First Quarter Market Update

Strong Dollar

The U.S. dollar is strengthening against other currencies reflecting a more robust economy as well as the anticipation of higher interest rates in the U.S. Also, other nations have attempted to weaken their own currencies in order to benefit exports and tourism in their regions.The effect of the strong dollar is that investments abroad are worth less for U.S. investors in dollar terms. We saw an extreme example of this as Japanese stocks posted a 9.5% 2014 return in local currency. A U.S. based investor, however, realized a -4.2% loss after adjusting for the strengthening dollar. This dynamic is also having a chilling effect on the earnings of Mutli-national US based corporations.

Interest Rates

Interest rates in the US remain depressed despite the unwinding of the Federal Reserves QE (Quantitative Easing) program.  In 2014 interest rates actually fell. Much of the rally in bonds was a result of the US being seen as a safe haven for fixed income compared to the rest of the developed world.  Whether this trend will continue remains to be seen, though there has been a slight rise in rates over the most recent 30 day period.


On Oil and US equities: Since 1974, there have been seven episodes of 35%+ declines in oil within a short period; equity market behavior was all over the map. When you consider the circumstances behind each, the outcomes make more sense. When the primary issue was increased oil production combined with improvements in oil efficiency, equity markets did well. When the primary issue was a recessionary decline in demand, equities did poorly. As a rough estimate, the current oil price collapse reflects more of the former (supply shock and increased efficiency) than the latter (demand decline in Europe and China due to weak growth). If so, the net impact on US equities should be a mild net positive. Its difficult to predict where the price of oil will settle, but taking into account the lower demand from China and Europe, and the lack of response from OPEC, its difficult to see oil recover to $90+ in the very near future.

The US 

The big picture, is broadly positive. The US is in the middle of the economic cycle rather than at the end. Over the next decade, its is expected that the current energy account deficit will narrow, a by-product of reduced oil and gas imports and/or increased exports. Corporate cash flow and cash balances are strong, giving US companies ammunition to hire and invest as the economy improves. In terms of investment, a composite of regional Fed surveys shows a solid rise in corporate capital spending plans in 2015; note that only 10%-15% of business investment ex-software is related to oil & mining.

2013 was a great year for US equity markets, but not for earnings: there was almost no earnings or revenue growth at all that year. Earnings growth began to pick up again in 2014, and based on manufacturing survey signals, S&P 500 earnings growth should be 7%-8% in 2015 after accounting for the drags from a stronger dollar and declines in energy sector earnings.

How much are investors paying for this good news? While P/E ratios computed on a market-cap weighted basis look average compared to the last 30 years, they are distorted by sky-high P/Es during the tech bubble. The P/E on the median stock is more meaningful, and is approaching its historical limits for a mid-cycle period. Its not beyond reason to expect limited (if any) multiple expansion in 2015, and equity market returns to broadly track earnings growth, as they did in 2014. Over the last couple of years, two solid sectors have been Technology and Healthcare. Both outperformed the S&P 500 in 2014, and there is no reason not to expect the same in 2015.

The Fed.  

The Federal Reserve is expected to raise interest rates in 2015.  While not set in stone, if a rate hike occurs it is expected to be gradual. The reasons: The US is in the middle of the cycle not the end, and depressed oil prices and a strong dollar should tame inflation.  Additionally capital spending and durable goods purchases are still relatively low, and the output gap (a proxy for excess capacity) is still large. Recessions tend to happen when rising investment and scarce capacity drive up inflation and force the Fed to raise the cost of money well above the rate of inflation to cool things off. That’s not widely expected in 2015 or 2016.


The 2015 outlook is likely to continue to be dominated by the potential impact of central bank decisions. A key difference from recent years is that we are likely to see bankers heading in different directions as the U.S. begins to raise rates while European and Japanese central bankers are likely to pursue more quantitative easing (QE) and keep rates low.

Stocks tend to be a leading indicator of the economy. However; if there is a US rate hike, equities will likely react quickly, then settle and watch for the real economic impact of such hike.  As long as the U.S. continues on a moderate growth path, stocks could still provide modestly positive returns even from today’s elevated levels, and should outperform bonds. Additionally, even though their P/E levels are elevated, foreign stocks could benefit from QE programs in the EU and Japan.

The importance of adequate savings rates and proper diversification, based on risk tolerance and/or time horizon, must continue to be reinforced.  When investors and retirement plan participants experience the multi-year euphoria of a bull run, it can be tempting to deviate off course by chasing performance and taking on excessive portfolio risk.