MARKET UPDATE AND COMMENTARY
January 12, 2014
With 2014 completed, I will spend a few moments discussing the year and then shift my focus to my thoughts regarding 2015. In my view the top three stories for 2014 was the fall in interest rates, the strength of the US Dollar, and the collapse in oil prices worldwide. I will address these stories in greater detail momentarily.
Below is an up-to-date look at key US equity index performance:
International markets under-performed the United States for a second consecutive year.
Source: The Wall Street Journal (Past Performance is Not Indicative of Future Returns). Year-to-date returns are through January 9, 2015.
Looking broadly at equity markets in 2014, it was a challenging time for diversified investors. Small capitalization stocks (Russell 2000) significantly underperformed large cap stocks after small caps led all key equity segments in 2013. Owning the S&P 500 index to the near exclusion of all other asset classes led to the best broad market performance in 2014. According to Morningstar®, less than one in four active managers in the large cap blend category were able to beat the S&P 500 index.
The Utility sector led the major economic sectors with a return of just over 24%, followed by Health Care (23%), and Technology (16%). Energy was the worst performing sector losing nearly 11% for the year.
Much like the equity markets, bond investors were not treated equally. The Barclay’s Aggregate Bond index which represents a broad swath of US bonds gained 5.9%. According to Morningstar® the volatile Long Duration US Treasury sector was the best performing bond sector gaining over 21%, followed by Long Duration Corporates at 12%, and Preferred Stocks at 11%. However, many other bond sectors under-performed. Emerging Markets bonds (-1%), Ultrashort bonds (0.3%), Bank Loan (0.5%), Short Government (1%), High Yield (1%) and World Bonds (1.7%) were the weakest performers
The UBS Commodity index, a broad indicator of commodity prices fell 17% in 2014 led by the collapse of oil and natural gas. West Texas Intermediate (WTI) crude oil fell 46% and natural gas lost 31%. Gold fell 1.6% in a choppy sideways market. Corn and wheat fell 6% and 3% respectively, and Cattle jumped 23%. A mixed bag but clearly driven by the drop in oil prices.
TOP STORIES IN 2014
Top Story #1--the drop in interest rates was not anticipated by investment professionals. The yield on the benchmark 10-year US Treasury fell from 3.03% at the end of 2013 to 2.17% at the end of 2014. This drop was unexpected because most economists felt that the end of bond purchases by the Federal Reserve (referred to as Quantitative Easing or QE) would reduce demand for new bond purchases and yields would rise to attract buyers. Clearly this did not happen. I believe this did not happen because the impact of QE on bond yields was not understood by most investors, and because of increased demand of US Treasuries by both domestic and international buyers anticipating higher yields in the US than abroad.
Top Story #2—the broad US Dollar (USD) index gained 12.8% in 2014, a large move in currencies. Looking at the two largest currencies beyond the US Dollar, the Euro and the Yen, the US Dollar gained 11.4% and 14.3% respectively. You have to look back to 2005 to see USD/Euro rates at this level. The stronger US Dollar is simply the result of demand exceeding supply. Demand is coming from international and domestic investors who are moving international investments here to the US. The why is up for debate, but I believe it is attributable to extremely low interest rates in Europe, a slowing Chinese economy, and renewed fears of a European Union (EU) crisis in Greece. Greek voters are returning to the polls January 25th to form a new government. The socialist party currently has a small lead and their leaders have threatened to destabilize the EU by reversing many of the austerity measures favored by the Germans and International Monetary Fund (IMF). There is an outside possibility, in my view, that Greece might exit the EU causing unknown consequences for investors.
Goldman Sachs has come out with a prediction that the Euro will reach parity to the US Dollar sometime in 2016 due to a lack of competitiveness in Europe, quantitative easing by the European Central Bank and generally lower interest rates compared to the US.
Top Story #3—the collapse in oil prices in 2014 was dramatic and has generated an enormous disruption around the world both in the energy markets and has the potential to destabilize some critical geopolitical regions like Russia, Iran, and Venezuela.
After falling 46% in 2014, WTI Oil has continued its slide and closed Friday at $48.36 and is now down another 10% since the start of 2015.
