At the beginning of the year, we identified several themes that might drive investment markets in 2015. Forecasting is a hazardous process, but it’s part of the job for tactical managers who have the freedom to move portfolios according to changes in macro and market conditions.
I recently reviewed our themes for the year (written up in detail in our latest quarterly), and made a few notes regarding how those themes are playing out.
Theme 1: Follow the dollar
We employ a strong dollar theme in multiple ways, including overweighting domestic stocks, increasing hedged currency vehicles, avoiding sectors with negative correlation to the dollar (i.e., energy/materials), reducing commodity exposure, and buying the dollar as a fixed alternative.
Working: The overall theme has caught fire as the dollar index has been surging versus a wide swath of global currencies.
Working: Currency hedged vehicles are crushing their local currency equivalents, particularly in Europe and Japan.
Working: Buying the dollar outright in fixed income has produced far greater returns than cash, and healthy positive returns versus a flat bond market.
Working: Being underweight commodities has been beneficial as they have already suffered a healthy decline this year.
Partially working: Being underweight energy stocks is still paying dividends, but materials have done better than the broad market (SPY).
Partially Working: Reducing international equity exposure for domestic exposure. This is working if one looks at a generic index of emerging stocks versus domestic stocks, but not working for parts of the world that have produced returns in excess of the broad S&P 500 (e.g., Europe and Japan).
Theme 2: Follow central bank liquidity
This theme acknowledged that divergences were beginning to crop up among central banks, and in particular highlighted the fact that the BOJ and ECB were upping stimulus efforts. This offered an opportunity to participate in markets that seemed primed for asset inflation based on continuing central bank largesse.
Working: Currency-hedged Japan, which has handily outpaced the EAFE benchmark on the year.
Working: Currency-hedged Europe, which has crushed the EAFE benchmark so far this year, with a large kicker coming from the currency hedge that has removed exposure to a plummeting Euro.
Theme 3: Avoid emerging market value traps
This theme is based on the idea that although emerging markets had a cheap P/E, they were likely a value trap. Note: Several other value traps were not mentioned in the piece, but we are steering clear of them, as well (e.g., we think the commodities super cycle is dead).
Working: The broad emerging market universe is trailing the developed world, as both share prices and currency values are under pressure.
Theme 4: Prepare for more disinflation
The thesis of this theme is that a strong dollar and weak commodity backdrop, combined with weak international growth, is a recipe for keeping inflation down and bond yields at bay. Therefore we concluded that duration profiles should be neutral, and that investors should barbell a portfolio between high quality bonds and credit that could benefit from strong U.S. balance sheets.
Working: Credit is currently outperforming the broad market, particularly defensively positioned short term high yield and bank loans.
Not Working: High quality government bonds. Although U.S. headline inflation has dropped precipitously over the past few months, bond yields have backed up on a flight out of quality and into risk, a perception that Euro area growth is recovering, a cooling off in geo political risk (think Russia/Ukraine), and an increase in the term premium.
In a globally diversified portfolio, there will always be positions that are winning and losing. While not everything we have forecasted is working according to plan, it’s nice to see that many of our themes are playing out as expected.