The fourth quarter again reminded us that volatility is alive and well in the equity markets. After a rough start to the quarter, U.S. stocks rallied and the Standard & Poor’s 500 returned 4.9% for the three‐month period. Many other U.S. stock categories performed even better. Investors were encouraged by respectable corporate earnings and economic reports, including an improvement in the top‐line unemployment figures. The Federal Reserve’s statement signaling patience for rate increases helped stocks in general, especially higher‐yielding stocks such as real‐estate investment trusts (REITs) and utilities. REITs continued their ascent during the quarter and ended the year as the best performing asset class in our clients’ portfolios. Despite the volatility, small and value stocks finished strong in the fourth quarter, ending the year in positive territory.
It was a different story for foreign equities. Foreign developed‐market stocks, measured by the MSCI EAFE index, declined in the fourth quarter and ended the year down ‐4.9%. Most major foreign stock markets had negative returns in the fourth quarter, partially attributable to a strengthening dollar. Economic data out of the Eurozone continued to disappoint investors, with Germany adding fuel to the fire with a cut to 2015 growth estimates. Emerging markets also declined. Fluctuating currencies, stagnating economies, and the complications of declining oil prices were to blame.
With foreign economies in an uncertain situation and oil price declines contributing to slowing inflation, investors flocked to dollar‐denominated fixed income. The yield on the ten‐year U.S. Treasury declined to end the year at 2.17%. Taxable bond values rose, helping the Barclays Aggregate Bond Index return 1.79% during the quarter. All of this occurred despite the absence of an important buyer ‐ the Federal Reserve discontinued its quantitative easing program in October. Municipal bond investments also benefitted from the declining‐rate environment, as well as a shortage of new issues. Municipalities have been working through the aftermath of the financial crisis and the issuance of new debt has slowed as a result. Increased tax rates and a reduction in new municipal bankruptcies have increased demand among investors.
The decline in commodity prices, particularly the energy complex, was one of the bigger developments in the second half of 2014. Oil prices have fallen more than 50% since June.
U.S. stocks registered their sixth consecutive annual gain in 2014 and the NASDAQ Composite, the closely‐followed tech‐ and growth‐stock index, closed the year within range of its dot‐com intraday high of 5,132. Investors have favored the perceived safety of U.S. markets as they search for yield and hope for continued momentum in U.S. stocks. At the same time, many foreign stock markets seem less attractive as their economies suffer from uninspiring rates of growth and the risk of deflation.
Recent analysis of this rotation to U.S. securities often cites the declining price of energy as a risk instead of a positive for the global economy. Typically, a reduction in energy prices is a boon to economic growth. Consumers spend less to fill their gas tanks, boosting confidence and leaving more discretionary income for shopping. Some corporations, such as airlines and manufacturers, enjoy improved earnings as input costs decline. Even some energy companies can benefit depending on how they contribute to the supply chain. Inflation pressures subside since energy is an important (and volatile) component of the goods we consume as an economy.
The cause of the recent decline in energy prices is attributable to a number of factors. Some suggest that a number of countries are colluding to punish Russia, a country dependent on oil revenues. Others assume that U.S. shale energy exploration has created a glut. OPEC countries continue to pump and cannot agree on production curbs to support prices, flooding markets with cheap oil. Many have reasoned that slowing growth in emerging economies, particularly China, has stalled global demand. Most of us hope we are making a meaningful change in our consumption patterns by driving electric cars and installing solar. No matter the cause, and it is likely to be a combination of these things, this decline in energy prices is perceived as a sign of global economic weakness, not a harbinger of growth ahead. In other words, this time is different.
The energy complex still seems promising in the U.S. According to the Economist, jobs in energy have nearly doubled since 2005. North Dakota has reduced its unemployment rate to 3% (well below the national average of 5.8%) due to energy sector job creation. The price of natural gas has remained low in the U.S. and periodically our newfound “energy independence” is boasted by a politician. Technology is helping the U.S. create supply that was too expensive to pump just a few years ago, but the declining price of oil, if sustained, could deter the economics of fracking. Even though energy production is a small part of our economy, this change could result in a reduction in the job creation we’ve enjoyed over the past few years. In this slow‐growth environment, every little bit counts.
For foreign markets, the results of falling oil prices are complex and intertwined with other political and economic events. Emerging markets, particularly those dependent on oil exports, have already felt the pinch of lower prices. Russian and Brazilian stocks fell nearly 33% and 15%, respectively, in the fourth quarter. The currencies have declined relative to the U.S. dollar, making imported goods that much more expensive. Both central banks have increased interest rates in the fourth quarter hoping to attract investment to support their currencies. Venezuela teeters on the brink of debt default because of declining oil revenues. For Europe, a large importer of foreign oil, declining prices threaten to contribute to disinflation or deflation, a circumstance that is difficult to control with central bank intervention and that is detrimental for stock prices.
While the drop in oil prices provides a welcome boost to household budgets, the magnitude of the drop and its impact on energy‐focused sectors and countries has the potential to increase stock market volatility in the year ahead.
Written by Colleen S. Supran, CFA, Principal; [email protected]
|Index||Market||Last 3 Months (10/1/2014 – 12/31/14)||Year-to-Date as of 12/31/14|
|Standard & Poor’s 500||Large Co. U.S. Stocks||4.94%||13.69%|
|Russell 1000 Value||Large Co. Value U.S. Stocks||4.99%||13.45%|
|Russell 2000||Small Co. U.S. Stocks||9.73%||4.90%|
|Russell 2000 Value||Small Co. Value U.S. Stocks||9.40%||4.22%|
|FTSE NAREIT Equity||Real Estate Investment Trusts||12.94%||28.03%|
|NASDAQ 100||Technology Stocks||4.62%||17.94%|
|MSCI EAFE1||Foreign Stocks||-3.57%||-4.90%|
|Barclays Aggregate||U.S. Dollar Bonds||1.79%||5.97%|
|Barclays Municipal||Municipal Bonds||1.37%||9.05%|
|BofA Merrill Global||Global Bonds||-1.05%||0.09%|
Key economic indicators compiled by Barbara A. Ziontz, CFP®, Portfolio Manager; [email protected]
Data Sources: The Wall Street Journal; U.S. Dept. of Commerce ‐ Bureau of Economic Analysis; U.S. Dept. of Labor; Bloomberg.com; Live.Lehman.com; MSCI.com; REIT.com; NYTimes.com; StandardandPoors.com; Vanguard.com; Dimensional Fund Advisors
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