Fourth-Quarter Market Update & Outlook
Author: Jeff Layman
The Economic Environment
The U.S. economy registered its strongest growth in nearly 11 years during the third quarter, as real gross domestic product rose 5 percent. Following the second quarter’s 4.6 percent gain, momentum continued building in the home stretch of 2014. Estimates for fourth-quarter growth range from 3 percent to 3.5 percent, and this strength will likely carry forward into 2015.
A key source of optimism regarding potential economic growth in 2015 is the significant tailwind at the back of the U.S. consumer. Personal consumption accounts for nearly 70 percent of the U.S. economy, so improvements in the consumer’s financial situation have a positive effect on the broader economy. Several developments should support increases in consumer spending in 2015, including:
- The unemployment rate has dropped to 5.8 percent, the lowest since 2007—the more people are working, the more income they have to spend.
- The dramatic decline in oil prices has reduced the “energy tax,” leaving more discretionary income for consumers to spend in other areas of the economy.
- The stronger dollar serves to reduce the price of imported products for U.S. consumers, giving them more purchasing power.
- Financial asset prices are near all-time highs, and home prices continue to recover. The “wealth effect” associated with these increases result in a more confident and willing consumer.
The significant drop in oil prices has been a boon for consumers and countries that are significant oil importers, including the U.S. However, there are potential negative consequences associated with this dramatic downward price movement. States like Texas, Wyoming and North Dakota have benefited from the U.S. energy boom and have led the nation in job creation. In fact, the Wall Street Journal indicates that one in seven jobs created since 2009 in the U.S. were created in Texas. At $50 per barrel, some oil companies are starting to cut back production, as oil becomes unprofitable at these price levels. This may translate into layoffs and job cuts, which could stall the significant improvement that has been made in employment.
The Fed officially ended its quantitative easing (bond buying) program at the end of October. Despite the gradual removal of $85 billion per month of Fed demand for U.S. Treasury notes and government agency bonds, interest rates declined in 2014. So, the initial stage of withdrawal of Fed accommodation proved to be a nonevent for the economy and markets.
By mid-2015, the Fed is expected to raise short-term rates, the second phase in the normalization of policy. This reflects the Fed’s view that the economy is healthy enough to withstand gradual tightening. Given that this action is widely anticipated, the market impact should be minimal unless the Fed takes a more aggressive approach than expected.
The Stock Market
Stock market returns were mixed in the fourth quarter, with U.S. markets posting solid results while international stocks declined. Here are the quarterly and full-year returns for the major indices:
U.S. large-cap stocks posted another year of above-average performance in 2014; however, most segments of the global stock market generated subpar results. U.S. small-cap stocks experienced a 15 percent correction during the year and finished with a return of less than 5 percent. Developed and emerging international markets also gained about 5 percent in local currency terms, but the strengthening dollar translated these positive results into negative returns for U.S. investors. This produced the widest divergence in U.S. versus foreign stock performance since 1992, according to Bloomberg.
The range of returns also was very wide across the 10 major economic sectors. The top-performing areas in 2014 were the conservative utility (+29 percent) and health care (+25 percent) sectors, while the worst-performing sector was energy, which lost 8 percent. Given the broad spectrum of returns, even small differences in sector allocation had a significant impact on portfolio returns relative to the primary market benchmarks in 2014.
The valuation of the U.S. stock market expanded slightly during the year, rising toward the upper limits of normal with a trailing price-to-earnings (P/E) multiple of 18. International stock market valuations are more attractive, due in part to last year’s weak price gains. Developed foreign markets now trade at a P/E multiple of about 15 times earnings, while emerging markets shares are discounted even further at 11 times earnings.
Stock market volatility spiked during the fourth quarter, with U.S. stocks falling more than 9 percent from their intrayear high by mid-October. The Chicago Board Options Exchange Volatility Index rose from its September low of 11 all the way to 31 in the first two weeks of the quarter, before settling back to more normal levels (midteens) by year-end. Given changing Fed policy, ongoing geopolitical uncertainties and extreme movement in energy prices, more bouts of volatility are likely in 2015.
