In BSW Blog, Economic Outlook, Emerging Markets, Portfolio Commentary

2015 Happy New Year greeting card

Just five days remain before 2014 is ushered out and 2015 takes center stage.  Looking back, 2014 exceeded expectations on many fronts.  Direct real estate produced outstanding returns on both exits and refinancings, US large cap stocks delivered another strong year and set all-time highs more than 50 times, and even bonds powered forward as interest rates retreated yet again – with long-dated US Treasuries actually doubling the return of the S&P 500.  It is also interesting to reflect on the many critical, yet largely unanticipated, factors that emerged, such as: Russia’s annexation of Crimea and aggression toward Ukraine; the global Ebola scare and emergence of ISIS, and, most recently, the dramatic drop in oil prices.  What off-the-radar dynamics will drive 2015?  While impossible to predict, my bet would be on flaring tension in the South China Sea between China, Japan, the Philippines, and Vietnam; the bursting of the Canadian housing bubble; and an intensified “Arab Spring”-like reshuffling of the Mideast political landscape driven by plunging oil revenues and Iranian nuclear brinkmanship.

Looking ahead, four primary factors are driving our outlook and portfolio positioning for 2015:

  1. Diverging economic conditions and policy measures between the US, Europe, Japan, and the Emerging Markets;
  2. Prolonged and increasing US Dollar strength;
  3. The limits of monetary policy and central bank shenanigans; and,
  4. Secular stagnation versus structural deceleration.

Diverging Economic Conditions & Policy Measures:

The US is likely to remain the principal engine of global growth, while the Eurozone will continue to muddle along, Japan rebounding some yet still stuck in low gear, and emerging markets continuing to slow. US economic resiliency has created a positive feedback loop of accelerating leading indicators, consistent job gains, and wealth-effect boosts to consumer confidence.  With nascent signs of wage-growth and corporate capital spending, modest US growth in the 2% GDP range appears sustainable and likely barring any exogenous shock.


Leading Economic Indicators Suggest Further US Strength

Meanwhile, US equity valuations appear reasonable on both absolute and relative bases, despite pockets of frothiness in places like internet companies (Facebook’s price-to-earnings ratio of 75 is 3X that of Google’s and 4.5X of Apple’s), US Small Cap, and dividend-focused sectors like utilities.  We intend to emphasize US large cap and quality via dividend growth and return-on-equity measures that can also help protect portfolios from the inevitable spikes in volatility that characterize the middle to latter stages of bull markets. 

US Valuations appear reasonable both on relative and  absolute terms.

US Valuations appear reasonable both on relative and absolute terms.

Economic conditions abroad remain markedly different than those in the US.  European indicators have turned negative once again and there is a real risk of a Japanese-style deflationary malaise. My favorite analogy about the Eurozone economy is that it is like a low-flying plane that constantly hits air pockets causing both occasional lifts and near-death experiences. Europe is toying with outright Quantitative Easing (QE, the purchase of sovereign bonds by the European Central Bank (ECB)), but getting approval to do so from Germany is still a long shot and I’m not convinced that QE alone will remedy the Eurozone’s ills (or Japan’s, for that matter). Meanwhile, Japan is embarking on QE-Extreme, even including printing money to buy Japanese stocks.  Yet as in Europe, without structural reforms to labor markets, Japan’s QE could lead to fiscal crisis, as their debt-to-GDP ratio is already the highest of G7 nations at a whopping 250%. 

These factors are also producing divergence in policy measures, as the US looks to tighten while others loosen.  While a Fed rate hike is likely in 2015, it is unlikely to be severe due to lower energy prices helping keep inflation in check.


In a nutshell, the US has both the best economic momentum and the most confidence-inspiring leading data.  While valuations may seem a bit rich relative to other regions, they’re justified by better underlying metrics, including profitability and return-on-equity.  Regarding other developed markets, as BSW founder Debi Baydush was fond of saying, “Sometimes things are cheap for a reason.”

Prolonged US Dollar Strength

Diverging economic conditions and policy measures are also likely to underpin a secular rally in the US Dollar.  First, if and when the US begins to raise rates, the interest rate differentials between US Treasuries and, say, Japanese Government Bonds or German Bunds will further support the dollar.  Meanwhile, US energy independence is improving the current account position, adding another layer of support. Consider that the US is set to overtake Saudi Arabia as the world’s top oil producer by 2015 – a clear testament to US innovation.  Finally, the end of the US Fed’s QE will effectively reduce global dollar liquidity by roughly $750 billion.  The implications of this are twofold.  First, foreign investments should be hedged, when prudent. And, two, emerging markets could suffer as their real funding costs increase and pegged currencies weigh on their competitiveness.

USD vs EAFE currency cycles typically last ~8 years.

USD vs EAFE currency cycles typically last ~8 years.

The Limits of Monetary Policy & Central Bank Shenanigans

Former Federal Reserve Chairman Ben Bernanke was recently in Denver as the featured speaker at Schwab’s annual conference.  Upon introduction, he got a standing ovation from the audience of advisors and industry folks which, quite frankly, was rather creepy.  Under Bernanke, the Fed’s balance sheet swelled from $700 billion to $4.5 trillion, much of that due to the oft-heralded QE programs.  However, as the ECB and BoJ are learning, monetary policy is rather impotent without structural rebalancing, and by that I mean the willingness and ability of corporations, consumers, and even the public sector to fire people, shed excess capacity and leverage, and, in essence, to get lean.  With the exception of the Federal government, the US has done a remarkable job of these tasks at the consumer, corporate, and municipal levels — they were the real drivers of the US recovery.  However, this is one of the reasons that future global economic growth prospects are increasingly worrisome.  Europe and Japan lack the political will to tackle these tasks, which will become increasingly difficult due to their unfavorable demographics. Meanwhile, the emerging world must thread the needle of transitioning from faster-paced but unsustainable infrastructure build-out to slower-paced yet sustainable consumption-driven economies. All of which brings me to the topic of Energy and the question of Secular Stagnation versus Structural Deceleration.


Eurozone unit labor costs remain uncompetitive , so performane gaps across countries persist.

Secular Stagnation versus Structural Deceleration

There has been considerable ballyhoo about the US energy renaissance and rightly so.  But the falling price of oil (or any other good or service), always has both a Supply and a Demand story.  The Supply-side story is sexy and appealing. Due to shale gas and advanced recovery methods US oil production has surpassed its prior peak in the 1970s.  The Demand-side story is more ominous: Europe teetering on recession, Japan already in recession, Chinese and emerging market growth slowing materially.  The demographic trends are clear: the developed world is aging rapidly, birthrates are slowing globally, and demand is following suit. Indeed, global economic growth is transitioning to slower pace.  This is not necessarily a negative, but it will certainly have an impact on future investment returns and considerations. 

In closing, our very best holiday wishes to our clients, colleagues, and friends.  It is truly a privilege to work for and with such exceptional people.  May 2015 bring you prosperity, health, happiness, appreciation and gratitude.  As always, if you have any questions or would like to discuss you portfolio in greater detail please contact us, we are happy to help.


David Wolf, Chief Investment Officer

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