The first quarter of 2015 is just over and it has been fairly disappointing for most investors. The S&P 500 was up 0.45% and the Dow Industrial Average was down -0.24%.
In 2014 the pundits couldn’t seem to resist the temptation to use the phrase “cleanest dirty shirt” to describe the idea that despite The U.S. economy being far from perfect, the U.S. was still the most attractive place to invest. We haven’t heard that much in 2015. What has changed is the realization that money is made at the margin and at the margin, other countries and regions have become more compelling:
- Europe – European countries do not have the rate of economic growth that the US is experiencing (2.2% GDP growth at last check), but Europe is clearly improving from previous quarters, where our growth appears stalled out. Europe is experiencing the benefits of sharply lower oil prices as all but Norway and the U.K. are oil importers. Their experience with quantitative easing is starting to bear fruit as the positives of increased export competitiveness outweigh the negatives of higher import prices. Earnings estimates are starting to rise. This contrasts with the U.S. where the earnings decline in the energy sector has not yet been offset by earnings increases in the consumer sector as had been expected. Dollar-based investors in Europe are up 4.3% this year through March 28th; in local currencies the gain is 11.3%.
- Asia (ex-Japan) – Asian countries tend to have their own currencies, unlike Europe, so it is harder to generalize about monetary policy. Suffice it to say they have been affected by the suddenly much more competitive Euro. China has responded by increasing reserves in its banking system, whereas raw material-exporting countries like Australia have seen their currency fall precipitously without having to resort to extraordinary financial measures. India has been helped by hopes for reform and the fact that it may have the world’s most favorable demographics. All in all, Asia (ex-Japan) is up 5.1%.
- Japan – Japan has been actively taking measures to weaken its currency for almost three years, and the pay-off has really been there this year for equity investors. The yen has fallen sharply this year (though it has risen in March) to a level that enables its extremely efficient exporters to post strong profits. It’s year to date gain is 11.3%.
It’s important to understand that when a country or region seeks to weaken its currency to try to improve its trade position, the gains are not instantaneous. Usually the currency needs to fall through a certain level before the markets really start to believe. For the Euro, that level was $1.18 give or take two cents. Once the Euro fell below that level, investors began to revise profit estimates in earnest. If, like China, the country more directly stimulates the economy by injecting liquidity into the banking sector, then the payoff to investors is usually immediate.
In any event, the relative out-performance of the U.S. relative to the rest of the world since 2009 has been enormous. This year has provided the first sign that the trend is reversing. I expect that the trend reversal will continue, barring a major adverse surprise. What I don’t know is whether this will mean U.S. market performance goes negative or is just less positive. The fact that the U.S. is the only major economy to be contemplating raising interest rates increases the likelihood that investors heavily weighted toward U.S. stocks will be disappointed.
Growth versus Value
Growth stocks continue to outpace Value stocks this year. The margin of victory is 624 basis points year-to-date.
The superior performance of the growth-heavy health care sector and the dismal showing of the lower P/E energy, utilities, and financial services sectors explain a lot of it. If you look back, value hasn’t meaningfully outperformed growth in any year since 2006 (the last year in an amazing run of value outperformance that began in 2000). A recent study suggests that the so-called “value premium” exists because value as a discipline is so hard to stick with over the long term because of long fallow periods like we’re currently experiencing. The takeaway: it may not be wise to try to take advantage of the value premium if you, or your clients, do not have the patience to see it through.
Bonds have provided surprisingly good returns yet again this quarter so far. The Barclays Aggregate Bond Index has advanced 1.2%, while some more adventurous funds have added a percent or more by taking more credit risk.
I am ambivalent about the merits of moving down the credit spectrum at this point. I suspect it will pay off for several more months, but the volatility may not be worth the added total return. My best idea is to be long duration in high quality bonds and short duration in “junk” or lower credit quality bonds. The latter might find the going a bit tougher if rising short term rates make refinancing trickier.