The year has begun in roller coaster fashion, and our team has been busy reading and digesting the many 2015 outlooks that come across our desks. But reading is the easy part, and now it’s our turn to distill the many facets of our process into a workable thesis that allows us to generate attractive risk-adjusted returns in this maturing market cycle. As tactical managers, we’re well aware that forecasts are always fraught with risk, but we also realize that in order to look forward, we need to have views that set the tone for the portfolio in the coming year. Below is our best articulation of how we see the investing world shaping up over the next year or two. Our aim is to inform you of our views, and to explain how they affect current asset allocation decisions.
Riding an Aging Bull Market
One of the first things to recognize is that the current bull market is not in the early innings anymore. In fact, at this point the market is approaching almost six years in age, and the S&P 500 is up approximately 238% with dividends off the bottom in March 2009. Even believers in the theory that the 2011 downturn was a mini bear market have seen a run of approximately 90% since then, with very little volatility along the way. While no one knows precisely how long the bull will last, what seems obvious is that stocks are edging closer to the end of this torrid run than to the beginning. That in itself implies that it is not a time to overreach for returns, but it doesn’t say anything about whether it’s time to bail on the bull or keep holding on tight for the remainder of the ride.
For that answer we must turn to the building blocks of our process to determine whether or not to remain near neutral levels of overall risk. Currently the message from the indicators we follow is mixed. Positives can be found in the form of a healthy U.S. economy, reflationary policies from overseas central banks, bullish quantitative models, and relative undervaluation in overseas markets. Negatives can be seen in a fading U.S. monetary policy impulse, weaker global economies, overvalued U.S. equities, and technical conditions that are showing some cracks beneath the surface. There is also the wild card of rapidly plunging oil prices, which we believe will ultimately be reflationary for the U.S. economy, but which also carries the risk of collateral damage for oil-sensitive companies and economies.
At this point the signals are mixed enough to keep us at neutral levels of portfolio volatility. We may be getting late in the move, and we’ll have to keep looking for more signs that this cycle is running out of steam, but for now we continue to ride an aging bull market, and our focus is on security selection rather than making a risky bet with overall asset allocation.
Themes for 2015
One way to focus on how best to position in this environment is to identify the themes that we believe may dominate the backdrop over the next year or two. For 2015 a number of things have risen to the surface that should help provide a roadmap of where to best capture returns.
Theme 1: Follow the Dollar
The first theme that we believe has both cyclical and secular legs is the likelihood of continued strength in the U.S. dollar. In a world where several foreign currencies are being devalued in an attempt to support struggling economies, the dollar enjoys a number of key attributes that should keep it buoyant. Some examples are healthier economic growth than foreign economies, the likelihood of interest rate hikes later this year, improving budget and trade deficits, low inflation, and a stable destination for foreign direct investment. The U.S. dollar will also likely continue to benefit from an unwinding of the commodity super cycle, which seems to be underway.
Since the 1970s bull markets in the dollar have lasted for roughly five years in duration and have gained nearly 50% on average, so it is conceivable that the current move may only be around its halfway point if things play out similarly to prior cycles. The biggest risk to this view probably lies in the fact that the dollar is overbought and over-invested in the short-term, and a countertrend correction could unfold at any time. However, any dips that occur would likely make an attractive entry point as long as the current supports for the dollar remain intact.
How to Play a Strong Dollar
In a globally diversified portfolio, there are many ways to take advantage of a strong dollar environment. These range from the obvious to the slightly more nuanced. In Pinnacle portfolios we will play this theme in the following ways:
1. Overweight domestic stocks, underweight foreign stocks
Since our investors are interested in maximizing returns in dollar terms, simply removing some foreign currency by reducing international exposure is one of the most direct ways to position for a stronger dollar.
2. Increase currency hedged vehicles in international investments
Currency-hedged instruments are widely available nowadays, and we believe that hedging (or reducing) currency exposure in certain international positions is prudent, particularly with foreign central banks that are actively driving down their currencies to support growth and equity prices.
3. Avoid U.S. sectors with strong negative correlations to the dollar while increasing exposure to those that have a positive correlation
Underweight Energy, Materials and global Industrials while overweighting domestically-focused Transportation and Consumer stocks.
4. Reduce exposure to commodities
Commodities are likely to remain weak and historically carry a very negative correlation to the dollar.
5. Use the dollar as a fixed income alternative
The dollar has a similar volatility profile as the aggregate bond universe. However, unlike bonds it has very little sensitivity to changes in interest rates, making it a potentially helpful diversifier within fixed income portfolios.
