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Per Stirling Capital Outlook – December 2014

12-1We would like to take the opportunity of the fiftyish edition of this writing to wish everyone a very happy and prosperous 2015. We are grateful to you, and to each of our readers, for your most welcome feedback, your kind comments, and for your making the time every month to read and consider the perspective of our analytical and research team.

Renowned British economist John Maynard Keynes once noted that, “If economists could manage to get themselves thought of as humble, competent people, on a level with dentists, that would be splendid!” The past several years have been a time when market analysts and portfolio managers should have been similarly humble. Indeed, according to BusinessInsider.com, 2104 was the worst year of relative performance for stock-picking fund managers in three decades.

As is illustrated by the relative return of hedge fund managers over recent years (since the beginning of 2011, the HFR Equity Hedge Index has fallen by 3.88%, whereas the Standard & Poor’s 500 Index has gained 78.73% over the same period), recent history has been even more challenging for tactical managers, who attempt to add value by both individual security selection and by making top-down allocation decisions between asset classes, relative market exposures and geographic allocations.

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This recent history has added greatly to the credibility of the efficient market and indexing proponents, who believe that investors are best served just investing in the unmanaged indexes rather than trying to out-perform the broad market.
We are inclined to view recent history from a very different perspective, as we maintain that the relative underperformance of stock-pickers and tactical allocators has almost nothing to do with the efficiency of capital markets and virtually everything to do with the Fed’s purposeful distortion of the capital markets. In other words, we hold that the Federal Reserve’s quantitative easing programs, despite all of their detractors, very effectively accomplished their primary goal, which was to distort the free-market pricing of securities and retard the efficient allocation of capital.

We know that this was the primary objective of these programs because former Fed Chairman Bernanke, who was responsible for their creation, told us in no uncertain terms during his Jackson Hole speech that creating financial asset inflation was, in fact, the Fed’s primary policy objective.

More specifically, quantitative easing was designed to inflate the prices of real estate, debt and equity securities and, by doing so, to create a “wealth effect” that would boost investor and consumer confidence, increase consumer spending, stimulate economic growth and, in conjunction with near-zero percent interest rates, force money out of savings vehicles and into the capital markets, which would thus catalyze a sort of virtuous economic cycle.

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As you can see, the Federal Reserve has been so committed to this policy that, since the collapse of Lehman Brothers, they have actually expanded their balance sheet (i.e. created new money) by a full $1 trillion more than the rest of the world combined.

It is not our intent to imply that quantitative easing is the only reason for the recovery in financial asset prices. After all, we have also witnessed a rather impressive rebound in both the domestic economy and corporate earnings. At the same time, the economic rebound in countries excluding the U.S. has essentially doubled that of the U.S. since the depths of the financial crisis. Despite this fact, as is shown in the first chart, the domestic equity markets have rallied over 60% since the Lehman collapse, whereas the global markets excluding the U.S. are virtually unchanged.

As pointed out by renowned economist James Bianco, while the massive and market distorting scope of the Fed’s quantitative easing programs is not the sole reason for such dramatic out-performance by the domestic markets, it is very difficult to explain this divergence without acknowledging the massive and market-distorting impact of these programs.

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Moreover, in our opinion, the price distortion created by these programs accounts for much, if not all, of the significant underperformance of most active and/or tactical managers since the onset of the Fed’s quantitative easing programs.
Simply put, quantitative easing changed the rules of the game by affecting valuations and how free markets normally allocate financial resources to various asset classes. While this change had almost no impact on those who simply invest in unmanaged baskets of stocks and/or those who make no attempt to allocate assets according to a top-down, macro-economic premise, it actually became a counter-productive influence on those who make their living based upon asset allocation and securities selection-related decisions.

