2014 – A Year of Surprises
January 16, 2015
From U.S. Treasuries to crude oil prices, 2014 marked a year of surprises. Consensus is not always right, as last year made clear. However, some markets performed closer to expectations, U.S. equities and the U.S. Dollar to name two. Both strengthened over the course of 2014, the former more evenly than the latter, with the S&P index up in each of the four quarters. The Dollar’s rise was concentrated in the second-half of the calendar. Stock volatility picked-up from very low levels, spiking a few times, mostly in the second-half. Gold remained in disfavor; a better H1 than H2. For the year, markets sold every rally in the Midas metal, closing with a small loss.
Longer-dated Treasuries, and long-duration bonds, won the day. Ten to thirty-year bonds feasted, providing double-digit returns to investors. Yields on the 10-year benchmark opened above 3%, quickly moved lower, and lower still, through winter, spring and summer. Selling pressure was contained, bumps erased usually in the same month, leading to even lower yields. Then came Q4, and a turn in portfolio positions from hedge funds and institutional accounts helped mark a memorable day in October. On Oct. 15th, for less than an hour, investors and speculators could not hold enough Uncle Sam debt…yield on the 10-year plunged well below 2%, before bouncing, though not straying far from 2.20% thereafter. The tone was set for the remainder of 2014.
The storyline was similar for crude oil prices. The year opened with WTI near the century mark, and Brent well above at $110. A benign first-half left prices generally in place, hitting its peak in June, before descending all of the second-half. In Q3, the decline remained mild, belying what lay ahead. Q4 opened with WTI at $90, not far from its price nine months earlier. Then, the sky fell, literally on oil prices over the next 90 days. By the time all was said and done, $90 became $73 at OPEC’s meeting in late-November to discuss whether reducing production would stimulate prices. OPEC decided to stay the course, and continue production at the same rate, keep the current quota, and hold-on to market share. With Saudi Arabia as the vocal leader of this strategy, prices kept moving south, another $20, and more than 20%. A collapse, at least in the short-term. What’s the end game? Is it one strategy, or several combined points of interests, political and economic in this calculation? Will prices nearer to $50 than $80 be enough to balance the market’s supply and demand? In general terms, consensus maintains it’s more a supply than a demand phenomena, but the lower the price moves, the more in question the current view becomes. These questions lead to greater uncertainty, economic and political. How will Russia, already in recession, react? Through a combination of sanctions for actions taken on its Western front, as well as general declines in commodity prices, all went wrong in one of the original BRICs…from soaring inflation and interest rates to capital outflows, to a plunging Ruble.
Far from Russia’s turmoil, U.S. equities enjoyed capital inflows, at times more than others, but consistently positive throughout the 12 months. The primary gauge for stocks, the S&P 500 Index, enjoyed a second year of uninterrupted quarterly increases. It closed up 13.7%, above its historical average. The other major indices beat the long-term averages; the Dow by a little bit, the NASDAQ by a lot. A number of record highs made the news, with the S&P marking more than 50 fresh highs. The fundamental and technical story remains aligned, though sentiment can change in a hurry. For now, the fundamentals appear to be constructive. Corporate earnings, almost always the main factor, are bringing near-record profits. The U.S. economy, over a full 12 months, and much more so the last 6 months, has been on a tear, far superior to growth in Europe and Japan. Subsets of GDP appear better balanced than in recent years, consumer spending picked-up as the year moved along. Housing is still a soft-spot, the FOMC minutes told us so. Interest rates remain very low. The possibility the Federal Reserve may lift the overnight rate in 2015, and assurances the pace of any moves would be gradual is viewed constructively by markets. Whether the Fed may feel compelled to move at a more aggressive pace, once liftoff occurs, is an unknown. The knowns: the Fed lowered its inflation forecast for 2015, while upping GDP growth and lowering the unemployment rate expected going forward.
