2014: Defying Expectations
As we entered 2014, it appeared as though it would be a somewhat quiet year. After outsized gains in US markets in 2013, few expected anything meaningful from equities this past year. Monetary policy, in spite of some tweaks, remained accommodative, and global growth appeared to be improving. Save for some concerns about emerging markets, there were few storm clouds on the horizon and no talk of volatility or major macro events to speak of. So much so, that at the beginning of the year, much of the market’s focus was actually on the weather.
An unusually cold winter distorted economic data at the beginning of the year, with some wondering whether the economic recovery in the US was beginning to falter. However, this proved to be a one-off event. As Janet Yellen took the helm of the Federal Reserve in February, tapering continued on course, and speculation continued as to the timing of a Fed rate hike.
However, this was decidedly not a year defined by central bank policy or the “polar vortex” but rather very much by rapidly escalating geopolitical situations. Take for example, the situation in the Ukraine: at the beginning of the year, it seemed to be little more than a flash in the pan story of regime change. However, it quickly became clear that that couldn’t be further from the case. Russia annexed the Crimean peninsula in March, and by summer armed conflict broke out in eastern Ukraine, as pro-Russian separatists, likely supported by Moscow, clashed with Ukrainian government forces. As this conflict continued to rage, we saw Russian relations with both the US and EU deteriorate considerably, as sanctions were countered with import bans and alarming anti-Western rhetoric.
In the Middle East, the Islamic State (IS), an al-Qaeda splinter group, began to draw international concern over the summer, as it took control of significant segments of both Syria and Iraq. The group is notable not only for its ideology, but how it has disseminated its message through digital media, capturing the world’s attention. Perhaps most disturbing however, is the number of foreign fighters it has recruited from the West, leaving the potential for a legacy of radicalization for many years to come. Syria, embroiled in a civil war approaching its fourth year, and Iraq, still struggling with sectarian instability, are both ill-equipped to deal with the problem. The US and its allies engaged in airstrikes on IS targets, while considering further action to stem the group’s advance.
The outbreak of Ebola in Africa and its subsequent spread to both the US and Europe incited a great deal of concern for many. Fortunately, success at containing the virus’ spread kept this situation from deteriorating. However, this crisis remains a massive challenge for global health workers. This outbreak, combined with a number of homegrown terrorist attacks in countries like Nigeria, demonstrates that Africa, while a region with exciting growth prospects, still faces a number of grave challenges in the near term.
Emerging markets everywhere, from Africa to Latin America, also felt the sting of what appears to be a slowdown in the Chinese economy. Throughout 2014, a number of data points have suggested at least a partial cooling in the world’s second largest economy. Attempting to both reign in excessive lending while maintain target growth numbers, Chinese policymakers face a tough balancing act. Whether they will succeed without seeing a hard landing remains to be seen.
In much of the developed world, things did not look much better. Japan, in spite of Prime Minister Abe’s best efforts, found itself in a recession by November, largely the result of a sales tax increase dampening consumer spending. Meanwhile, the Eurozone continued to see little in the way of growth or inflation, in spite of some measures undertaken by the European Central Bank. An Italian recession and political instability in Greece later in the year further intensified concerns about the state of the Eurozone, and highlighted the likely need for further monetary stimulus down the line.
The markets reflected these newfound worries of slowing global growth, especially in the latter half of the year. These concerns, combined with perceived oversupply in energy markets, led oil prices to drop precipitously. Renewed Libyan production, combined with OPEC’s decision in November not to cut supply further intensified the free fall, with companies and economies levered to the energy sector particularly hard hit. However, investor skittishness impacted markets as a whole, with two large spells of volatility hitting in October and December.
In spite of these two temporary routs and plenty of causes for concern this year, equity markets (at least in the US) managed to defy expectations, with the S&P 500 hitting new highs. If nothing else, this is a testament to the strength of the US recovery. Third-quarter GDP growth in the US was revised upward to 5%, a pace not seen in over a decade. At the same time, employment numbers have continued to improve and the recent drop in oil prices has provided a boost to consumer spending. Though there may be signs of a slowdown abroad, economic conditions have remained healthy in the US. As we begin 2015, many are wondering whether this trend will continue.
While one can never know what lies ahead, making inferences about an upcoming year given the current global situation is especially difficult. This bull market is approaching its sixth year which, by many accounts, makes it somewhat “long in the tooth.” Should pressures exerted by a slowdown in Europe, China or elsewhere manifest themselves in the US, it isn’t out of the realm of possibility to see some headwinds appear in the markets. At the same time, the past year has likely proven to us that the US recovery may be entering a new phase, one where growth is not only going to be more robust, but also more noticeable.
Among market pundits, the word “divergence”, comes up a great deal when discussing 2015, and rightly so. Many are expecting a world in which the US breaks out from the pack, as growth picks up and economic data improves. Subsequently, the Federal Reserve will likely take this as a signal to begin raising rates at some point in this year, some catastrophic event notwithstanding. This could potentially lead to an increase in the value of the dollar, and ultimately, some argue, bolster domestic markets.
