The market movements witnessed at the end of 2014 are notable for the fact that they were driven by trends we think will persist well into 2015. While risk assets were largely supported into the New Year, a variety of divergences could be seen across regions and asset classes. We think this is largely due to the de-synchronization of global central banks and rising geopolitical risk. U.S. equity markets outperformed while stocks in Europe nearly erased all their 2014 gains. U.S fixed income outperformed while HY credit spreads widened. The U.S. Dollar (USD) strengthened while the euro continued to trend lower. Investment grade outperformed high yield. Oil prices continued to slide. Political risk ticked up, from Moscow, to Athens to Caracas. Equity market volatility rose.
As the U.S. bull market enters its sixth year, we believe that markets will continue to be supported by still abundant liquidity, but the optimal landscape for returns—rising earnings and lower interest rates—is giving way to a new environment of rising interest rates and rising earnings. The following are some of the main ideas contained in our upcoming 2015 Outlook.
We are most encouraged by the U.S. which grew at its fastest pace since 2003 in 3Q14 at 5%. The U.S. is a bright spot in a world of lower growth and its continued expansion should bring a pickup in corporate spending, M&A and hiring. Still, U.S. stocks are not cheap; nor are they wildly expensive. At 15.8x, the forward P/E ratio for the S&P 500 is above it historical range of 13.8x.
We expect U.S. equities to gain between 5-7% next year, coming mainly from strong earnings rather than multiples expansion. Indeed, it appears that the multiples expansion phase of the current bull market ended in 2013. In 2014, earnings growth contributed around half of the growth in the S&P 500 compared to around 20% in 2013 and 30% in 2012. We believe that earnings growth in 2015 should come in between 7-10%.
Sentiment towards European equities deteriorated markedly towards the end of 2014 as a combination of factors led to major outflows from eurozone stocks. A series of weak data points showed up in Europe’s core countries, previously a standout in the region. This was exacerbated by a continuation in Russian instability which continued to weigh on German equities. All of this was set against a backdrop of uncertainty over the extent to which fiscal and monetary programs could spur aggregate demand in the eurozone and tame disinflation. For the year, European equities as measured by the Eurostoxx 50 have underperformed the S&P500 by 22.75% in USD terms.
While the macro backdrop remains weak, we still see reason for maintaining exposure, albeit at reduced levels, to European equities. This view is based on attractive valuations and support from still abundant liquidity as the ECB has given further evidence that it will boost its balance sheet to levels last seen in 2012. We also believe that sentiment towards the region may have reached extreme levels.
We believe that Japan offers one of the most attractive landscapes for equity returns. The Abe government, which recently expanded its two-thirds parliamentary majority, delivered three key policy bazookas this year which helped propel Japanese stocks in 3Q14: an expanded and open ended QQE (quantitative and qualitative easing) program from the BoJ, new asset allocation targets for the Government Pension Investment Fund (GPIF) and a postponement of the second leg of Japan’s consumption tax hike.
We believe that the government and BoJ’s all in belief that monetary stimulus will boost the economy provides a very supportive backdrop for further gains in equity markets. Japanese stocks are also the most attractively valued among DM markets, trading at 18.9x versus a 10-year average of 22.3. Given our view of a stronger USD and JPY weakness, our exposure to Japanese equities is dollar-hedged to protect against further USDJPY declines.
Our views on EM equities are rather mixed following a year in which the asset class underperformed the broader index, down 2.6% y/y. While nominal growth across EM economies is likely to be relatively flat in 2015, improving current account balances, easing biases across central banks and relatively attractive valuations provide some opportunities. On a whole, EM equities are trading some 25% below their DM counterparts making this asset class relatively cheap. Key to 2015 will be identifying the proper country and regional allocation within EM as it is becoming increasingly difficult to treat EMs as a single asset class. We continue to see good value in parts of emerging-Asia and China and are underweight Latin America.
Within credit, we think the weakness in the energy sector (which accounts for ~15% of the Bank of America Merrill Lynch HY Index) as well as uncertainty regarding the timing and pace of interest rate hikes in the U.S. will add volatility to U.S HY. We think returns will be driven more by carry as the rise in Treasury yields will likely more than offset any modest spread compression. Within Europe, we think HY spread compression will more than offset the modest rise in Bund yields as an expansion of the ECB balance sheet, which could include corporate bonds, should continue to support the HY asset class.
Markets are growing increasingly vulnerable to changing expectations of Central Bank behavior—namely the ECB and Fed. This environment is creating divergences but also opportunities. In that context, risk-management combined with rigorous sector and geographical selection will remain key factors for investment performance. As usual, don’t hesitate to contact us to discuss our investment views or financial markets more generally.