The Bond Market
Bond market returns were stronger than expected in 2014, as interest rates fell despite consensus expectations that they would rise along with Fed tapering. Declining interest rates pushed bond prices higher, resulting in solid total returns for the year. Since credit spreads were relatively stable across the investment grade spectrum, portfolio duration proved to be a key driver of relative returns. Long-term bonds experience more price appreciation when interest rates fall than short-term bonds, so the biggest gains are realized in the longest maturities. For the year, the taxable Barclays Aggregate Bond Index gained 5.97 percent, while the Barclays Municipal Index rose 9.05 percent on a total return basis.
Satellite bond returns were mixed for the year, with emerging markets bonds posting solid returns of 6.15 percent while high-yield bonds producing a subpar gain of 2.5 percent, according to Bank of America Merrill Lynch US High Yield Master II and JPMorgan Emerging Market Bond Index Plus. Energy sector bonds have nearly twice the representation in the high-yield market that they did 10 years ago due to rapid industry growth. This contributed to late-year weakness in the asset class. In July 2014, corporate high-yield bonds were removed from our portfolio models based on valuation concerns.
The reversal of the Fed’s zero interest rate policy in 2015 is likely to cause short-term interest rates to rise by midyear. With 10-year U.S. Treasury yields now hovering just above 2 percent, longer-term rates may rise as well, particularly if inflation expectations pick up. However, even at 2 percent, U.S. Treasuries offer a higher yield than most developed world government bonds. This should keep a cap on the U.S. 10-year and cause a further flattening of the yield curve, as short-term rates rise more quickly than long-term rates.
The Investment Outlook
The economy ended 2014 with its greatest momentum since the end of the Great Recession in 2009. Financially healthy consumers and corporations are poised to help extend this positive economic energy into 2015. In general, this provides a backdrop that supports stock prices.
U.S. large-cap stocks drove portfolio returns in 2014, posting their third consecutive year of above-average gains. However, most other asset classes included in portfolio design delivered much more modest returns for the year, including slightly negative results for some. When blended into a balanced investment portfolio, the result was a full-year return somewhere in the mid-single digits for most.
Does this mean diversification failed investors in 2014? No, since diversification is a risk management tool rather than a method of return maximization. The wide range of asset-class returns experienced in 2014 is a perfect example of why diversification is so important, because history shows the year’s best-performing asset class rarely repeats.
With the Fed’s quantitative easing program now completed and gradual Fed tightening of short-term rates on the horizon, the market won’t benefit nearly as much from monetary policy tailwinds going forward. Therefore, U.S. stocks are likely to produce more muted returns, all other things being equal.
Meanwhile, quantitative easing programs are ramping up in Europe and Japan. These economies haven’t recovered nearly as well as the U.S., which is reflected in inferior stock market returns for the past two years. However, these economies may benefit in a similar way to the U.S. from stimulus measures, increasing the upside potential for economic and stock market growth. Couple that with more attractive valuation levels and a more supportive demographic profile in emerging economies, and the result is a strong argument for owning international stocks despite their poor recent investment performance.
Given that 10-year U.S. Treasury yields have declined toward 2 percent and credit spreads have stabilized, expectations for bond returns are modest for 2015. The globally suppressed interest rate environment should allow for positive performance in the year ahead but not as good as the results of 2014.
After a year where asset class returns varied over as wide a spectrum as they did in 2014, the tendency of investors may be to gravitate toward what performed best last year. Historically, that hasn’t been the optimal approach. The best opportunities often lie in the most unloved asset classes. Maintaining a well-diversified portfolio and regularly rebalancing from the strongest recent performers to the weakest has served investors well over time and likely will going forward. This process also serves to keep the appropriate risk posture in place, which is important for withstanding future market turbulence when it occurs.
Thank you for the confidence you have placed in our firm and best wishes for a healthy and prosperous 2015!
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.