The U.S. Dollar bolstered its status as the reserve currency, gaining major ground against its G7 counterparties and versus Emerging Markets (EM). Differentials in sovereign bond yields, inflation, and growth, alongside expectations of a continuation to the pattern in the New Year has seen the Dollar climb to levels not seen in almost a decade vs. a basket of currencies. Against the majors, the Dollar, in round numbers, strengthened from $1.40 to $1.21 vs. the Euro, from 105 to 120 vs. the Yen, and from $1.65 to $1.55 vs. the British Pound. EM currency devaluations were attributed to a combination of weaker global growth, capital outflows, and the specter of higher U.S. interest rates down the road.
In Europe, last year – like prior years – did not meet expectations. It was accentuated by minimal growth, miniscule inflation, a weakening currency (beneficial), and less than effective European Central Bank (ECB) intervention. It is here that 2015 starts, with markets focused for the umpteenth time on Mario Draghi’s back-and-forth Hamlet-esque debate of whether quantitative easing (QE) will finally grace the Eurozone. Several dates in January will be on investors’ radar screen…the next inflation reading, and the initial ECB meeting of 2015, January 7th and 22nd, respectively. Stepping back, the reason for all the attention is simple. Europe’s economy is at a near standstill and in dire need of rejuvenation! GDP is well under 1%, powerhouse Germany saw a significant slowdown over the course of the year. Inflation is closer to zero than 2%, the central bank’s mandate. On the positive side…the bar is very low!
Whether full-fledged QE is the magic wand that unlocks credit lending in the EU is a guess at this point. A key question is whether marginally lowering already historically low interest rates actually changes the bigger picture. How well capitalized are banks’ balance sheets after another round of stress tests? What is considered optimal growth for the continent? Though Mr. Draghi’s words and actions have yet to match, markets have taken him at his word. The consensus view as we open 2015 is the central bank’s balance sheet will increase, weakening the Euro further, as the ECB finally institutes purchases of sovereign bonds. To what degree remains unknown, but market expectations are clearly high that the ECB’s president will do more, perhaps much more, to invigorate Europe’s economy…the 2nd largest bloc in the world.
Optimism for Japan at the start of the year quickly faded, the economy came under pressure from another ill-conceived consumption tax, and equity markets sold-off accordingly. After a poor first-half, and reassurances from its central bank (BoJ) that, if needed, more would be done to stimulate the economy, the Nikkei and Topix (the two main indices) recovered their balance. The second-half of the calendar was more exciting and rewarding for investors. Stocks closed on a positive note, impressive considering how sharp the first-half correction had been. The currency, on the strong side early-on, gave way in spurts, usually 5 numbers at a time vs. the Dollar (105 became 100, then back to 105 and 110). It was not until Q4 that fireworks lit the Japanese sky. On the final day in October, the BoJ announced a major change, even more bonds would be purchased (in percentage terms, much more aggressive purchases than the Fed’s). In addition, Japan, Inc. was alive and well. The government’s large and powerful pension fund would allocate less of its portfolio to bonds, replacing JGBs with equities, both domestic and foreign.
The news was received as a win-win by markets… driving prices higher the first week and month, then moving sideways in December. Most of the year’s gain was concentrated in the final quarter. Dollar-Yen moved from 110 to 120 and, as was the case for most of the year, was inversely correlated to equities. The formula was based on a lower Yen improving exporters’ bottom-lines, thus helping corporate earnings, and propelling stock prices higher. At times it worked to a tee. Other times, movement stalled. Which one leads? The currency generally moves to a new level, breaking above a previous range, and equity prices follow.
Emerging Markets had a rough start and a tough year. The opening months saw the space pressured by Russian-Ukrainian tensions, and talk of cold war vestiges. Afterward, a period of calm was enough to turn outflows into inflows, at times in a pronounced way. By mid-year, EM looked better. However, the 2nd-half was not hospitable. Pockets saw improvements, more in debt than equities, but almost without exception currency weakness vs. the Dollar eroded gains in local terms. Better inflation and growth outlooks improved the external debt picture in select countries.