I spent some time discussing this story in the December 14, 2014, Market Update and Commentary so please go back and review if you missed (you can find my previous comments at www.ntrustwm.com). However, I will add that since writing that article, the continued slide in oil prices reflects, in my view, a belief that Saudi Arabia will no longer be the swing producer to help keep oil prices elevated. They have a strong desire to maintain their market share and are benefiting indirectly by putting pressure on Iran and other less-friendly oil-producing countries.
The drop in energy equity prices within the US, in my opinion, reflects concerns over reduced profitability and cost of production issues. I have a great deal of confidence that US energy companies will be able to continue to lead the way forward with technological developments. This in turn should continue to drive down the cost of production and make oil profitable at lower prices.
LOOKING AHEAD
I believe the top economic story for 2015 will be the timing and magnitude of the Federal Reserve’s expected interest rate hike. Keep in mind that the Fed only sets the Federal Funds rate which is the interest rate paid by the most credit-worthy banks for overnight borrowing. This has a great deal of influence on other rates, however, and all other rates are determined by open market transactions.
For the past five years, the Fed has maintained a 0% to 0.25% target for the Fed Funds rate. This is seen as an extremely accomodative monetary position geared to keep cheap cash flowing through the economy. Raising the Fed Funds rate will increase the cost of borrowing and has the potential to slow growth. The debate among economic policy wonks is whether or not an increase is warranted and if so, by how much. Complicating the debate is the fact that rates have never been held so low for so long coupled with such massive quantitative easing. Brian Wesbury, Chief Economist of First Trust Advisors, has said repeatedly that raising rates should have a minimal impact on equity markets because until the Fed Funds rate reaches 3.5% or greater, the policy by the Federal Reserve is simply “less accomodative” rather than restrictive.
It is nothing but speculation to try and peg the timing and the magnitude of Fed rate changes. All I can do is try to read the vast number of stories by economists and investors on this topic and try to gauge some kind of consensus about what the market is thinking. Here is what I currently believe:
1) The Fed Funds rate will be raised in 2015. Late spring/early summer is the market consensus for timing.
2) The Fed will try to telegraph the rate increase as much as possible within their market commentaries in order to allow the markets to come to terms with the new rate.
3) The Fed will keep the rate of increase very small at 0.25%. Additional increases will come slowly.
What is impossible to guage is the stock market’s reaction to the increase. Every hint of a rate increase has tended to push equity markets down which is, in my opinion, unwarranted. However, what I believe is irrealevent. What matters will be the market’s reaction. I will not speculate what that reaction will be until we get closer to the actual rate increase (assuming it happens at all). For bond investors, the key will be a gradual and orderly increase in interest rates. Sharp changes up or down in interest generally rates causes bond prices to fluctuate more than what is usually expected.
The other major story for 2015 is likely to be the continued weakness in oil prices. I believe lower oil prices is actually a significant boost to economic activity and that the fall of stock prices in 2014 and so far in 2015 is an overreaction caused by energy pricing fears. In my view, lower oil prices are positive long-term.
US equities are clearly the top-ranked major asset category on a relative strenght basis of the six I follow. Over the holidays, International equities fell from the second position to third being replaced by Bonds. I contine to recommend avoiding international equities, especially European stocks, due to their under-performance relative to US equities. The big unknown is whether or not the Eurpean Central Bank (ECB) will engage in quantitative easing. The ECB has resisted thus far, however, as the European Union continues to struggle economically, there is mounting pressure for the ECB to ease. If this happens, I would not be surprised to see stocks jump in value even though the fundamentals do not warrant such increases. I would also expect US stocks to rise in conjunction with such a move.
The Money Market asset category remains number four of the major asset categories followed by Currencies and Commodities. I believe the energy sector will remain under pressure for now until oil and natural gas prices stabilize, but keep an eye on precious metals. Even though I think gold is overvalued at this time, there has been a subtle shift upwards in the trend of gold prices.
