Investors would be hard-pressed to find many broad asset classes that had done anything but go up this year until volatility reared its head in October. While there have been periods of dispersion in returns, most portfolios are sitting on decent gains since markets bottomed in March 2009.
This year, risky assets have performed resiliently in the face of negative headlines ranging from the lack of conviction in economic growth to geopolitical risks percolating from all corners of the globe. Exchange traded fund (ETF) investors have followed suit by tilting allocations toward the top performing asset classes and sectors. We believe this is a sign that we increasingly live in the world of the “butterfly economy,” in which we must prepare for risks emanating from all corners, leading to pockets of opportunities that can be exploited by savvy investors.
2015 Market Outlook
BASE CASE – 2015’s playbook resembles 2014’s. Across the stock market, we continue to believe that the US remains the most attractive region as its competitive renaissance makes it the best house in an improving neighborhood. We expect profit margins to remain elevated due to cyclical and secular influences. This leads us to favor cyclical sectors over defensives.
Due to the negative impact the Ukraine crisis is having and lingering structural imbalances, we have become less favorable on Europe, but the potential for monetary stimulus may provide support for asset prices. The Bank of Japan initiated additional quantitative easing during late 2014, which is meant to reassure markets that the central bank is able and willing to stimulate the Japanese economy.
At the same time, we increasingly believe emerging markets are attractive from a valuation standpoint, but are concerned about deterioration in earnings expectations and growth concerns from the BRICs (Brazil, Russia, India, China), tempering our expectations. A developing trend is the ability for investors to access the liberalization of key markets, such as China, which will likely capture the market’s attention, as non-local Chinese investors are now able to capture complete market exposure from the world’s second largest equity market.
We feel that convertible securities are an attractive option for investors, especially as US small caps appear to be stretched and convertibles are an attractive means of protecting against rising rates. The high yield market may be prone to technical led sell-offs, but it still offers investors an opportunity to add income as credit fundamentals are strong. In addition to high yield, we see opportunities in investment grade credit. While long duration has outperformed this year, we maintain a belief that investors should diversify their fixed income exposures toward the shorter end of the yield curve.
While we believe that commodities should play a strategic role in portfolios from a diversification perspective, we feel that the investment environment for commodities is weak. One driver of this is that we are entering a phase of strong dollar and the commodity super-cycle is waning. As China seeks to engineer an economic repositioning, its formally insatiable demand for natural resources has and will likely continue to slow.
BULL CASE – While global economies have been growing, they have not been expanding at a pace that has reached escape velocity. Our base case incorporates that central bank action will provide a boost to risky assets, but in a bullish scenario growth is more organic as central bank policy plays a diminished role in affecting the trajectory of developed and emerging economies. In either case, the US will likely lead the global economy forward.
However, since actions speak louder than words, a decisive action by the ECB does seem to be the catalyst that investors need to wade back into the pan-European waters. As such, a definitive policy action would be an all clear signal to the markets to go “full bull”; as market participants have had pent up demand for years and it seems that a more euphoric state could be right around the corner. This may help investors overlook idiosyncratic geopolitical headlines and further the bullish case for risky assets.
BEAR CASE – ANY escalation of geopolitical tensions, ranging from Russia shutting off natural gas exports through the Ukraine, to an intensifying of the situation in the Middle East, could spill over into financial markets.
The short bouts of market volatility that we experienced in 2014 are indicative of a potential impact on asset prices. As uncertainty would increase markedly, investor sentiment would shift toward a risk-off stance. As such, this would be bullish for safe-haven assets as investors would likely flock back to gold after its fear premium evaporated over the last year. Investors may also likely discount credit risk to a greater extent than interest rate risk. Investment grade would benefit relative to high yield. Due to a stronger U.S. dollar, emerging market local currency debt would sell off. Commodities, except Gold, and commodity-sensitive assets would suffer a setback as global economic growth declines.
Global stock markets would suffer, some sharply. All else being equal, equity investors would favor the US, especially those companies that are more defensive in nature. In other markets, a bias toward inexpensively priced quality companies with low volatility would be rewarded over those companies with excess leverage, high valuations and highly volatile share prices.