The 2015 investor notepad: Things to remember during the year ahead
We have characterized the current economic/market moment as the “Great Divergence.” It is the time when growth trajectories around the globe are starting to part ways.
Residents of the United States, please read this important information before proceeding
As they do, we may well see differentiated returns across both regions and asset classes. With the velocity of growth splintering among nations, there are a handful of ideas to keep firmly in mind:
- Volatility, by its nature, is unstable. Periods of low volatility are dangerous as they lull investors into believing market risks have subsided. Quantitative easing programs have likely muted volatility, as money created through these schemes has created a bid for financial assets. Volatility is or at least should be volatile.
- Interest rates are in a period of transition. In the euro zone and Japan, interest rates will likely remain repressed by central bank quantitative easing. In the United States, the transition to a more market-based pricing of money is underway as quantitative easing has come to an end, and the advent of higher interest rates is likely only months away. Financial history has demonstrated that prolonged periods of cheap and easy money create all sorts of mal-investment that are – often painfully – revealed when market forces begin to reassert themselves.1 “Low for longer” can no longer be the mantra of the fixed income set.
- Diverging interest rates will impact currency prices. The near-parabolic rise in the trade-weighted US dollar since early July aligned well with the realization that the United States was beginning to pull away from other developed markets in terms of its growth trajectory and that interest rates will likely follow. Money tends to follow economic growth and interest rates. Both of these are set to trend higher in the US in 2015.
- Geopolitical developments can be fodder for arresting headlines, but the promise and the reality of these developments often fail to durably manifest themselves in asset prices. Russia, ISIL (Islamic State of Iraq and the Levant), and Ebola were all real and difficult human issues in 2014, but none really changed the course of financial markets.
- Beware of extrapolating the immediate past into the future. The path of events rarely moves along a straight line. Whether it is interest rates, oil prices or asset-class returns, the temptation to extrapolate current price trends far out into the future is considerable, and no community does that better than Wall Street or the Financial City of London.
- Higher interest rates due to faster growth are not a curse but a blessing. A great deal will be written about the impact this will have on equity markets. The first interest rate increase will be the hardest for the market to digest. It forces the formation of a new consensus. A Federal Reserve official recently opined that when the central bank raises interest rates, it will be a historic event.3 This is nonsense. It will be a normal event in the context of a recovering economy. Faster economic growth that brings with it more investment, consumption, employment and profits, with or without higher interest rates, is always better than low interest rates and weak growth. Beware the zeitgeist of muddling groupthink.
- While we are in the Age of the Central Banker, it is important to remember that central banks cannot fix economies, create jobs, or cure the structural employment/business environments of a country. What they can do, and have done throughout their existence, is to be the lender of last resort. They effectively buy time for an economy by stepping into the breach while the private sector finds its footing. Investor attention in 2015 will likely remain focused on the utterances of central bankers from Frankfurt to Tokyo in an attempt to discern how they will guide their respective economies. These civil servants are not the engines of growth for their economies, but agents for the private sector from which growth emanates.
- Economic growth does not always translate into higher equity prices. This concept, as counterintuitive as it might seem, has been on display in China during the last several years, and it has been demonstrated clearly in the United Kingdom in 2014. Growth flows from an economy to the companies within it by varying degrees. In the UK, economic growth has been quite strong, averaging roughly 3% in 2014, but the FTSE 100 has been one of the poorer performing developed markets due to the market’s composition – a heavy weight in energy and financials.2 Earnings are the drivers of economic value. Corporate assets that are intelligently utilized will generate a return. That return is the profit upon which a price can be calculated. Pay attention to economic growth, but focus on corporate profits.
- Consider the asset class returns cycle. There is a good chance that this year’s laggard is next year’s leader. A passing glance at a table of asset class periodic returns over time decisively makes the point. This should not be surprising as bargain-hunting, price-sensitive investors are always searching for the next investment. As money is attracted to the story of these out-of-favour sectors, it creates the seed from which grows a new view, which in turn attracts more money to the asset class or sector.
- Do not confuse the price of something with its value. They are very different concepts. The point here is not a philosophical one. The famous Warren Buffet quote, “Price is what you pay; value is what you get,” is the organizing insight. There is a temptation to look at an asset class or sector and proclaim its attractiveness based on its price, when in reality, the value that the investor would receive doesn’t fit with the price. Consider the high yield market: the Barclays US Corporate High Yield Index Yield-to-Worst stands at 6.65%. In a zero interest-rate world, this is an attractive price of money. Or is it? When we examine the option-adjusted spread of the index, 4.87%, the picture that emerges is quite different. Through this lens, which measures how much more income you receive versus a low-risk benchmark, this market is not as attractive.3 At 4.8%, the yield enhancement from this portion of the fixed income market is below its five- and 10-year averages. Consequently, the value the investor receives in this market, despite the higher yield, is lower than meets the eye.
Whatever the future(s) hold for investors in 2015, keeping this handful of principles in mind will help to separate signal from noise.
1 Bloomberg, as of 4 December 2014.
2 Bloomberg, as of 9 December 2014.
3 Bloomberg, as of 9 December 2014. At 4.87%, the spread is roughly 76 basis points below its 10-year average and 39 basis points below its five-year average.
Past performance does not guarantee future results. An investment cannot be made directly in a market index.