I will wrap up by saying that I believe volatility will increase this year. Last year’s volatility was clearly an increase from 2013. We had several 5% corrections and one that slid into a 10% correction during the fall. Very normal. Volatility is extremely unpleasant and I am afraid we may see more volatility in 2015 due to the impacts of commodity prices and speculation over the Federal Reserve’s rate increase. That is the bad news, however, I do believe that US equity prices will end the year positive based upon the economic fundamentals with another low, double-digit gain similar to 2014.
I will expand on these themes and provide you up-to-date commentary going forward in 2015.
I wish everyone a very Happy New Year!
Paul L. Merritt, MBA, C(k)P®, AIF®, CRPC®
Principal
NTrust Wealth Management
P.S. If you think this type of analysis would be of benefit to anyone you know, please share this communication with them.
Past performance is not indicative of future results and there is no assurance that any forecasts mentioned in this report will be obtained. Technical analysis is just one form of analysis. You may also want to consider quantitative and fundamental analysis before making any investment decisions.
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Information in this update has been obtained from and is based upon sources that NTrust Wealth Management (NTWM) believes to be reliable; however, NTWM does not guarantee its accuracy. All opinions and estimates constitute NTWM's judgment as of the date the update was created and are subject to change without notice. This update is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Any decision to purchase securities must take into account existing public information on such security or any registered prospectus.
Emerging market investments involve higher risks than investments from developed countries and involve increased risks due to differences in accounting methods, foreign taxation, political instability, and currency fluctuation. The main risks of international investing are currency fluctuations, differences in accounting methods, foreign taxation, economic, political, or financial instability, and lack of timely or reliable information or unfavorable political or legal developments.
The commodities industries can be significantly affected by commodity prices, world events, import controls, worldwide competition, government regulations, and economic conditions. Past performance is no guarantee of future results. These investments may not be suitable for all investors, and there is no guarantee that any investment will be able to sell for a profit in the future. The Dow Jones UBS Commodities Index is composed of futures contracts on physical commodities. This index aims to provide a broadly diversified representation of commodity markets as an asset class. The index represents 19 commodities, which are weighted to account for economic significance and market liquidity. This index cannot be traded directly. The CBOE Volatility Index - more commonly referred to as "VIX" - is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500® Index (SPX) option bid/ask quotes. VIX uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index.
TIPS are U.S. government securities designed to protect investors and the future value of their fixed-income investments from the adverse effects of inflation. Using the Consumer Price Index (CPI) as a guide, the value of the bond's principal is adjusted upward to keep pace with inflation. Increase in real interest rates can cause the price of inflation-protected debt securities to decrease. Interest payments on inflation-protected debt securities can be unpredictable.
The NYCE US Dollar Index is a measure that calculates the value of the US dollar through a basket of six currencies, the Euro, the Japanese Yen, the British Pound, the Canadian Dollar, the Swedish Krona, and the Swiss franc. The Euro is the predominant currency making up about 57% of the basket.
Currencies and futures generally are volatile and are not suitable for all investors. Investment in foreign exchange related products is subject to many factors that contribute to or increase volatility, such as national debt levels and trade deficits, changes in domestic and foreign interest rates, and investors’ expectations concerning interest rates, currency exchange rates and global or regional political, economic or financial events and situations.
Corporate bonds contain elements of both interest rate risk and credit risk. Treasury bills are guaranteed by the U.S. government as to the timely payment of principal and interest, and if held to maturity, offer a fixed rate of return and fixed principal value. U.S. Treasury bills do not eliminate market risk. The purchase of bonds is subject to availability and market conditions. There is an inverse relationship between the price of bonds and the yield: when price goes up, yield goes down, and vice versa. Market risk is a consideration if sold or redeemed prior to maturity. Some bonds have call features that may affect income.
The bullish percent indicator (BPI) is a market breath indicator. The indicator is calculated by taking the total number of issues in an index or industry that are generating point and figure buy signals and dividing it by the total number of stocks in that group. The basic rule for using the bullish percent index is that when the BPI is above 70%, the market is overbought, and conversely when the indicator is below 30%, the market is oversold. The most popular BPI is the NYSE Bullish Percent Index, which is the tool of choice for famed point and figure analyst, Thomas Dorsey.
