Island Light Quarterly Commentary (Apr 2015)
“Within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. Believe me, it will be enough.” (Mario Draghi)
First Quarter in Review
So Mr. Draghi spoke in July 2012 and in March 2015, the European Central Bank started a one trillion euro bond-buying program aimed at boosting inflation and reviving European economies. As in both Japan and the US, the short term impact was a boost in European equity returns and a weakening of the Euro relative to the US dollar. Demand for the highest quality European bonds soared, sending global interest rates lower. In Europe, roughly a quarter of the top-rated government bonds have negative interest rates. It’s another day in paradise for the global investor.
With the US economy continuing to grow, albeit more slowly than many would like to see at this stage of a recovery, US stocks and bonds had positive returns with the S&P 500 index, which measures the largest US stocks, returning 1.0% for the quarter and the Barclays US Aggregate Bond index, which measures the US bond market, up 1.6%. The US economy grew 2.4% year-over-year (Dec), the dollar grew 9.0% versus a basket of foreign currencies and US inflation year-over-year was near zero (Feb).
The real story this quarter in equity markets is the strength of non-US equities, with non-US developed markets up 4.9% in dollar terms and 10.8% in local currency. Japan was the strongest performer of the major markets, returning 10.2% in dollar terms. Thus far, monetary easing and renewed optimism for economic growth in the rest of the world are driving equity prices higher.
US large and mid-capitalization stocks produced modest returns in the first quarter (1.6%). We also observed a continuation of the demand for smaller capitalization stocks which returned 4.3% for the quarter after a very strong fourth quarter (9.7%). The largest growth-oriented (high book to price) stocks outperformed the largest value-oriented stocks (low book to price) by 4.5% and mid-cap stocks outperformed by 2.4%. Volatility, as measured by the VIX, ranged from 13 to 22 year-to-date and ended the quarter 15.3, below its 10 year median of 17.2.
The major sectors of the US economy had very different performance records. Utilities fell from a strong prior quarter, losing -5.2%. On the other hand, healthcare (6.3%) and consumer discretionary stocks (4.8%) rose strongly. Energy also suffered modestly as the price of oil (West Texas) went from $53.27 per barrel at year end $47.60 on March 31, a drop of 10%. The materials, technology, and consumer staples sectors were modestly positive, near the S&P 500 return of 1.0%.
REITs (Commercial Real Estate) continued their strong run for the quarter, returning 4.7%. REITs tend to do well as the economy and job outlook improves and demand for commercial office space increases, leading to stronger cash flow from increased occupancy and higher rental income. In addition, with interest rates low, investors seeking higher yield look to REITs to provide more income than a traditional bond.
New optimism in the European and Pacific markets drove international developed markets sharply higher in the first quarter with a total dollar return of 4.9%. The continued strength of the US dollar was a headwind from the perspective of a US investor as the same markets in local currency terms grew 10.9%. European developed market returns were up 3.5% in dollar terms and up 11.6% in local terms. Pacific region developed market equities gained 7.6% in dollar terms but returned 9.4% in local currencies. Emerging market returns showed a similar pattern with the return in local currencies up 4.9% and up 2.2% in US dollars.
The rush towards a stronger dollar that began in June 2014 has continued through the most recent quarter. We believe that the factors leading to the strong dollar are primarily policy related; Fed policy to stop quantitative easing as other countries in the world begin (Europe) or continue (Japan) their monetary expansion policies leads to an increased demand for dollar denominated assets. Regional interest rate differentials also play a major role and, surprisingly, our interest rates are higher than many rates around the rest of the globe. Euro rates shorter than 7 years in duration are below zero and the 10 year rate is 0.2%, roughly 1.7% below the comparable US Treasury.
Regionally, as the US economy gains strength, while the European economy remains mired in slow growth and structural unemployment, particularly in the peripheral economies, there is some reason for hope. Low oil prices, weakening currencies and excess capacity should lead to an increase in exports and more competitively priced goods and services. And as we noted above, the ECB is flooding the markets with free money. All of this stimulus should provide leverage for European companies to increase production.
Japan, too has benefited from monetary stimulus, falling oil and commodity prices and aggressive fiscal policy, leading Pacific equity markets sharply higher in the first quarter. Japan grew at a 1.5% annualized growth rate (November), but this is much stronger than the previous two quarters and expectations for a strong end of year (March) are high. Other regional markets have also benefited recently with new optimism in Chinese markets.