By contrast, in much of the rest of the developed world, uninspiring growth and little to no inflation will induce looser monetary policy. While the Bank of Japan will have a hand in this, consensus seems to indicate that the European Central Bank will be leading the charge. While the ECB has taken measurable actions with interest rates and asset purchases in the past, the quantitative easing program announced just today by Mr. Draghi will hopefully finally address moribund growth and continued signs of deflation in Europe.
Much like in the developed world, emerging markets will also see diverging paths. A rise in US interest rates for commodity oriented economies like Russia or Brazil will likely prove difficult, especially as Chinese growth slows simultaneously. Whether China can make that slowdown a graceful one remains to be seen, and will impact how much it will drive global growth going forward. Overall, emerging markets who seek to open up their economies and implement reforms will benefit, with lower energy costs providing additional tailwinds for some.
While this narrative or some variation thereof seems to be somewhat of the consensus view for 2015, we do recognize that there are risks. Undoubtedly, there are many unresolved situations from the previous year that, should they deteriorate, have a negative impact on markets. In particular, a worsening slowdown in Europe or China could derail markets globally, as could a repeat of the emerging markets crises we saw in the late 1990s. Geopolitical tensions could have an impact as well, especially if Russia were to take its sabre rattling beyond Ukraine, or if conditions worsen further in the Middle East. While some of these situations may diffuse or dissipate over the coming year, for now they all require close monitoring.
Understanding and managing such risks becomes particularly important in market environments like these. After several straight years of impressive gains, many posit that although fundamentals are strong, valuations are somewhat rich. What’s more, investors, by many measures, are rather complacent. As a result, market shocks, if they do arise, could be more pronounced. With reduced liquidity provided by the Federal Reserve as rates rise, such events could be even more turbulent. With these considerations in mind, regardless of whether markets rise or fall in 2015, we are of the opinion that there is good reason to expect higher volatility than we’ve seen in the past couple of years.
Moving Forward: Our Direction for 2015
While such an outlook may seem unnerving to some, we feel that recognizing both current and potential risks can make navigating volatile equity markets somewhat smoother process. To that end, much of our time recently has been dedicated to stress testing portfolios and making adjustments that attempt to insulate against these risks. Recent spates of volatility are likely a sign to tread carefully, but also to be vigilant for opportunities that may present themselves. Risk management is a central component of our investment process, and we feel that managing the risk of opportunity cost is an often ignored part of that. Though such a balance is difficult to say the least, we believe that volatile markets, no matter how unsettling, can be overcome through patience and discipline.
When considering our fixed income portfolio, we have worked to better refine our positioning for the changing environment ahead. We have taken a hard look at the risk management capabilities of the outside fund managers we employ, and have considered whether their mandates fit in with our views of the markets. Ultimately, we maintain a preference for nimble, opportunistic managers to navigate these conditions.
While equity markets have had an exceptional run-up in the past few years, we still see many compelling opportunities in the asset class. Concerns about global growth have hit both energy and materials producers significantly, and we believe this has made many companies with strong fundamentals very attractive. In addition, though many investors have avoided the Eurozone as of late, we believe the region is home to a number of highly innovative companies decoupled from Europe’s fortunes (or misfortunes) thanks to their global presence. Taking a long term perspective on global growth, we believe equity investors still have some excellent options.
Although our focus is very long term in nature, we also take our short term relative performance to the specific indices we use to track our holdings very seriously. In this light, our performance in the 4th quarter of last year was very disappointing in our eyes as the precipitous drop in energy prices combined with a sizeable drop in one of our longer term holdings, IBM, impacted many portfolios. While we have made some adjustments to better attempt to insulate portfolios from continued risks, we also believe we have identified a number of compelling new opportunities as well. Admittedly, this was a challenging year, but we are quite optimistic going into the coming year regarding the prospects for the individual companies we own.
Looking beyond the markets, we as a firm are very excited for the year ahead. 2014 saw the addition of two new members of our team, Ron Welz, our Director of Operations, and John Zelenka, SVP of Client Service and Business Development. Ron comes to us from Fidelity Investments, and has nearly two decades of experience in operations and client management. John has come on to spearhead client relations and business development efforts for our firm, after ten years working for Cornell University’s development office, in both Ithaca and, more recently, New York City. With their impressive backgrounds, both have already made notable contributions to the firm in their short time here.
In addition, Matt Bean, our intern from last summer, will soon be coming on full time to support our investment research efforts. Matt recently completed his MBA at Texas Christian University, and we know his well-honed skillset and passion for investing will make him a valuable member of the team. We look forward to his arrival later this spring.
These three great additions bring us to a total of six team members, all a part of our ongoing efforts to further build a team-based, full service firm for our current and future clients. We believe that now, more than ever, we can strive to further enhance the client experience and be a more valuable partner to you. If you wish to learn more about our efforts, please do not hesitate to get in touch. As always, we thank you for your continued support and trust, and wish you all the best for 2015.
Legal Information and Disclosures
This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Drum Hill Capital, LLC (“Drum Hill Capital”) has no duty or obligation to update the information contained herein. Further, Drum Hill Capital makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss. This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Drum Hill Capital believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Drum Hill Capital, LLC.