|All the CIO interviews|
As the largest equity market in the world – representing 52% of global market cap – the S&P 500’s total return of 13.7% was a notable surprise last year, albeit a pleasant one. While we had forecast a positive return and advised clients to remain invested in US equities, the double-digit increase was much stronger than we expected.
The chief difference from our forecast resulted not from better-than-expected earnings growth, but rather a further expansion in valuation multiples from already elevated levels on the back of lower interest rates. This unexpected decline in rates was the second surprise last year. Contrary to almost universal expectations of a further increase, long-term rates declined instead.
In the US, yields at the long-end were primarily pressured by concerns about US trend growth, loose monetary policy abroad, purchases by the Federal Reserve through October of last year and purchases by foreign investors in search of yield.
Lower oil prices – the third surprise of 2014 – also contributed to the decline in interest rates. Oil’s sharp drop in the second half of the year was unexpected both in magnitude and speed. The oil price has declined 56% from its peak in July; a decline of similar character has only been seen three times since 1984.
What regions are you expecting to see the most growth this year?
We expect the US transition from mid-2% growth to an above-trend growth pace of more than 3% will be the most important growth development in 2015.
While some emerging markets (EMs), such as China and India, are likely to post faster growth rates, the US remains the single-most important driver of the global economy. For example, according to the IMF, a 1% negative surprise in US growth would lower other countries’ GDP growth by 0.2% – double the impact of similar growth surprises in Japan and China. As the IMF writes: “Only the US seems to matter profoundly to everyone.”
The expected acceleration in US GDP growth is driven by a combination of dissipating fiscal and balance-sheet headwinds, strong employment growth and the collapse in the oil price. In contrast, other major developed countries will work hard to stay out of recession by simply maintaining sub-1% growth rates. Outside of the developed markets, we expect growth in EMs to slow.
What is your view on fixed income for 2015?
We recommend that investors underweight investment-grade fixed income because we expect US interest rates to gradually rise this year, resulting in price losses that exceed today’s low bond yields. Even if conditions in the rest of the world weaken, or slower-than-expected inflation delays Federal Reserve policy tightening, we believe the ongoing improvements in US employment will warrant an increase in the Fed funds rate later this year.
We expect the policy rate to be in the 0.75% to 1.00% range by year-end. As the policy rate starts to rise and pushes up long-term yields, long duration instruments could quickly give up their entire yield in capital losses. That said, other areas of the fixed-income market, such as high yield, continue to offer attractive spreads relative to our view of expected defaults.
What asset classes do you expect to outperform in 2015?
Pockets of the equity market offer potential for the strongest returns in 2015. In the US, shares of banks are likely to outperform thanks to accelerating loan growth, rising rates, an attractive multiple – P/B multiple has been higher 72% of the time since 1988 – and increased capital distributions to shareholders.
Outside of the US, we see strong return potential in Japanese and Spanish equities, both on a currency-hedged basis. Japanese shares should benefit from Japanese yen depreciation, continued monetary easing, investment inflows and accelerating GDP growth domestically as well as in the US (Japanese companies’ second-largest customer after domestic Japan).
Prospects are also positive for Spanish equities, due to a combination of attractive valuations, the ongoing benefits of structural reforms and potential earnings growth that exceeds that of the broader eurozone. Moreover, the ECB’s newly announced quantitative easing (QE) programme provides another important tailwind, similar to the tailwind that Federal Reserve and Bank of Japan QE provided their equity markets.
Biggest unknowns/risk for 2015?
It is said that the only certainty is uncertainty, and 2015 has its fair share. The beginning of policy rate normalization is the most significant risk to the US economy. While we do not expect a disorderly transition to policy normalization that would impact the real economy, it cannot be ruled out.
Additionally, monetary policy errors in Europe or Japan could have negative consequences, as could political discord in Europe. Already, upcoming elections in Greece, Spain and Portugal and rising populism across the eurozone are threatening reform momentum and undermining confidence in the region’s fragile recovery.
Ongoing flare-ups in several geopolitical hot-spots also remains a risk this year – ranging from North Korea, to the progression of ISIL, to the war in Syria, to the potential for an oil shock from Venezuela, Nigeria or Libya.
Finally, while an Ebola epidemic spreading beyond Liberia, Sierra Leone and Guinea is a low-probability risk, West Africa is far from free of Ebola. We expect these and other unknowable risks to make headlines throughout 2015.