First-Quarter Market Update & Outlook
Author: Jeff Layman
U.S. economic growth slowed in the fourth quarter, expanding at a pace of just 2.2 percent in real terms. Projections for the first quarter of 2015 suggest an even slower rate of growth. This represents a significant deceleration from the consecutive quarters of 5 percent growth posted in mid-2014.
A key factor affecting the pace of growth is the significant strengthening of the U.S. dollar over the last nine months. The dollar has gained about 20 percent against a basket of major foreign currencies, causing our country’s exports to become more expensive to foreign buyers. Some economists estimate this factor alone has reduced gross domestic product by 1 percent.
While creating a headwind for exports, dollar strength is a tailwind for consumers, as it reduces the cost of imported goods for U.S. buyers. The strong dollar also has contributed to the decline in the price of oil, creating another significant benefit to U.S. consumers. Although wages have been growing at a modest 2 percent pace, muted inflation readings (minus .19 percent over the past 12 months) have translated into greater household purchasing power. While there’s evidence consumers have recently chosen to bank—rather than spend—their fuel savings, consumption growth should be well-supported through the remainder of 2015 and provide a greater contribution to overall economic growth.
Although job gains softened somewhat in March, employment growth for the three months ended January 2015 was the strongest since 1997, according to Capital Economics. In addition, the U.S. Department of Labor reported the number of U.S. job openings rose to more than 5 million in December for the first time since January 2001. Commensurately, the unemployment rate hit a post-recession low of 5.5 percent during the quarter.
Strength in the labor market should prompt the Federal Reserve to begin raising short-term interest rates as early as this summer. However, the rise in rates is likely to be gradual, given that inflation is in check.
As the Federal Reserve winds down its monetary stimulus efforts in the U.S., the ECB began its own quantitative easing program in January. Economic indicators are improving across the region, and further progress is expected.
Stocks rose during the first quarter of the year, with international stocks leading the way. Here are the returns of the comprehensive market indices for the period, according to Morningstar:
Local currency returns stretched into the mid-teens in European markets, as the ECB’s stimulus plans sparked a strong rally. Importantly, more attractive initial valuation levels should continue supporting the strength of foreign markets relative to the U.S. However, dollar strength continued eroding international stock returns for U.S. investors, offsetting a good portion of the underlying market strength.
U.S. stocks posted gains for the quarter after spending most of January in negative territory. Results varied greatly by industry segment. The health care sector posted the strongest returns, up 7 percent, while utilities (minus 6 percent) and energy (minus 4 percent) posted negative results.
Earnings for S&P 500 companies declined year-over-year in the fourth quarter, due to the effects of plunging oil prices and the strong dollar. Profits for companies in the energy sector fell more than 25 percent and are expected to post another decline in the just completed first quarter, according to Standard and Poor’s. Since more than 40 percent of S&P 500 earnings come from abroad, the strong dollar also has negatively affected profit growth. U.S. goods become more expensive to foreign buyers as the dollar strengthens, which can negatively affect revenues and profit margins.
The advance in share prices, combined with the decline in earnings, served to push the forward price-to-earnings multiple for U.S. stocks to 17, which is at the high end of the normal range. Most developed international markets now trade at normal to slightly above normal valuation levels, albeit with more favorable earnings growth potential going forward. Meanwhile, emerging markets stocks still trade at a valuation discount of about 25 percent relative to the developed markets, with significant variation from country to country.
Bond yields generally declined during the quarter, with the benchmark 10-year Treasury note yield falling to 1.93 percent from 2.17 percent. This allowed for modest price appreciation in addition to coupon income, translating into total returns of 1.84 percent for the Barclay’s Aggregate Government/Credit index and 1.01 percent for the Barclays Municipal Bond index.
The satellite bond categories produced solid results during the quarter, as investors pursued higher yields. Corporate high-yield bonds gained 2.54 percent while emerging markets debt rose 1.87 percent. Volatility could increase in these segments once the Fed begins to tighten.
Given the likelihood of Fed rate hikes beginning soon, bond investors are preparing for a rising interest rate environment. However, as 2015 progresses, a dichotomy is likely to develop. The shorter end of the maturity spectrum, where rates have been held artificially low by Fed policy, will likely lift along with each Fed funds rate increase. Intermediate and longer bonds aren’t as likely to rise because even at 2 percent, U.S. rates are among the highest in the developed world. Therefore, the most likely scenario is a flattening of the yield curve, where short-term rates rise while long-term rates hold steady.
Financial markets have been characterized by extreme movements in recent years, including a magnificent rise in stock prices from the bottom in March 2009, a sharp decline in the price of oil and other commodities over the past year and a steep spike in the value of the dollar since mid-2014. These movements have affected trailing investment returns and will affect asset class return potential going forward.
U.S. stocks have benefited from a steadily growing economy, greatly improved consumer and corporate financial health and easy monetary policy. Stock prices have been propelled higher by improved profits and expanding price-to-earnings ratios, resulting in a five-year trailing return of nearly 15 percent for the Russell 3000 index. But the environment is changing, and returns likely will be more modest going forward for several reasons:
- At the margin, U.S. monetary policy is tightening.
- The strong dollar is negatively affecting the foreign sales and profits of U.S. companies.
- The valuation of U.S. stocks is at the high end of normal, leaving little room for further multiple expansion.
Meanwhile, the strong dollar is one of several tailwinds for international economies in 2015. While dollar strength has decreased investment returns for U.S. owners of foreign assets, it has increased the appeal of imported goods for U.S. consumers. This provides a boost for foreign exporters. In addition, Europe and Japan are applying significant monetary stimulus to their respective economies, similar to what the Fed has done in recent years. Extremely low borrowing costs and declining oil prices have improved consumer purchasing power in developed economies. Finally, corporate profit margins are at mid-cycle levels in most foreign markets, leaving room for expansion. These factors leave international stocks in a better position to produce above-average returns going forward.
For bonds, the best estimate of future return potential is the yield available in each market segment. For investment-grade bonds, this is currently 2 percent to 3 percent. Given such low initial yield levels, returns from this portfolio component are likely to be limited. Despite this, bonds still play an important role in portfolio design as the first line of defense against stock market volatility.
Alternative investments represent a wide range of strategies and asset classes. Those that anchor our allocation are “real return” oriented, offering inflation protection as a primary emphasis. Inflation expectations are low due to the dramatic decline in energy prices and strong dollar, meaning many of these assets can be purchased at attractive valuation levels. This should allow for improved returns from this segment in the future.
In summary, the investment backdrop is changing, but many appealing opportunities remain in the global opportunity set. We look forward to what the remainder of 2015 holds.
Jeffrey A. Layman, CFA®
Chief Investment Officer
BKD Wealth Advisors, LLC is an SEC-registered investment advisor offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks, and it should not be assumed that future performance of any investment or investment strategy or any non-investment related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.