Investment Review and Outlook

Winter 2015

A handful of big-picture issues dominated the investment landscape in late 2014: the plunging price of oil, positive economic indicators in the United States relative to most of the globe, and the ongoing influence of central banks.

In terms of the investment environment, the U.S. economy looks to be in good shape over the near term. Fed monetary policy remains something of a wild card, but based on the Fed’s words and actions, we would be surprised if it shocks the economy or markets with an unexpectedly strong interest-rate hike.

Investment Review & Outlook

In the financial markets, the year saw strong gains for REITs, U.S. large-cap stocks, and core bonds. REITs were up 14% for the fourth quarter and 30% for the year. Large-cap U.S. stocks continued their unusually long and strong stretch of gains. The S&P 500 rose 14% and avoided even a modest 10% “correction” for the third year in a row. On the fixed income side, many were surprised when the 10-year Treasury yield declined and bond prices rose. The core investment-grade bond index was up 6% for the year and municipal bonds also fared well. We believe higher interest rates are likely over a multiyear investment horizon, although the timing and magnitude are uncertain.

Most international stock markets fared poorly in 2014. Developed international stocks lost 4% and emerging markets stocks were up just 1%. These returns reflect the significant headwind presented by the strengthening U.S. dollar.

Oil prices hit five-and-a-half-year lows in late December (falling 40% in the fourth quarter alone) as new sources of supply met with potentially slowing global demand. While a decline in oil prices is typically viewed as an unambiguously positive development for the global economy, the result this time around is different. The rapidity of the plunge, the current fragile global economic environment, and existing deflation concerns in Europe resulted in intensifying the worldwide deflationary risks.

Central banks continued their ongoing influence. Even as the Federal Reserve suggests it is on track to begin raising rates in the face of U.S. economic improvement, it once again soothed markets by reaffirming that it would continue to be patient in shifting its stance. Given the poor economic conditions that persist in Europe, investors continue to expect the European Central Bank to take a more meaningful step toward full quantitative easing (i.e., purchasing bonds and other assets with the aim of stimulating the economy). Meanwhile, central banks in Japan and China expanded their stimulative policy efforts in 2014. The takeaway is that even as the Fed prepares to scale back its support, there appears to be no shortage of supportive monetary policy globally. At the same time, the fact that central banks continue to undertake (or contemplate) aggressive action provides a reminder of the broader economic risks we continue to navigate.

While our clients’ diversified portfolios participated in the strong U.S. stock and REIT returns, they faced several headwinds for the year including an allocation to foreign stocks and our overweighting of small cap stocks.

When it comes to the financial markets, it’s worth putting recent results into the context of history. This has been an unusually long and strong period of positive performance for large-cap stocks. Since 1945 there have only been three other periods where the S&P 500 has had a longer streak of gains without at least a 10% correction, according to Ned Davis Research. In addition, over the past two years, the S&P 500 has outperformed both developed international and emerging markets indexes by an unusually large margin relative to history. These observations don’t mean U.S. stocks are necessarily set to tumble in the near term, but we think this data does provide some perspective as an argument for global portfolio diversification and prudent risk management.

Individual Asset Classes

U.S. Stocks

The S&P 500 index gained almost 14% and, for the third year in a row, avoided even a modest 10% “correction.” On the other hand, U.S. small-cap stocks dropped more than 13% from their summertime high through mid-October, and ended the year up 5%. The U.S. economy looks to be in pretty good shape for the near term. There are several positives: the labor market continues to strengthen, inflation remains subdued, manufacturing indexes and other leading economic indicators are consistent with solid GDP growth, low oil prices should boost consumer spending, and government fiscal policy is likely to become more of a growth tailwind than a headwind as the impact of past budget cuts rolls off.

Fed monetary policy remains something of a wild card, but based on the Fed’s words and actions, we would be surprised if it shocks the economy or markets with an unexpectedly strong interest-rate hike.

Developed International Stocks

Outside the United States, most major stock markets performed poorly. Developed international stocks lost 4% and emerging markets stocks were up just 1%. These returns reflect the significant headwind presented by the strengthening U.S. dollar, which detracted from returns for dollar-based investors. In contrast to the United States, the eurozone continues to fight deflationary headwinds. The December year-over-year headline inflation number fell to negative 0.2%, real GDP growth is below 1%, and two-year government bond yields in Germany and France are actually negative, meaning investors are paying the government for the privilege of owning these bonds.

Emerging Markets Stocks

There is a lot of negative news surrounding emerging markets stocks—such as slowing growth in China and other BRIC countries and the decline in emerging markets currencies. Despite their poor short-term performance, we remain optimistic about emerging markets’ long-term fundamentals and believe they are likely to outperform U.S. stocks over a five-year investment horizon. However, we are conscious of the shorter-term downside risk and volatility they pose.

Investment-Grade Bonds

Contrary to the expectations of economists and professional investors coming into 2014, the 10-year Treasury yield declined and bond prices rose. The core investment-grade bond index was up 6% for the year and municipal bonds also fared well. We believe investment-grade bonds are likely to generate very low single-digit annualized returns over a five-year investment horizon. This low return estimate is explained by the very low current yields and our expectations that interest rates will move higher over a five-year time frame, although the timing and magnitude are uncertain.

In Conclusion

Our clients’ investment performance often won’t track the performance of the benchmarks we’re measured against because we are not afraid to construct portfolios that look different than the benchmarks. Our willingness to not track the benchmarks is a function of our confidence in our investment process. Avoiding investing in line with benchmarks provides the ability to add value, as we have done for our clients over the many years we’ve been in business.

In the big picture, we view it as our responsibility to manage portfolios that meet our clients’ needs, not benchmark comparisons.