As we close out 2014 and look forward to 2015, let's review events nobody forecast in January 2014. This process keeps us humble, but also helps us think about opportunities for 2015.
Russia squanders Sochi goodwill by invading Crimea - sanctions collapse their economy. Russia was the worst performing market in 2014 - down 45% in dollars. As we learned, Putin's support of Russian rebels in the Ukraine is not a sign of strength but of weakness - the need to distract average Russians from the kleptocracy in charge of the Kremlin. Combined with a poor demographic situation (falling birth rates, falling marriage rates, increased emigration) Russia is sprinting from Second World to Third World status.
Europe enters 6th year of recession, made worse by Russia situation. Unemployment rates in much of Europe (e.g. Spain 24%, Ireland 11%, Italy 13%, Greece 26%) remain at Great Depression levels, but there is no political will to address the underlying problems - rigid labor markets, uncompetitive export skills, over-emphasis on "austerity." The final straw was the collapse in the Russian Ruble, which caused Eurozone exports to Russia to fall 15% in 2014. We don't know what can be done to turn this situation around.
The US Dollar soared 12.4% - most international returns negative as a result. For 40 years, the long term trend of the US dollar was down - which we would expect given persistent trade deficits and artificially low interest rates. There are two previous occasions where the dollar rallied - 1981-1984 as the Federal Reserve drove rates high to kill off inflation, and 1999-2002 following the introduction of the Euro in an environment of poor growth in Europe. The first scenario is not applicable, but the second scenario - Europe in recession - seems like a reasonable model. If so, the dollar could gain another 30% against the Euro over the next three years.
The dollar also gained 19% against the Yen, as Japan is another major industrial country stuck in recession with economic growth unchanged since 1995. The Chinese Renminbi, which strengthened steadily against the USD since floating in 2005, stabilized in 2014 and closed out the year down 3%. This is good news for American consumers as lower cost imports keep inflation down, good news for the US trade deficit, but bad news for American corporations, which derive significant revenues from international operations. Lower overseas profits will weigh on S&P profits in 2015. Also, modest positive returns for European and Asian stock markets in local currencies are negative in dollar terms for 2014. As we typically keep 10-15% of our clients' accounts in non-US stock markets, our overall returns suffered in 2014.
China now world's largest economy (but be skeptical of the numbers) - China could be slightly larger than the US according to recent IMF numbers, or could still be a third smaller than US by other measures. Government statistics in general contain error. In the case of China, government statistics could be entirely fictitious. It is obvious that the Chinese economy is slowing as the ruling party attempts the transition from an export driven economy to a service and consumer driven economy, which places China in the same position as the United States in 1950, Japan in 1990. Using "hard power" comparisons: China is trying to acquire the skills to support one aircraft carrier. Great Britain has one carrier, with a second on order. Italy has two carriers, France, India, Russia, Spain, Thailand each have one. The United States has 11 carrier groups. This differential is just one of many examples of the enormous gap between US and Chinese power at presen. That gap won't exist by 2040 if the US continues its dysfunctional political process.
Crude oil collapses 50% since June, Gold down 37% from 2011, commodities in general down 13% from June. For a decade, all we heard about was "peak oil" and the US's dependency on foreign oil. Turns out, at the right price, there are still trillions of barrels of oil that can be extracted with the right technology. So much oil was extracted in the US from fracking in 2014 that analysts began talking about the US as a net oil exporter by 2020. At present, the US produces domestically about 60% of oil consumed, imports the rest primarily from Canada and Mexico, with additional supplies coming from Saudi Arabia, Venezuela and Russia.
The last time oil prices were this low was during the 2008-9 Financial Crisis (oil fell below $45/barrel.) We don't think oil will stay at the current level of $53 for long. The breakeven point for most US Fracking operations is about $70/barrel, which means that producers will continue to pump from current wells (which should exhaust in about a year) but cancel contracts for new wells (thus the stock prices of oil service companies fell an average of 38% over the last 6 months.)
