2015 will likely be a transitional year for the markets. As financial advisors meet with their clients at or around the beginning of the new year, they should be mindful of these economic and market trends:
- The US economy is likely headed toward peak rates of growth. In order for the economy to accelerate from the almost 4% real GDP rate of 2014’s third quarter, a number of changes have to take place:
- Productivity will need to rise. Over the past seven years, productivity (output per hour worked) has risen about 1.5% annually–down from 2.6% the previous seven years. Business technology spending growth was below trend coming out of the 2007-2009 market debacle. There are signs that technology spending is accelerating which may not only help earnings growth in this sector, but lead to productivity improvements across the economy.
- Wage growth has lagged behind productivity growth. Until the 1980s, individual income growth was in line with productivity growth. Since then, the benefits of productivity growth have, for the most part, accrued to providers of capital. These individuals do not consume to the same extent as the typical worker and reduces potential economic growth.
- Recent declines in oil prices are putting cash in consumers’ pockets and purses. Although this helps holiday season retail sales, much of the additional cash flow will be used to reduce consumers’ extended debt levels.
- International economies continue to experience tepid growth. Although their central banks will accelerate the pace of money supply increases, Europe and Japan have structural problems that preclude strong growth. The resultant low-interest rates will:
- Keep Europe out of recession;
- Lift Japan to zero growth;
- Increase demand for U.S. dollar assets.
Emerging markets growth will continue to outpace that of the developed markets with the possibility for acceleration as commodity prices bottom and US economic growth boosts emerging market goods’ demand.
- U.S. equity markets will continue to perform well as earnings growth produces positive surprises and the Federal Reserve keeps interest rates low. Although the rising U.S. dollar will negatively impact multinational and resource-based companies, other sectors will benefit from increased revenues due to secular changes as well as cyclical strength:
- Financial companies are seeing a rebound in demand as consumers’ balance sheets are being repaired.
- The Affordable Care Act has led to greater demand throughout the health care sector.
- Technology spending is lifting from its below trend behavior as replacement and upgrade cycles are in the acceleration phase.
- Therefore, investors need to be on the lookout for the following events that may impact equities negatively:
- As the Federal Reserve begins raising interest rates, investors often become nervous about the pace of increases. This can lead to stock price declines until the picture becomes clearer.
- If commodity (especially, oil) prices rebound, concerns may increase that consumers will reduce their enthusiasm for spending.
- Investor sentiment could turn negative due to a variety of geopolitical events that are unforeseen at the present time.
Recommendation: For the past few years, the phrase “be long or be wrong” has been a key in the U.S. Stock Market. iSectors’ top performing allocation over the past three years is Domestic Equity, which is always fully invested in stocks (past performance is not indicative of future returns). But given the equity market’s fair valuation and the potential for a bumpy ride (or even a top) in 2015, advisors should consider switching some or all of their clients’ equity allocations to a dynamic strategy. According to Morningstar, iSectors Post-MPT Growth has been a top exchange-traded fund (ETF) strategy over the past five years even during the 2011 market correction. Throughout its ten-year history, Post-MPT Growth has shielded portfolios from the full effect of market declines by allocating to low and uncorrelated asset classes such as utilities, bonds, and gold. The strategy has participated in bull markets by owning leveraged ETFs. Such an allocation may provide the insurance necessary to participate in the equity market in 2015.
- U.S. fixed income markets continue to be unattractive. The combination of low nominal rates, negative real short-term yields, and a Federal Reserve increasing short rates will not lead to robust total returns for U.S. bonds in 2015. We agree with Fed Fund futures that the first Fed tightening will take place in the summer of 2015 with year-end Fed Funds in the 0.50% to 0.75% range. The futures predict that year-end 2016 Fed Funds will be in the 1.50% to 1.75% range. Thus the market expects a 25 basis point increase every other meeting once the Federal Open Market Committee begins the tightening cycle. But this slow pace is already reflected in current interest rates. Since there is greater risk that the pace of increases will be quicker rather than slower compared to current market indications, U.S. fixed income investors need to be concerned about rising interest rates.
Recommendations: The reasons to hold bonds historically stem from their features that provide attractively priced diversification from equities including:
- Capital preservation;
- High levels of income to offset inflation;
- Returns uncorrelated with the equity markets.
Given current fixed income market conditions, these risk-reducing attributes are in jeopardy. It will be perilous to hold a bond portfolio strongly indexed to a standard benchmark such as the Barclays Capital U.S. Aggregate Bond Index. For instance, the Aggregate Index has the duration of about 5.5 meaning that for every one percentage point increase in interest rates, the value of the index will decline 5.5%. Since the index yields 2.2%, it will take a small increase in rates (approximately 40 basis points) to wipe out a year of yield and experience capital depreciation. Even if interest rates do not increase, the index’s 2.2% yield is barely above the expected inflation rate of 2% in the coming years. Finally, given the recent record levels of equity prices and the prospect of declining economic growth in the years ahead, there may be periods when rising interest rates (falling bond prices) and declining equity prices go hand-in-hand.
Therefore, financial advisors will need to take a multi-allocation approach to invest the non-equity portions of client portfolios and provide effective diversification. We recommend that all three of the following approaches be utilized to meet this goal:
- Enhanced cash allocation – The iSectors Capital Preservation Allocation is comprised of short maturity Treasury, global investment-grade and high yield corporate, and mortgage securities with a capital preservation objective and greater return potential than can be provided by money market or cash equivalent portfolios.
- Global conservatively invested balanced allocation – The iSectors Global Conservative Allocation owns a global investment grade and high yield portfolio to diversify from the potential rise in U.S. interest rates and receive enhanced current yield (75% of the Allocation). The other one-quarter of the Allocation is comprised of a global developed and emerging market dividend oriented equity portfolio for extra yield (higher that of the Barclays Aggregate Index) and return potential.
- Exchange-traded alternatives allocation – The iSectors Liquid Alternatives Allocation is a portfolio of hedged strategies, private equity, and real assets using ETFs, mutual funds and other exchange-traded securities that should create a return pattern highly diversified from the stock and bond markets.
- Model Portfolios: – Since each client has different objectives and risk tolerance, it is difficult to create model portfolios that are applicable in every, or even most, cases. Financial advisors are responsible to take this information and determine the best investment program for each client. As a benchmark from which to start, an advisor with a client with moderate risk tolerance that has historically been invested in a standard 60% stock and 40% bond portfolio (minimum $500,000), may wish to consider the following allocation design:
- 60% – iSectors Post MPT Growth (Risk-managed equities).
- 20% – iSectors Capital Preservation (Capital preservation with yield).
- 10% – iSectors Global Conservative (Global sources of yield).
- 10% – iSectors Liquid Alternatives (Diversified sources of returns).
Again, this portfolio should only serve as a guide for financial advisors.
If you are a financial advisor, and would like to discuss a client’s specific portfolio needs, please contact Scott Jones at 1.800.869.5184 or [email protected].