Fourth Quarter 2014 Investment Overview -- Our Thoughts

by Mark Waterhouse, Chief Investment Officer, Shepherd Financial Partners

The fourth quarter of 2014 experienced a return to the “risk on” trading environment despite a collapse in the price of oil, continued and heightened geopolitical risk, further declines in US interest rates, and a renewed slowdown in emerging markets. For the quarter, the Russell 2000 returned 9.7%, almost 2x the return for the S&P 500. In addition, the Russell Microcap Index returned 11.2%. When small capitalization stocks experience this kind of outperformance, it is usually a strong indicator that investors are willing to take on additional risk. Ironically, in the same quarter, the best performing sector in the S&P 500 was the Utilities group, which usually is more defensive. However, the strong performance in Utilities can largely be attributed to the decline in interest rates and the collapse in energy prices.

Perhaps the biggest surprise of 2014 was the collapse in oil prices during the fourth quarter, which caused a shock to global stock prices and will impact the global economy going forward. The price of West Texas Intermediate (WTI) crude oil peaked on June 20th at $107 per barrel. By the beginning of the fourth quarter, the price had declined to $91. In most prior cycles, a decline of this magnitude would have been a prelude to OPEC reducing production and thus stemming the price decline. However, due in large part to the combination of global shale discoveries (which substantially changed world supply dynamics) and geopolitical tensions, OPEC announced on November 27th that it would maintain production levels. This move was clearly designed to take out the marginal shale players in an attempt to slow down the energy industry’s ability to increase long-term supply. The result of this decision was a subsequent collapse in the price of oil with WTI falling to $53 per barrel by the end of the year.

International markets were again lower across the board for the fourth quarter. The MSCI EAFE Index lost 3.6% as most global economies experienced slower GDP growth. Far East markets lost ground as well, with the MSCI Pacific ex Japan Index declining 1.5%. Hit particularly hard was the MSCI Frontier Markets Index, which declined 12.5% and lost 65% of the prior 2014 gains. Lastly, emerging markets also declined as the MSCI Emerging Markets Index posted a 4.5% loss for the quarter, dragging the YTD performance into the red for a negative 2.2% return for the full year 2014.

Looking forward to 2015 we are cautiously optimistic for the US equity markets and less positive on international and developed markets. The US consumer is in good shape, wages are showing some signs of stabilization, unemployment is improving albeit at a slower pace than previous recoveries, and valuations are at the high end of historical ranges but nowhere near “bubble” periods. The major risks to the US market remain a more aggressive stance by the Fed (which we do not see), a continued strong dollar (which we do see) and a contagion to the US economy brought about by a slowdown in other global economies (which is our largest concern at this time).

The outlook abroad is less constructive. The International Monetary Fund (IMF) recently decreased their estimates of global GDP growth rates for 2015 and 2016 by -0.3% to 3.5% and 3.7% respectively. The primary culprits for this reduction in the IMF’s growth outlook are the slowdowns in the growth outlooks for Japan, Europe, and China. The recent slowdown in China’s housing market is particularly worrisome as housing has been a significant engine for growth over the past five years. The recent collapse in the price of oil will be a significant tailwind for certain economies such as the US and China and headwind for others such as Russia and Argentina.

At Shepherd Financial Partners, we firmly adhere to the philosophy of sound asset allocation strategies and disciplined investment. We continuously monitor the risks associated with various asset classes and make tactical adjustments to our clients’ portfolios with the goal that they may realize the benefits of a properly constructed diversified portfolio with the lowest risk-adjusted profile possible.

The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. Economic forecasts set forth may not develop as predicted and there can be no guarantee that strategies promoted will be successful. All indices are unmanaged and may not be invested into directly.

Investing involves risk including loss of principal. The prices of small cap stocks are generally more volatile than large cap stocks. International investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. These risks can be heightened for emerging and frontier markets.