Ten year yield falls from 3% at start of year to 2.2% at year end. The overwhelming majority of analysts, and our own firm, expected higher rates in 2014. Indeed, 2013 ended with the ten year a 3.0%, trending, we thought, towards the 4-4.5% rate we think is "normal" for an economy growing 2.5-3% with low inflation. Instead, yields fell steadily through the year, ending at 2.2% and giving US consumers yet another opportunity to refinance home mortgages at low rates (June 2012 was the best moment since the 1950's, when the ten year touched 1.5%.)
All the signs point to a recession in the US, yet US economy finally at highway speed:
- Most recent GDP at 5% in the 3rd quarter, averaging about 3% over the last year.
- Unemployment at 5.8%, lowest level since George Bush cratered the economy.
- Housing prices a long way from the peak, but 30% off the low.
- US Christmas sales rose a robust 5.4% as confident consumers spend gas pump savings; retail margins still tight.
Generally, falling commodity prices and falling bond yields are indicators that the US economy is heading into recession. For the first time in 6 years, the economic evidence shows an economy that should expand for a while. So the big question for 2015 is: does the US resume its traditional role of the engine pulling along the economies of all other nations, or does the slow down in Europe, Asia and emerging markets drag down the US as well. Our bet is that the US is the engine, but we'll just have to see.
Stock market returns were quite uneven in 2014. Clients have heard about the S&P 500 doing well this year, making about 50 record highs and rising 13.7%. The NASDAQ also did well, only 10% below the level last achieved during the Internet bubble that burst March 2000. But small and mid cap stocks, along with international developed stock markets did poorly, commodity and emerging markets delivered negative returns.
- Large cap stocks do well - Russell 1000 up 13.2%.
- Small & Mid cap stocks do poorly - only up 4.9%.
- Euro area up 2.8%, but down 9.2% in dollars.
- Developed international markets gained only 4.3% in dollars
- Emerging markets declined 4.4%,
- Whole world only gained only 3.3%
- Hedge funds return -0.7%-2%, perhaps 1000 will close by year end
We have clients' assets spread across US large, mid and small cap stocks, international developed stocks and international emerging markets stocks, with generally no more than 30-40% in US large cap stocks. As a result, client returns significantly underperformed the S&P 500, though were within reasonable range of the blended benchmarks comprised of the S&P 500, MSCI EAFE (Europe Australasia Far East) index. We're not going to make major changes in our asset allocations as a result of this one year. Over the last 20 years, our blend of US and International stocks and bonds easily outperformed the US only strategy. We will be looking closely at returns during the first 6 months of 2015 to see if the disparity continues, or more likely, reverses.
Events we expect for 2015
- Commodity prices stabilize near current levels, start rising again.
- The US dollar rises another 15-20% against world currencies, then resumes a long term slide.
- The Eurozone fractures, with basket case countries such as Greece leaving the Euro to achieve the devaluation that makes their economy competitive again. Even Spain and Italy are candidates for abandoning the Euro. If this happens, Germany will plunge into recession as her primary export markets dry up.
- The 70 month bull market in US stocks finally runs out of steam. US large cap stocks which did so well in 2013 and 2014 may return nothing in 2015. Earnings at small and mid-sized corporations continue to expand, enabling the small and mid-cap indexes to outperform large caps
- 2015 ends up like 2011 where the S&P 500 gained only 2.1%.
All in, not a very sanguine environment to be an investor. Should we dump stocks and go to cash? Unfortunately no investor can precisely define the exact moment to get out and then back into stocks. Over the 20 years ending 12/31/2013, the S&P 500 gained 9.20%/year on average, which grows an initial investment of $10,000 to $58,137 or 581% over 20 years. The average investor, through market timing and fad chasing, only received 5.02%, which grew the same $10K to $26,634 or 266% over 20 years. Being clever robbed the average investor of 55% of US stock market appreciation over that time period.
We are not clever, but we are disciplined. As we often observed, "our best forecast is that the stock market will fluctuate." So funds needed within a year have to be in cash. Funds needed within 1-5 years can be in bonds. Funds needed beyond 5 years SHOULD be invested in stocks. You will never get the long term returns you need without riding out short term unpleasantness.