U.S. equities posted strong calendar-year gains once again as the S&P 500 Index and Dow Jones reached record levels on multiple occasions. However, these advances were far from broad-based across capital markets. A sharp rally in the U.S. dollar (USD) and tumbling oil prices were critical factors that resulted in a stark contrast between the first and second half results for many asset classes. These factors had wide-ranging effects, including the quick reversal of the year-to-date gains posted by natural resource stocks and commodity indices through June.
During the first half of the year, the USD was largely stagnant, but the second half was a different story. The Dollar Spot Index rallied 13.2% from June 30th forward, while the Federal Reserve’s Broad Index of the Foreign Exchange Value of the Dollar (a broader trade-weighted measure of the value of the USD compared to U.S. trading partners) gained 9.4%. Weak economic data and deflationary pressures in Europe and Japan stoked expectations that policy divergence would widen. Markets began anticipating the need for more significant policy accommodation from the European Central Bank (ECB) and the Bank of Japan (BoJ). Meanwhile, U.S. economic data continued to show improvement and the Fed actively wound down its quantitative easing measures.
The first half also saw the 2-year U.S. Treasury note rise 8 bps to 0.46%. However, by the end of December it vaulted to 0.67%. Conversely, the 2-year German bund, a proxy for European rates, fell 20 bps to 0.03% in the first half and plunged further to −0.11% by year-end. Similarly, the 2-year Japanese Government Bond yield fell 2 bps in the first six months to 0.07%, only to drop to −0.03% by year’s end. These relative yield differentials to the U.S. were additional factors driving the USD rally against other G3 currencies, with the greenback gaining 11.6% against the euro and 15.4% against the yen.
The market consensus heading into 2014 was that U.S. interest rates out the curve would continue to rise as the Federal Reserve tapered its bond purchases, and the economy would continue to improve. But the market moved strongly counter to conventional wisdom as the relative attractiveness of U.S. yields to other developed markets caused heightened demand for intermediate and long-term U.S. Treasuries. Federal Reserve data showed China increased U.S. Treasuries holdings by $183.9 billion from the start of the year through October. It was the largest absolute first 10-month increase in purchases since records began in 1977 and exceeded the total of the previous calendar year by more than $100 billion. Beyond the impact of China’s increased demand, Treasury issuance was also lower in 2014 as the federal deficit contracted and tax receipts rose due to the improving economy. Other factors likely contributing to the decline in U.S. Treasury yields included ongoing geopolitical risks and the continual shift by pension funds toward long duration-focused strategies. In this environment, the 10-year U.S. Treasury yield fell 73 bps to end the year at 2.2% and the Treasury yield curve flattened.
Another major theme broadly impacting capital markets was the sharp decline of crude oil prices, which plummeted 45.9% over the calendar year. WTI closed at $53.27 per barrel, the lowest spot price since the depths of the financial crisis more than five years ago. Prices advanced incrementally in the first half, from $98 per barrel to a peak of $107 in late July as daily production was threatened by escalating geopolitical risk in the Middle East, Nigeria, and Ukraine/Russia. A myriad of factors then triggered a dramatic price slide, including continued growth in global crude supply—led by a renaissance in U.S. production. Through October, increased shale-drilling activity combined with consistent advances in technology boosted daily U.S. crude production by 13% year–over-year, and more than 61% over the trailing four years. Also, growth in production from both OPEC and non-OPEC producers—notably Russia, Libya, and Iraq—served to further boost supply. Other key drivers included: (i) weaker global demand growth, particularly from China and other emerging markets (EM); (ii) a strengthening dollar, which made USD-denominated oil trades more expensive; and (iii) a lack of realized material supply disruptions from the numerous conflicts in producing regions. The sell-off was fueled further by OPEC’s late November decision, led by Saudi Arabia, to maintain the cartel’s production target and not support sliding prices. The OPEC decision sparked a price war amongst member countries, as Saudi Arabia and others cut prices to European and Asian buyers in an effort to shore up market share.
Amid this backdrop, the traditional 70% domestic equities (S&P 500 Index)/30% fixed income portfolio (Barclays Aggregate Index) returned 11.4% in 2014. This outperformed the 3.2% return of a broader diversified portfolio mix, which incorporates non-U.S. and EM equities, private equity, real assets, hedge funds, and non-U.S. bonds. Several factors accounted for the return differential. First, the diversified portfolio’s lower weight to equities (the U.S., in particular) was a significant hindrance. Second, energy- and oil-heavy commodity and commodity-linked natural resources equity assets sharply underperformed the broader equity market. Commodities (Bloomberg Commodity Index) declined 17.0% and natural resources equities (S&P North American Natural Resource Index) fell 9.8% despite first half gains. Elsewhere within real assets, REITs posted strong gains in the falling interest rate environment and amidst improvements in property market fundamentals. The broad U.S. TIPS market also ended the year with positive absolute returns, providing some insulation from the portions of the real asset portfolio that are more directly influenced by the fall in commodities.
