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Question of the Week - February 23, 2015

Question of the Week - February 23, 2015

Guest Post - Monday, February 23, 2015

How are things stacking up so far for 2015?

This has been an unusual few months, with several themes working in 2014 carrying through to early January, and then reversing somewhat in recent weeks. This has surprised investors and forecasters that assumed that the momentum of 2014's trends would continue indefinitely. For one thing, indexes tracking economic surprises from Europe have now crossed over, from negative into positive territory and surpassing those of the U.S., which has seemingly lost a bit of momentum. This comes at a point where foreign assets and currencies were under intense scrutiny at year-end and were arguably hitting another round of pessimism, in keeping with 'it's different this time' in regard to the surging U.S. economy and dollar. This can be measured by not only anecdotal evidence, but also flows into such products as 'currency hedged equity' and other strategies aimed at getting the best of both worlds—retaining the benefits of a strong dollar but also tip-toeing into cheaper foreign markets as well. Unfortunately, getting the timing right and full benefits of diversification through such a narrow window of risk factors can be extremely difficult and not always straightforward.

On a technical level, the dollar has hit a patch of consolidation over the last few weeks, which may have been inevitable, given its meteoric rise higher in 2014. The intermediate-term streak of American leadership may not be over, but this serves as another reminder that 'few trees grow to the sky,' as a wise investor once said. Eventually, such trends can reverse, but it does take a bit of 'guts' to be on the opposite side of a popular trade—the more popular it gets and the more mainstream recognition it is given, a momentum effect can kick in, which perpetuates is popularity, but ultimately reverses, leaving the last folks to jump on the bandwagon disappointed.

Some bond investors have been left perplexed by the epic performance of long-duration government assets in 2014. With returns well into the double-digits, and estimates of rising rates last year not coming to pass, we hear of some bond managers now increasing duration in fears of either a 'new paradigm' or simply not wanting to 'miss out' on gains on that part of the yield curve. As much as that continued in January, rates have bumped up strongly since then, which would imply losses in many of these positions. Fixed income can be a complex area to navigate, with a variety of crosswinds, but when it comes down to it, it's all about the math. Even if the curve doesn't experience a parallel shift across all maturities at the same time, a smaller rate increase coupled with a very long duration can spell trouble. Very long bonds perform best in environments of falling rates, including conditions like stagnant growth or outright deflation.

Real estate was the big winner of 2014, notably REITs in the U.S., as low interest rates and stable economic growth led to what has been described as the best fundamental real estate backdrop in 15 years. This includes strong tenant demand, low vacancies and, as importantly, not a significant pickup in new building supply, which typically spells the downfall of real estate market cycles. So, there could be room for this to continue, and valuations are not excessive.

In commodities, conditions have also flattened somewhat in recent weeks. Here, with no cash flows to provide valuation guidance, it's about finding a supply/demand balance. Oil is a prime example, but the question became, how low will prices get and how long will they stay there? Estimates have been evolving, and even the most bullish (as in believing oil prices should be higher) seem to think it may take quite some time to see a return to where we were. This may pressure energy companies, but could certainly help consumer spending—although this could take time, as such impacts happen with a lag. If consumers expect oil/gas price savings to be a long-term phenomenon, it may start to affect big-ticket items, such as autos (especially SUVs and trucks) as well as other durable goods. However, if buyers think low oil/gas prices are temporary, they may splurge a bit more on restaurant meals and lower-end purchases (which has happened) but may hold off on the more expensive things.

Some recent work by investment firm GMO most recently demonstrated (we say 'most recently' as it's been pointed out by others as well) that 3-year winners on a trailing basis often turn out to be losers over the next few years (and vice versa). This appears to be true whether one is looking at equity markets or country GDP growth. GDP can matter in the short-term, but has been shown to be less relevant for equity returns over the long run, where valuations and earnings growth play a much larger role. In today's world, where a multi-national firm could be based in one domicile yet earn revenues completely unrelated to where it's headquartered (Unilever and Colgate-Palmolive are two key examples), this lack of correlation between GDP and country equity returns is even more distinct. Longer-term, it seems 'GDP surprises,' or conditions turning out better than expected (even if still poor at the time), is an even better catalyst than any type of nominal ranking. Earnings surprises have this same characteristic, which again feeds into the market reaction to the current 'known' versus an outcome better than we first expected. If we already expect good things, there is usually less room for upward surprises.

Additional Reading

Read our Weekly Review for February 23, 2015.

Read the previous Question of the Week for February 23, 2015.

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