Quarterly Investment Outlook: December 2014

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SUMMARY

  • U.S. real GDP growth is tracking at 2.2%, which is roughly in line with real income less transfer payments.  This is close to estimated potential GDP growth of 2% (.5% from labor force plus 1.5% labor productivity).
  • Bloomberg consensus growth estimates for 2015 are 3% for the U.S. economy.  This seems high.  Nevertheless, growth should get a boost from an accommodative Fed, modest fiscal drag, low interest rates and the recent decline in oil prices.
  • The Eurozone will continue to struggle under the weight of high debt/GDP in the peripheral countries, which may be exacerbated by the ECB’s inability to initiate QE.  However, following the Asset Quality Review, banks should be more willing to extend credit to small businesses and households.  Low interest rates and oil prices should also buoy aggregate demand, coupled with the lagged effect of a weaker euro.  Eurozone equities remain cheap as they trade at roughly a 50% discount to the U.S. on a cyclically adjusted price earnings ratio.  The bar for a period of outperformance is low.  The European Economic Surprise Index has bottomed and is moving higher.  Spanish banks look attractive!
  • In Japan, Abenomics (code word for massive yen devaluation), has generated a yoy inflation rate of 0.9%, with the country still mired in recession.  Unfortunately the "third arrow" (consisting of structural reforms) is nowhere to be found. Other Asian nations have seen their currency weaken recently, so it's unclear whether Japan's strategy is working.
  • A recent PBOC decision to lower policy rates in China has boosted investor confidence. The Shanghai Composite has broken out of a seven year bear market.  Borrowing costs remain high for small businesses, which has resulted in a lack of credit demand.  More stimulus will be needed!
  • The above average strong performance of long duration U.S. treasuries is getting "long in the tooth."  Early in 2014 few investors were concerned with deflation.  Most expected yields to rise and maintained fixed income portfolios that were short duration.  The collapse in oil prices, due largely to a supply shock, has caused bond investors to panic into treasuries, extrapolating that the decline in inflation expectations will lead to a decline in general price level inflation.  We take this as a contrarian signal and expect to dial down our risk profile and reposition fixed income portfolios to average duration on future market strength.
  • While modest U.S. growth and stable inflation is positive for U.S. equities, at 16x forward estimates the S&P 500 has already discounted this "Goldilocks" environment.  However, valuations have rarely been a good market timing tool.  With the Fed on hold, possibly for all of 2015, the market could witness a classic melt-up.  We intend to continue de-risking our client's portfolios and have officially adopted a cautious investment strategy.

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