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The Federal Reserve has told us that the growth in these expansive monetary policies has now come to an end in the U.S., and that the next step is to see both the historic expansion of the Fed’s balance sheet and the near-zero percent interest rates start to be reversed. In light of the importance that we attribute to the inception and expansion of these programs, it should be no surprise that we expect for the specifics regarding the eventual unwinding of these monetary policies to be a key influence on how the capital markets perform in 2015.

Of equal importance should be the increasing monetary and fiscal stimulus that we are likely to see intensify in all of the major economies outside of the U.S. This foreign stimulus should help to offset the potential drag on the global economy from the reversal of domestic stimulus, and may have a big influence on the relative attractiveness of markets around the world.
In short, 2015 is likely to be another year when monetary policy will be a primary driver of global securities prices and when governments and central banks will continue to distort what have traditionally been free-market pricing mechanisms, in their efforts to influence their respective economies and currencies. Importantly, at this point, the U.S. is so far ahead in this cycle of economic recovery that it is scheduled to finally start tapping on the brake just as the rest of the world is applying more pressure to the accelerator.

While we expect for government monetary and fiscal policy to have a major influence in 2015, we do not believe that this is purely a binary trade where one should sell domestic equities because the Fed is on the verge of a tightening cycle and invest solely in Europe, Japan and China, because they are all increasing monetary and/or fiscal stimulus.

At the same time, it is noteworthy that, since 1970, there have only been four years when there has been as big of a divergence in performance between international and domestic equities as we saw in 2014 and that, in the previous three times, international stocks outperfomed domestic ones by an average of 14% in the following year.

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At first glance, Japan might look like a particularly compelling opportunity. It boasts the world’s third largest economy and stock market, a massive and growing stimulus program, and an apparent willingness on the part of Prime Minister Abe to do whatever is necessary to pull the Japanese economy out of its decades of stagnation. However, we are concerned that Japan’s problems are currently as much cultural, structural and demographic as they are fiscal or monetary, and there is very little that Abe can do to influence those issues.

Moreover, global investors have become increasingly disillusioned by “Abenomics”, as illustrated by the fact that foreign inflows into Japan were down 94% in 2014 from 2013 levels (the smallest annual capital infusion since the 2008 global financial crisis).

Similarly, the world’s emerging markets have their own set of problems. Russia is on the verge of a massive 1998-style financial crisis (when they defaulted on their sovereign debt), and its problems are bleeding over into Eastern Europe. Much of Africa, the Middle East and Central /South America are being severly impacted by falling oil prices. Further, since most emerging market debt purchased by foreigners is demominated in dollars, the ongoing rally in the U.S. dollar is causing a significant headwind. Specifically, every increase in the value of the dollar increases the level of indebtedness of most emerging market countries. It also causes emerging market interest rates to move higher, as it reduces the creditworthiness of issuers. Higher rates are also often required to limit capital outflows from these countries. You can see this reflected in the widening difference in yields between U.S. and emerging market government debt yields of the same maturity.

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China is probably the most compelling of the emerging market opportunities. It has recently surpassed Japan as having the second largest economy and equity market in the world and boasted last year’s top-performing equity market (the Shanghai Composite, which foreigners can not invest in, gained 45% last year). In addition, China is increasingly committed to monetary stimulus and a transition from an exporting to a consumer-based economy. At the same time, they have major solvancy issues in their banking system, their economy is slowing, deflation is a growing risk, and you can never really trust China’s economic numbers. China may be worth an allocation, but is a risky market under the best of circumstances.

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Despite the potential for some short-term volatility related to a possible, but we think unlikely, Greek exit from the European Union, Western Europe may present the most compelling investment opportunity in the world. Equity valuations are very inexpensive, interest rates are the lowest in 600 years, and European Central Bank President Mario Draghi is giving every indication that, despite the vociferous objections on the part of Germany, Europe will launch an America-style quantitative easing program as soon as January.

