Investment Review and Outlook

Fall 2014

The recent stock market volatility has reminded investors of the normal, consistently unpredictable nature of investing in equities. Short-term gyrations, such as the ones we have seen recently, typically reflect investor reaction to news headlines or other developments.

Global stock markets fell in the third quarter, as financial market results were set against a familiar set of macroeconomic and geopolitical considerations and worries. The United States seems on a path of modest recovery, Europe faces stalled growth and potential deflation, and China continues to seek a balance between maintaining sufficient economic growth on the one hand and slowing credit growth on the other. Geopolitical issues, most recently with the escalation of U.S. military action in the Middle East, and concern about high stock prices in the United States are other issues investors are weighing.

Investment Review & Outlook

In the United States, larger-company stocks were the best performers, with the S&P 500 gaining 1.1% while smaller-company stocks were down 7.3%. Developed international and emerging-markets stocks fell during the quarter, particularly in dollar terms as the U.S. dollar rose against other currencies. In the bond market, yields rose slightly at the prospect of the Federal Reserve’s exit from its bond buying program, anticipating the eventual rise in interest rates which is likely to occur in 2015. The core bond benchmark was flat for the quarter.

Monetary policy remains one of the largest unknowns and risk factors. The statements and actions of global central bankers continue to exert a powerful influence on financial markets. In October, the Fed said it would end its bond-purchase program, known as quantitative easing (QE), as expected. The Fed did nothing to dispel market expectations that they are likely to start raising the federal funds rate around mid-2015, given the current trajectory of economic growth and unemployment. Federal Reserve Board Chair Janet Yellen again reiterated, however, that all of their decisions will be data dependent, not calendar driven.

Key to the Fed’s monetary policy decisions is the outlook for U.S. inflation, wages, and employment. Brief updates on recent developments for each of these variables is below.

• Inflation: In the most recent three months, the inflation rate stabilized at levels below the Fed’s long-term target of 2%. Inflation expectations remained relatively stable as well. With this inflation backdrop, the Fed has more leeway to remain accommodative and core bond interest rates are unlikely to move sharply higher. Extremely low rates in Europe and other developed economies means Treasury bonds should remain in demand among global bond investors due to their relatively attractive yields as well as a strengthening U.S. dollar.
• Wages: Both average hourly earnings and real (inflation-adjusted) hourly earnings increased slightly over the past three months. But they remain well below what Yellen has said she wants to see as evidence of a healthy labor market—probably at least 3% nominal wage growth and 1% real wage growth. Broader indicators of labor’s share of the economy also suggest we are still early in the cycle of wage gains. While additional wage growth and a rising labor income would be healthy for the economy, it has potentially negative implications for corporate profit margins (which remain near historical highs) and, therefore, earnings growth and stock market valuations.
• Employment: Despite a disappointing August number, job gains continued to be reasonably strong, averaging 207,000 per month over the past three months through August. The unemployment rate dropped slightly to 6.1% in August, still well above the Fed’s estimate of “full employment,” which is in the low-5% range. However, the labor force participation rate remains stuck at a 36-year low. The Fed’s view is that labor is significantly underutilized.

The news from the European Central Bank during the quarter highlighted the divergence among global central bank policies. In early September, ECB president Mario Draghi announced additional stimulative monetary policy actions in response to worsening eurozone economic data and deflationary indicators. The ECB not only cut rates but also announced its plans to buy private sector asset-backed securities and certain types of bonds backed by loans from banks, with the aim of increasing the flow of credit, particularly to small- and medium-sized businesses.

The ECB will essentially print euros to buy the securities, similar to QE in the U.S. where the Fed bought government bonds, but on a much smaller scale. In theory, buying the securities from banks will free up capital enabling banks to make new loans to businesses and stimulate growth.

If the ECB’s latest steps don’t do enough to move the economic needle, it may ultimately have to engage in large-scale QE—as the Fed, Bank of England, and Bank of Japan have done—in order to try to prevent deflation from taking hold in the eurozone. Deflation in Europe would have very negative consequences for the global economy and equity markets. On the other hand, a strong shot of QE liquidity from the ECB could give a boost to global stock markets just as the Fed is starting to tighten U.S. monetary policy.

While the United States is on a slow path of recovery with very gradual improvement in growth and employment, much of the developed world is in worse shape, facing slower growth, higher unemployment, and worrisome deflationary trends. The role of monetary policy—specifically the timing and impact of the Fed’s gradual winding down of its stimulative policies—is a major unknown. In addition, there is the risk of a greater slowdown in China’s economic growth.

Current Views and Portfolio Positioning

The overall environment still seems supportive of higher equity prices due to mild but positive economic growth, low inflation, accommodative Fed policy, and weak competition from bonds and other asset classes.

Stock market volatility may continue in the near-term. However, this is part of long-term investing. Core bonds are held in balanced portfolios to mitigate the volatility of equities. While return potential for core bonds is very low, they remain in our clients’ balanced portfolios to offer some respite in the event of a stock market decline.

Ultimately, in our investment analysis and portfolio-positioning we focus on what is knowable within a reasonable range of outcomes and probabilities. There are times when what we determine is right for our clients’ long-term benefit appears to be at odds with what the markets are doing in the short term. However, we believe our discipline gives our clients the ability to meet their investment objectives over the long-term.