While overall Emerging markets returned 2.2%, there were major regional differences. For example, Asian emerging countries (China, India, Phillipines) each grew more than 5% while Latin American countries more dependent upon commodities and linked to the dollar, such as Brazil, were sharply negative. Eastern Europe (Russia, Hungary) were very strong performers as the Ukraine crisis dissipated.
Domestic Fixed Income
Bonds were positive in the first quarter as interest rates continued to slide lower during the quarter. The 10 year Treasury, which began the year at 2.2%, ranged between ranged between 1.8% and 2.4% and ended the quarter at 1.9%. Longer maturity (20+ year) Treasuries benefited with returns of 3.9% while shorter maturity Treasuries (1-5 year) returned only 0.9%. Fixed income plays an important role in a well-diversified portfolio, helping to dampen equity volatility and reduce risk of loss. Credit spreads tightened from the end of the year as investors search for higher yield. As spreads tighten, risky bonds tend to perform better; as spreads widen, the price of corporate bonds drop relative to their government bond maturity-equivalent.
Our views on equity markets and the global economy have not changed dramatically in the last quarter. We expect that the strong dollar will continue, but at a much decelerated rate than we have observed in the last nine months. Some pullback should be expected, but there is little reason to believe that the dollar trend will change without some exogenous shock to markets. Oil production has slowed from the end of the year as unprofitable oil wells are temporarily shuttered and demand has increased modestly, so we think most of the oil price drop has occurred. We expect that oil prices will stay in the current trading range, and we expect price increases later in the year as the world moves to a new equilibrium price closer to the $100 range of the last three years than the $50 range of the last three months. Energy dependent countries will see marginal growth and energy suppliers will suffer.
While US equity valuations are higher than at the end of 2014 and higher than their 20 year averages, they don’t appear to be irrationally high. On the positive side, corporate earnings are at record levels and while earnings growth has slowed in the last quarter, we expect profit margins to stay high. The strong dollar and weak oil price are a mixed bag; consumer sentiment has improved markedly in the last quarter, labor gains have remained consistent with unemployment falling to 5.5%. Certain sectors, such as consumer discretionary and utilities, should benefit from lower energy costs; energy and materials sectors are likely to suffer lower profits; healthcare should continue to benefit from regulation and an aging consumer base. On the other side, valuations are high and therefore going forward, the potential rewards for equity ownership are likely to be muted. Global economic weakness and the strong dollar will be harmful to US corporations increasingly dependent upon foreign sources of revenue.
The current valuations of non-US developed equity markets are lower than both their 10 year averages and the current US market and thus attractive to the value investor. Exposure to these foreign equities may well benefit from these attractive relative valuations, but a stronger dollar will create headwinds for the US investor. On the other hand, non-US emerging markets valuations, while attractive relative to the US, are near their 10 year averages. We expect to continue to increase our non-US markets exposure over the next few trading cycles.
At the beginning of the quarter, we felt that rates would decline temporarily and increase later in the year. Weakness in foreign fixed income rates will dampen expectations for US fixed income rate increases, but US economic growth and wage increases will lead the Fed to raise rates in the third quarter. We don’t expect radical change in interest rates, however, until demand for bonds of all flavors diminishes. We are a little bothered by low trading volumes in some corporate bonds as some market makers have eliminated their corporate trading desks due to higher regulatory costs. This could lead, someday, to a liquidity/trading crunch in lower-rated corporate bonds, even as a surplus of sovereign debt crowds the marketplace.
Thus far, 2015 has been a year where exposure to foreign assets has benefited the global investor, despite the strong dollar. Developed market equities outperformed emerging market and US large cap stocks. Small, mid-cap and US growth stocks have also performed well. Low oil prices and high corporate earnings have helped the economy grow with little inflation, declining unemployment and very low interest rates. At long last, Europe looks to be poised to enjoy stronger economic growth. Going forward, an optimally diversified investment portfolio that includes global assets will fall in the middle of a wide range of possible outcomes and this approach will lead to reduced investment risk, more certain outcomes, and better risk-adjusted returns.
Matthew V. Pierce, President