Theme 2: Follow Central Bank Liquidity
2014 began a major shift in global central bank policies, and 2015 seems set for divergences to continue to build. We currently anticipate that the Federal Reserve will begin to normalize short-term rates sometime around the middle of this year. Importantly, the Fed has shown patience and a willingness to err on the side of keeping policy loose so as not to short circuit the economic recovery. With that in mind, the current low inflation environment will likely give policymakers plenty of reasons to proceed cautiously. But assuming the economy continues to expand, employment continues its upward trend, and no major external shocks occur, it is increasingly likely that the Fed will begin to normalize policy by hiking rates later this year.
At the same time that the Fed is beginning to tap the brakes, other major banks are jamming the pedal to the metal in an attempt to lift inflation expectations, asset prices, and growth rates. Japan is clearly intent on ending its battle with deflation, and the Bank of Japan is buying an unprecedented amount of assets with the goal of achieving higher inflation expectations. Time will tell if the strategy will work as intended, and there are clearly structural and demographic hurdles that Japan faces that will make their goal an uphill challenge. What seems clear is that the BOJ is committed to higher inflation, and that it will likely continue to weaken its currency and print money until it gets the desired effect (or markets force it to adjust). We’re not sure how effective the policy will be in the long run, but on a cyclical horizon this prescription ought to stimulate more asset inflation in Japan. Therefore, Japan offers an opportunity… though U.S. investors need to protect against further weakness in the yen if the BOJ is intent on driving it lower.
Elsewhere, the European Central Bank (ECB) has its eyes set on price stability, but the soggy nature of world growth and cratering commodity prices has inflation falling at a rate that approaches outright price deflation. As a result, the bank just announced its own quantitative easing program that will involve the purchase of $1.3 trillion of European bonds over the next year and a half. Europe’s banking system is more complicated than that in Japan or the U.S., but the ECB has shown a clear commitment to jumpstarting the Eurozone economy. Despite very low growth rates and continuing structural challenges, the ECB’s measures are likely to boost asset prices over a cyclical time frame just as they have in other markets with QE programs. So despite sour sentiment towards European assets at the moment, we think Europe also offers an opportunity, mainly due to central bank largesse.
Theme 3: Avoid Emerging Markets Value Traps
Emerging markets (EMs) have enjoyed higher growth rates than developed markets for many years, making them a popular choice for investors. But more recently EMs have underperformed, creating the perception that they offer good value. On the surface many EM countries do have lower price-to-earnings ratios compared to developed markets, but that may be more of a value trap than representative of true underlying opportunity.
A decade ago a solid portfolio was built on the back of the BRICs (short for Brazil, Russia, India, and China). Today however half of that BRIC complex is in recession, with Russia in complete turmoil driven by sanctions, plummeting oil, and a collapsing currency. Brazil is facing an inflationary recession, while China is experiencing a slowdown due to a bumpy transition from an investment-led growth strategy to a more consumption oriented model.
Lastly, many emerging markets countries are commodity producers, which will likely continue to put pressure on their economies as commodity prices fall. In short, emerging markets are no longer the slam dunk that they were several years ago, and many countries are likely cheap for a reason. While there may be select markets that have compelling stories and ultimately buck the trend, we view the broad emerging market asset class with skepticism.
Theme 4: Prepare for More Disinflation
A strong dollar coupled with weak commodities and slower growth outside of the U.S. is an inherently disinflationary combination for the global economy. While U.S. Treasury bonds have seemingly lacked value for several years, we don’t believe that longer-term rates are headed significantly higher in the near-term due to the lack of inflation pressures and a yield pickup relative to bonds of other global economies that are even lower. For large foreign buyers, an appreciating U.S. dollar is an added benefit that could sustain a surprisingly strong level of demand for Treasuries, even at these yield levels.
Therefore, despite paltry absolute levels on yields, we think investors should carry no less than neutral levels of interest rate sensitivity in portfolios. Pinnacle fixed income portfolios are currently positioned with a barbell approach that consists of a combination of high quality bonds that can help protect against a global tip towards deflation, paired with credit-sensitive bonds that provide extra yield and will likely benefit from an improving U.S. economy. Despite the temptation to bottom fish in energy-related bonds that have suffered recently due to the drop in oil, we continue to prefer more conservative strategies due to the age of the credit cycle and valuations on non-energy related issues that are still attractive (but aren’t screaming bargains).
In sum, we believe that there are still plenty of opportunities for investors, despite an aging market cycle. We have already taken steps to position portfolios to take advantage of the more attractive ideas that we currently identify, without significantly increasing overall levels of risk. As usual, our views are subject to change if market conditions dictate, but we remain cautiously optimistic as 2015 gets underway.