Willow Creek Commentary: Winter-2014

2014 REVIEW: ECONOMY & MARKETS

Despite a bumpy ride throughout 2014, the US economy gained pace while the US equity and fixed income markets outperformed most markets around the world. This performance came with higher market volatility in the US, a rallying dollar, slowing economies in Europe and Asia, and rising geopolitical tensions, including conflicts in Ukraine and the Middle East.

While US stock returns were high relative to those of other regional markets, returns within various US market segments diverged. US large cap stocks significantly outperformed small cap stocks; large value slightly outperformed large growth. Among small cap stocks, growth outperformed value.

In international markets, all segments had negative performance. The strength of the US dollar had a significant negative impact on returns for US investors with holdings in foreign stocks. The chart below highlights the currency impact on investment returns for US investors in Europe, the UK, and Japan:
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As a general principal, investors gain when their home currency falls relative to the local currency of the foreign asset they own, but lose when a rise in their home currency reduces the value of the foreign investment in the local currency.

Although 2014 proved to be a difficult year for US investors of foreign stocks, it remains essential to hold meaningful exposure to foreign developed and emerging markets. Just as these companies are critical to the long-term success of the global economy, they are equally important to the success of a long-term investment strategy.

In any given year, a single asset class can outperform all other asset classes by a wide margin. 2014 proved to be one of those anomaly years, where the US Large Cap stocks have outdistanced all other major asset classes.

Since a simple portfolio of US large stocks and bonds did well in 2014, should we abandon the diversified portfolio for a simpler 2-Asset Class model in 2015? If history can tell us anything, it favors by a wide margin, the more fully diversified mix of assets.

7assetPortfolio

Chasing asset class performance is a risky proposition as the randomness of individual asset class investment returns is well documented. Also, the ability to predict returns for any individual asset class (in the short term) has proven impossible.

 

ECONOMIC BACKDROP

The economy showed signs of weakening in early 2014, with Q1 GDP growth reported at an annualized 2.9%. In Q2, GDP rebounded strongly at a 4.6% annual growth rate—the highest since 2003. Growth in Q3 was even stronger at 5%, capping its best six-month stretch since 2003 and reaching the highest annualized growth rate in 11 years.

A host of indicators pointed to improving conditions during the year, including:

  • Employment: The US economy added 2.7 million jobs through November, the best employment growth in 15 years. By year-end, the US had recovered all jobs lost to the past recession, and joblessness was at a six-year low.
  • Manufacturing: Economic activity in the manufacturing sector improved throughout most of 2014. For the year, the purchasing managers index (PMI) recorded its best reading since the first full year after the recession in 2007-09.
  • Consumer spending: An improving labor market and lower energy prices translated into higher income and purchases among American workers. US equity market gains over the past three years have added $7 trillion to household wealth, which many believe has helped fuel spending.
  • Company earnings: The Department of Commerce reported a 2.8% rise in US corporate profits in Q2, followed by a 5.1% increase in Q3, marking 12 straight quarters of year-over-year growth.

Declining Oil Prices
Oil prices fell by almost half during 2014, a victim of excess supply due to rising production—particularly in the US, where production soared to its highest level since 1986—and to weakening demand from the economic slowdown in Europe and Asia. In the US prices dropped from $107 per barrel in June to just over $53 at year-end. The price decline most affected the economies and currencies of oil-exporting countries, especially Russia.

Soaring Dollar
In 2014, the US dollar rose against the currency of every developed market. Overall, it gained 12.5% against a basket of widely traded currencies, measured by the Wall Street Journal dollar index. This was the dollar’s best gain since 2005 and second-best on record. The rise was attributed to stronger US economic data, falling global oil prices, expectations of higher interest rates, and weakened currencies resulting from monetary easing by the Japanese and European central banks.

Weak Inflation
Despite rising to an 18-month high in May and June (2.1% each), average US inflation remained low throughout 2014. In November, year-over-year inflation fell to 1.3%. Since rising inflation is normally viewed as a sign of an economic uptick, some believe that weak inflation influenced the Fed’s decision to not raise interest rates in 2014.

The improving US economic indicators are already reflected in the strong double digit performance of last year’s stock market. Of course, the investment returns for 2015 will be impacted by new and unknowable economic data and global events.