There was no shortage of surprises in 2014. Russia invaded the Ukraine, ISIS gained traction as a growing global threat, West Africa experienced an Ebola outbreak, and oil dropped by more than 50%. During the fourth quarter, Brent Crude Oil declined from $94.16 per barrel to $57.33 per barrel at the end of the year with energy-dependent currencies and companies declining in tandem. The Russian economy came under pressure as its dependence on oil amidst global sanctions weighed on the ruble and the Russian stock market. The Bank of Japan announced a substantial quantitative easing program while the ECB hinted at doing something similar. GDP growth was uncharacteristically strong in the U.S. and the GOP handily took control of the Senate.
Economic data reported during the fourth quarter was largely positive. Third quarter S&P earnings growth was about 9% quarter over quarter with 79% of companies beating earnings according to the Bloomberg Surprise Index. GDP growth for the third quarter registered 5%, which was well ahead of expectations, and job growth continued to be strong. Payroll growth for October (214,000 revised upwards to 261,000), November (321,000 revised upwards to 353,000), and December (252,000) was robust. Wage growth, while modest, was also trending upward. Aggressive monetary policy in the US continued to facilitate a very healthy M&A market in 2014 due to the low cost of borrowing and high stock valuations, often used as currency in acquisitions. During the quarter, Actavis PLC agreed to buy Allergan for $66 billion and Halliburton agreed to purchase rival Baker Hughes Inc. for $34.6 billion. U.S. consumers have benefited from a rising stock market, improved employment picture, and increases in home prices. Seasonally adjusted debt payments as a percentage of disposable personal income are the lowest on record. Consumer confidence is at highs not seen in approximately eleven years. The decline in oil prices is seen as a net positive to consumers as they will have more disposable income to contribute to GDP growth. The strength in the US economy combined with weakness in larger developed international currencies (namely the yen and the euro) and commodity price declines have contributed to a very strong US dollar. The chart below (via Bloomberg) outlines the appreciation of the USD relative to other major currencies during the fourth quarter.
On November 1st, the Bank of Japan announced an expanded quantitative easing program in response to stubbornly low inflation. The new program represents an increase in stimulus of roughly 33% when compared to the existing program. In addition, Japan’s $1.2 trillion pension fund (the largest in the world) announced that it plans to more than double its allocation to domestic and foreign stocks to 25% each in an effort to generate higher returns. Prime Minister Shinzo Abe was re-elected on expectations that his easing programs will continue to encourage investment and ultimately improve growth in a region hampered by a weak economy and persistently low inflation for decades.
Despite Germany’s reluctance, ECB President Mario Draghi asserted that "we will do what we must to raise inflation and inflation expectations as fast as possible as our price stability mandate requires of us." This led investors to believe that some form of quantitative easing was imminent as a last ditch effort to boost inflation. The ECB is expected to increase the size of its balance sheet by $500 billion to $1 trillion dollars through the purchase of sovereign debt across the region. However, there is some concern that Germany will be reluctant to support such a policy and only escalate the deflationary concerns.On November 11th, China cut interest rates for the first time in two years after third quarter GDP growth came in at 7.3%, below the target of 7.5%. If China does not reach this target, it would be the first time in sixteen years. Both the one year loan rate and one year deposit rate were also reduced. Additionally, China initiated a program to spur foreign investment in capital markets by creating the Shanghai-Hong Kong Stock Connect which allows any investor (rather than only preapproved institutional investors) to buy shares of select Shanghai stocks through the Hong Kong Stock Exchange and vice versa (though a cap is in place). Investors welcomed the news as local markets experienced rapid appreciation throughout the quarter rising 36.86% during the period.Equity MarketsOn October 1st, a U.S. District Judge rejected the claims of a handful of investors that were arguing that the government’s handling of promised dividends and liquidation preferences during the bailout of Fannie Mae and Freddie Mac was a breach of contract for private investors. The securities of both companies dropped substantially in the following days sending many investors to the exits. On October 7th, the IMF trimmed its global growth forecast for 2014 from 3.4% to 3.3% and for 2015 from 4.0% to 3.8%. News out of the Eurozone was disappointing as German industrial production declined more than expected in August to reach its lowest month over month decline in 5 years and France’s sovereign debt outlook was downgraded from stable to neutral. An appreciating dollar drove commodity prices and world currencies lower while creating a more challenging export environment for the US. In response to declining equity markets, some large institutional players sold their more liquid, higher quality assets to raise cash and reduce risk while waiting for the market events to play out. Many crowded, popular names traded down in tandem since there were less market participants willing to take the other side of the trade. The potential for a global Ebola outbreak only amplified the existing fear factors. These events created a capitulation across capital markets during the first two weeks of the fourth quarter. By October 16th, the S&P 500 Total Return Index was down -8.4%, the Russell 2500 Index was down -11.3%, the Euro Stoxx 50 Index was down -25.9%, and the MSCI EM Index was down -13.9% from their peaks. Three out of the four equity indices experienced corrections (down -10% or more) and many others were at or near similar levels.In a matter of weeks, the Ebola outbreak in the US was largely contained and central banks around the world were implementing or talking about implementing easing programs. As investors digested some of the earlier news, markets quickly rebounded. By the end of the quarter, most domestic equity benchmarks were in positive territory with the S&P up 4.92% for the quarter. Mid and large cap stocks, as measured by the Russell indices, were up between 4.8% and 6% during the quarter. Small cap indices returned 9-10% during the quarter after lagging for most of the year. Sector performance in Q4 varied widely with the energy sector down -10.6% and the utilities sector up 13.2%. Below is a chart with