks to be in pretty good shape for the near term. There are several positives: the labor market continues to strengthen, inflation remains subdued, manufacturing indexes and other leading economic indicators are consistent with solid GDP growth, falling oil prices should boost consumer spending, and government fiscal policy is likely to become more of a growth tailwind than a headwind as the impact of past budget cuts rolls off.
Fed monetary policy remains something of a wild card, but based on the Fed’s words and actions, we would be surprised if it shocks the economy or markets with an unexpectedly strong interest-rate hike.
While the economic and monetary backdrop looks likely to remain broadly supportive over the near term, our assessment of the attractiveness of U.S. stocks is based on a longer-term (five-year) assessment of potential returns across a range of scenarios. That analysis continues to indicate that the expected returns from U.S. stocks are potential lower than other risk assets.
In contrast to the United States, the Euro zone (ex-U.K.) continues to fight deflationary headwinds. The December year-over-year headline inflation number fell to negative 0.2%, real GDP growth is below 1%, and two-year government bond yields in Germany and France are actually negative, meaning investors are paying the government for the privilege of owning these bonds. Our view is that in Europe we are getting below trend or below normal earnings at average to below average prices, which is why we have a slight relative overweight to European stocks versus U.S. stocks. But we are not increasing our weighting to European or developed international stocks because we believe the deflation or stagnation risk in Europe is not yet adequately priced in.
There is a lot of negative news surrounding emerging-markets stocks such as slowing growth in China and other BRICs and the decline in emerging-markets currencies. Nevertheless, we remain optimistic about emerging markets’ long-term fundamentals and believe they are likely to outperform U.S. stocks over our five-year investment horizon and this is why emerging markets stocks is our largest overweight in our portfolios. However, we are conscious of the shorter-term downside risk and volatility that currency risk presents to this market. This is one reason why we have not increased our overweight to emerging markets relative to U.S. stocks as a percent of our equity allocation.
From an asset class perspective, we believe investment-grade bonds are likely to generate very low single-digit annualized returns over our five-year investment horizon, which incorporates a range of economic scenarios. Our very low return estimates are explained by the very low current yields and our expectations that interest rates will remain lower longer than most people think. As such, the majority of our fixed-income exposure remains in opportunistic, flexible, and absolute-return-oriented bond funds that we believe offer superior longer-term risk/reward profiles compared to core bonds, including Guggenheim Macro Opportunities, a new fund we are adding in the first quarter to replace the sale of PIMCO Unconstrained.
Given the recent underperformance of our portfolios, we have received a number of questions from clients about our investment research. So perhaps we are a good case study for the question of why good managers go through periods of underperformance versus their benchmarks. Our performance often won’t track the performance of the benchmarks we’re measured against because we are not afraid to construct portfolios that look very different than our benchmarks. Our willingness to do this is a function of our confidence in our investment process, our commitment to do what is right for our clients, and our knowledge that this is what it takes to outperform over the long run. If we always invest in line with our benchmarks, we wouldn’t have been able to add the value that we have over the many years we’ve been in business.
In the end, we view our responsibility in terms of our client’s needs and not benchmark comparisons. We believe if we do these things well over the long term, we will be able to continue to meet our client’s financial needs.
Jon Houk, CFP®