Exposure to emerging markets equities and currencies was also a headwind to the diversified mix in 2014. Within EM, country-level performance varied widely, as country-specific events, heightened geopolitical tensions, and global macroeconomic factors influenced each differently. Currency played an important role in investor returns. Countries with high current account deficits and reliance on foreign capital (South Africa, Turkey, etc.) experienced a sharp pull-back in their currencies. The significant drop in commodity pricing, namely oil, also impacted each country’s returns differently. The economies of high oil-producing countries, such as Russia and Brazil, felt added pressure, while high net importers like China, Korea, and India were helped.
Over the course of the year, many EM countries experienced political changes. Presidential elections in India and Indonesia were important catalysts for positive performance as each equity market exceeded 20% in annual returns. Conversely, Brazil’s highly contested election brought added volatility as the re-election of President Dilma Rousseff weighed on equity market returns (−14.0% in USD). Despite continued concerns over slowing GDP, the MSCI China Index rose over 8% for the year. China’s local market, the Shanghai Index, gained nearly 58% in local terms, much of which came in the latter half of 2014. Strong stock performance was driven by investor optimism over policy stimulus and increased foreign access to the market through the Shanghai-Hong Kong Stock Connect. This wide dispersion of returns across emerging countries provided an opportunity for active managers to add value relative to the broad benchmark.
The diversified portfolio’s exposure to hedge funds also detracted from results relative to the 70/30 mix as the hedge fund industry average return was in the low to mid-single digits. There were several factors that contributed to the hedge fund industry underperformance, but the primary issues related to generally weak security selection within the long side of many portfolios. In a reversal from 2013, security selection on the short side was stronger, but the level of alpha generated was modest.
Outside of general stock-picking issues, there were also specific periods where hedge funds struggled. A dramatic sector rotation out of higher growth companies—specifically within technology, media, and health care—earlier in the year led to losses for many funds that trafficked in these crowded trades. The sharp decline in oil prices late in the year weighed on results for managers actively trading in the energy sector. However, some funds that had hedged the commodity exposure in their long books were able to mitigate losses. The problems in the energy industry also spilled over into credit-oriented hedge funds as many companies in this segment had aggressively issued debt in recent years, which resulted in spread widening as oil prices fell. Credit funds with exposure to performing high yield in the energy sector struggled, while more distressed managers increased their focus on the industry. The first two weeks of October proved to be among the most difficult periods for event-driven managers since the 2008 market crisis. Investors seeking profits from Fannie Mae and Freddie Mac had a lawsuit rejected, causing the share prices to halve in the first part of month. This was followed by the collapse of the AbbVie/Shire merger, which was a core position for many event-driven managers. In both instances, these positions were typically liquidated and losses were realized.
While it was a difficult year overall, manager selection within the hedge fund space continued to meaningfully impact results. Morgan Stanley’s prime brokerage group estimated the year-to-date performance difference between top- and bottom-quartile long/short managers was more than 800 bps through November. We continue to recommend hedge funds within the client structure because of their diversification attributes, return potential during market dislocations through the latitude of the wider opportunity set, and the potential downside protection they offer the total portfolio.
Since the market trough in 2009, the activities of central banks around the globe have been largely accommodative—although the tools utilized and degrees of dovishness have varied by country. The United States, for example, was relatively early and aggressive with the implementation of non-traditional measures such as quantitative easing. The near-term effectiveness of these measures was an important driver of the sharp recovery in the U.S. stock market in absolute terms and relative to the other geographic regions. Entering 2015, the direction of monetary policy in the U.S. is leaning toward less accommodation. Quantitative easing has ended and the language around the zero interest rate policy has changed. Meanwhile, outside of the U.S., central bankers are implementing or considering the implementation of measures similar to the programs utilized by the U.S. with the hope of replicating the results. While the BoJ and ECB have the Fed’s playbook, successful execution will be extremely difficult. It is unclear whether the modest tightening in The United States will derail the local equity market, which has reached record highs. It is also unclear whether Europe or Japan will be able to achieve similar results as the U.S.
However, it is clear that something is changing. Directionally, the Fed is moving toward tighter policies while Europe and Japan are implementing easing measures. The consensus view is USD and USD-based assets will continue to dominate, but that is not as obvious to us. The environment entering 2015 is different than a year ago, and thus, the assets that performed best last year may not be poised to repeat. In fact, it may be the unloved markets outside the U.S., freshly fueled by their central bankers, that show signs of life. The timing of change is very difficult to predict, which is why we advocate thoughtful diversification when building long-term portfolios that are designed to perform in a variety of economic and market environments.