First Quarter 2015 Commentary

April Already?

So far this year, the action in the stock and bond markets has been pretty uneventful.  Most of the major averages sit near where they were at the beginning of the year.  Stocks showed some life in February, advancing roughly 3%, only to see those gains evaporate the next month.  As of March 31st, the S&P 500 was only up 0.5% on the year.  The small and mid-cap sectors of the market performed better, but only slightly.

Our expectation for this year remains unchanged.  In our last commentary, we expressed our belief that 2015 will look a lot like 2014.  While this year, thus far, hasn’t had the same level of volatility as last year, there are several significant economic factors that are building behind the scenes which we believe will be the main drivers of stock performance in 2015. 

The most notable of these factors are global interest rates and their effect on the dollar’s value.  As everyone is aware, interest rates in the U.S. have remained at historic lows since the 2008 financial crisis.  This has been true for all maturities and can be seen by the yield on the 10-year Treasury bond which has declined steadily for almost two and a half years. The yield now sits below 2%.  As paltry as two percent seems, this is actually high by comparison to other developed sovereign debt such as the Eurobond and Japanese debt. 

In Europe, interest rates have been falling sharply, in some cases into negative territory, since the European Central Bank last year introduced measures meant to spur the economy in the Eurozone, including cutting its own deposit rate. The ECB in March also launched a bond-buying program similar to what the Federal Reserve had undertaken, driving down yields on Eurozone debt in hopes of fostering lending.

Another major player in the global bond market is the Bank of Japan.  In fact, last month the BOJ over took China as the largest holder of U.S. Debt.  Japan has also been undergoing their own monetary easing program.  The impact has been just what we’ve seen everywhere else – ultra low interest rates.  Their 10 year bond only yields 0.34%.
So it’s basically the same story around the world.  High credit sovereign debt is extremely expensive and thus their yields are miniscule. The result is U.S. treasuries, by comparison, are the best game in town and international investors are buying them in droves.  The side effect of this demand for U.S. debt is that it has greatly increased the demand for the dollar. The stronger dollar has become a major headwind for U.S. firm’s exports.

This has become the biggest concern for stocks this year.  In particular, it has been a bigger concern for large-cap stocks, as they tend to have a larger proportion of their sales overseas.  So far, there has only be a slight downturn in exports.  Last year, U.S. firms exported a little over 2.3 billion dollars of goods and services.  That number is trending down to be more like 2.2 billion dollars.  It’s still too early to predict what the annual export number is going to look like this year, other than it will be lower.

We view this as the real headwind to stocks this year.  On the flipside, lower energy prices should provide a significant boost to earnings and consumer spending.  Our belief is that this economic benefit will outweigh the negative impact of exports and thus our positive expectation for stocks this year. 

Stock prices are much more influenced by future expectations than actual results.  Because of this, our guess is that there will need to be more clarity in the relationship between the dollar and oil before stocks are able to sustain a rally.  That likely won’t occur until the second half of the year.  Until then, stocks are likely to trade in a narrow range similar to what we’ve seen so far.

The good news is that the major stock indexes’ performance has finally broadened.  Over the last three quarters, the gains have been concentrated in the large cap sector of the market.  This has caused our most diversified equity positions to underperform the Russell 1000 benchmark.  This will happen from time to time, but usually only for one quarter.  This quarter’s results are finally reversing that trend with most of our client equity positions out pacing the Russell 1000 by half to one and a half percent.