As Draghi stated in a December interview with German newspaper Handelsblat, “The risk that we don’t fulfill our mandate of price stability is higher than it was six months ago,”. “We are in technical preparations to alter the size, speed and composition of our measures at the beginning of 2015, should this become necessary, to react to a too-long period of low inflation. There’s unanimity in the ECB council on that.”

The main risk is that the markets have already largely priced in the European adoption of quantitative easing (QE), so equity markets are likely to be severly punished if QE is not implimented. An additional risk takes place in January 14th when the European Court of Justice rules on the legality of the bond-buying program that would be at the core of any quantitative easing program. We are concerned that, without a credible QE program, disinflation will become imbedded in the European economy.

While much of the world is either embarking on or adding to extisting stumulus programs, the United States is, at least in theory, moving in the opposite direction. This is important because, at least according to common perception, the party is over for both equity and debt investors as soon as the Fed starts to raise interest rates. However, as is illustrated by the following research from Ben Carlson, CFA, who is the editor of the A Wealth of Common Sense blog, perception is not always based in reality.

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His research, which goes back to the mid-1950s, looks at every period when the Fed has been raising rates. Remarkably, of those fourteen periods of Fed tightening, twelve of them have been accompanied by equity bull markets. Perhaps even more remarkable (and certainly more counter-intuitive given that bond prices move inversely with interest rates) is the fact that the bond market actually posted positive total returns, including yield, during half of those tightening cycles. Of note, these sometimes stellar returns on bonds were due to the fact that bond yields were so high when the Fed started tightening (which means that the yield was more than suffuicient to offset the losses in pricipal value). That is unlikely to happen in this cycle, since yields are already near historic lows.

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Another reason to be less concerned about higher rates is found in a review of how stock and bond prices have historically performed one, three and five years after Fed stopped raising short-term interest rates, over which periods returns were generally quite bullish.

Granted, the perceived risk of higher rates is different than the ramifications of a shrinking of the Fed’s balance sheet (the unwinding of QE), regarding which there is virtually no historical precedent on which to base expectations. However, any such unwinding should be partially offset by growing foreign monetary stimulus, an accelerating domestic economy and plummeting oil prices. Of note, according to David Sowerby of Loomis Sayles, there have been four previous times oven the past thirty years when oil prices have dropped at least 50%. In all four cases, domestic equities had double-digit gains over the 12 months following the low in prices.

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While we expect for falling oil prices to once again provide a strong tailwind for the economy, it is almost certain to cause some investor angst over the near term as it depresses energy sector earnings. Indeed, since the peak in oil prices, fourth quarter 2014 estimates for earnings growth on the Standard & Poor’s 500 Index have fallen from 11.0% to 6.4%, which is likely to make domestic equities look over-valued over the short term. It is also a potential negative as it adds to global deflationary pressures (particularly in Europe).

On the other hand, it should be very stimulative to the global economy (as we discussed in our last issue), and should help to encourage additional monetary stimulus overseas while making the Federal Reserve very cautious in regard to both the timing and scope of any contraction in domestic monetary stimulus.

Further hindering the Fed’s ability to “normalize” monetary policy is the fact that domestic inflationary expectations have continued to decline to the point that we are actually seeing a few hints of actual, albeit modest, deflation. For example, the difference in yields between Treasury two-year notes and comparable maturity inflation-indexed securities turned negative in late December for the first time since the aftermath of the global financial crisis in 2009, and the December ISM survey was weak because many purchasing managers were waiting for lower prices before placing orders. Further, the composition of the Fed’s Federal Open Market Committee itself is growing increasingly dovish, with the members who had been pushing for higher rates either leaving the board or losing their voting status and being replaced by members who have expressed a willingness to tempt a renewal of inflation by keeping policy very stimulative.

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While the past is not necessarily prelude, history suggests that 2015 will ultimately be a very volatile year in the capital markets due to these very divergent economic and monetary policy paths. However, when all is said and done, we believe that equity investors (particulaly in the U.S. and Europe) will find plenty of profitable opportunities amidst the volatility.