YTD sector performance for the S&P 500 that outlines the very wide dispersion in returns.International equity markets didn’t fare nearly as well with the MSCI EAFE index declining -3.5% and the MSCI EM index declining -4.6% as commodity price pressures and fears of deflation in developed markets brought emerging and developed international equities down. Additionally, fears of Eurozone instability and the renewed potential for a Greek exit from the EU worked to exacerbate volatility. The following chart highlights third quarter performance for various equity markets:Bottom Line: Equities remain an attractive source of long term growth for client portfolios. We continue to favor domestic over international and emerging markets as the risk to the downside is substantially less. However, the results of QE programs in Japan and the Eurozone and some clarity on the direction of oil prices could lead us to shift more equity exposure to international markets (both developed and emerging). We expect recent levels of higher volatility to persist throughout 2015.Fixed IncomeCredit markets were not immune from the volatility in oil prices during the quarter. With energy representing approximately 15-17% of the domestic high yield market as of October 1st, market participants aggressively sold off high yield instruments to limit exposure to energy credits that could breach covenants as the value of energy reserves plummeted. The Barclays Global High Yield index finished the quarter down -2.5% and the Barclays Global Aggregate Bond Index was down -1.1%. The downward pressure in bond markets was exacerbated by the lack of liquidity available to market participants. Proprietary trading desks at the large banks are no longer liquidity makers and this has impacted trading volume in the markets. We discussed this concern in a previous white paper but witnessed it in real time during the quarter. As investors tried to reduce risk by selling assets, there were no buyers at the margin forcing assets to be priced down even further.Municipal bonds and Mortgage Backed Securities were both up during the quarter as real estate assets continued to appreciate and the demand for tax exempt bonds remained strong. The biggest surprise for the quarter, and the year, was the advance of 10 Year and 30 Year US Treasuries. For the year, the Barclays US Treasury 10+ Year Index rallied +24.4% as the 10 Year yield fell from 3.02% to 2.19% and the 30 Year yield declined from 3.96% to 2.78%. We believe the risk-off mentality across the globe attracted capital to safety in long-term US bonds. Remarkably, this flight to quality rally in Treasuries happened while high yield bonds declined even in the face of lower benchmark rates.The following chart summarizes credit market performance in the fourth quarter:
Bottom Line: We continue to approach credit markets with extreme caution. While we favor credit risk over duration risk across the board, we realize that even shorter duration assets could experience principal volatility as the Fed increases short term rates, albeit slowly, at some point in 2015.
Hedge fund returns were mostly positive during the quarter. Long/short credit managers were hardest hit as most didn’t foresee the magnitude of the liquidity driven selloff in high yield so their long books suffered. Even high quality, shorter duration bonds were sold as investors sought liquidity. Global macro strategies, on the other hand, benefitted from currency trades that finally played out. The strong dollar relative to a weak yen and weak euro contributed to positive results for many of the global macro strategies.
The following chart summarizes quarterly performance for select hedge fund strategies:
Bottom Line: The environment was difficult for hedge fund strategies throughout the year as short trades generally didn’t work and unexpected macro and geopolitical events surprised many managers. We continue to believe that hedge funds represent a risk- managed component to client portfolios but recognize their relative underperformance for the year. With equities at all-time highs and credit markets becoming increasingly risky, alternative strategies continue to have a role in client portfolios as a hedge against market dislocations and a volatility dampener at the portfolio level due to lower correlations to other asset classes.
Conclusion and Outlook
2014 was a challenging environment for the investment management universe. The Fed- driven liquidity post-2008 has proven challenging for all actively managed strategies. We believe the environment is changing and being mindful of risks to the downside will prove beneficial over the long term.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by Massey, Quick & Co., LLC), or any non-investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Massey, Quick & Co., LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. Massey, Quick & Co., LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. If you are a Massey, Quick & Co., LLC client, please remember to contact Massey, Quick & Co., LLC, in writing, if there are any changes in your personal/financial situation or investment objectives for the purpose of reviewing/evaluating/revising our previous recommendations and/or services. A copy of the Massey, Quick & Co., LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
Historical performance results for investment indices and/or categories have been provided for general comparison purposes only, and generally do not reflect the deduction of transaction and/or custodial charges, the deduction of an investment management fee, nor the impact of taxes, the incurrence of which would have the effect of decreasing historical performance results. It should not be assumed that your account holdings correspond directly to any comparative indices
Indices included in this report are for purposes of comparing your returns to the returns on a broad-based index of securities most comparable to the types of securities held in your account(s). Although your account(s) invest in securities that are generally similar in type to the related indices, the particular issuers, industry segments, geographic regions, and weighting of investments in your account do not necessarily track the index. The indices assume reinvestment of dividends and do not reflect deduction of any fees or expenses.
Please Note: (1) performance results do not reflect the impact of taxes; (2) It should not be assumed that account holdings will correspond directly to any comparative benchmark index; and, (3) comparative indices may be more or less volatile than your account holdings.
Please note: Indices are frequently updated and the returns on any given day may differ from those presented in this document.
Index data is supplied from various sources and is believed to be accurate but Massey Quick has not independently verified the accuracy of this information.