Economies around the world have experienced mixed performance. The U.S. economy has been relatively strong during the year and continues to trend positively. After posting a -2.1% GDP in the first quarter, U.S. growth has been 4.6% in the second quarter and 5.0% in the third quarter. The outlook for fourth quarter growth continues to be favorable. Employment in the US continues to improve with the unemployment rate dropping from 6.7% at year end to 5.8% through November. Manufacturing data has also been strong as evidenced by automobile sales. Economic growth has been constrained by tight lending standards and subdued consumer spending.
Despite the strong U.S. economy, global growth has been subpar due to slowing European growth, resulting from the impact of sanctions on Russia and continuing austerity measures. The Japanese economy has entered into a recession despite significant monetary stimulus, while the Chinese economy continues to be in a period of transition.
In developed economies, falling inflation has been a consistent theme in 2014. Inflation in the U.S. has been the exception as the Consumer Price Index (CPI) had risen from 1.5% at year end 2013 to 1.7% in October 2014, but it recently dropped to 1.3% due to the significant decline in energy prices. Inflation in Europe recently fell to a five-year low of 0.3%. As a result, concerns about deflation have increased.
Central banks around the world continue to be in the spotlight as monetary policy has been a major driver of financial markets in the post 2008 financial markets. Unprecedented actions by central banks continue to be closely monitored by market participants.
The Federal Reserve has been tapering its quantitative easing program during 2014 and, as of October, it has fully exited its new asset purchasing program. The impact of the reduced Treasury purchases did not have the expected significant impact on the Treasury market as the reduction in asset purchases was offset by an improving deficit due to the strong performance of the economy. The markets are now focused on discounting the timing and possibility of a Federal Funds rate increase during 2015 given the current environment of an improving economy while inflation is low and potentially falling.
The European Central Bank (ECB) has been increasing its stimulus measures during 2014 by purchasing covered bonds and asset backed securities, reducing interest rates several times to negative interest rates and offering longer term loans to banks. These programs were not sufficient to offset a slowing economy and falling inflation. Despite current economic conditions, the German government continues to oppose a full scale government bond purchase program.
The Japanese Central Bank has been providing unprecedented amounts of stimulus (Abenomics), however, to date, it has been ineffective in generating improved economic growth.
Interest Rates and Credit
Interest rates around the world have fallen during 2014, despite market consensus for rates to rise. In the U.S., long interest rates have declined while short term rates have increased modestly.Exhibit 1: Bond Market Performance (as of 12/31/2014)
U.S. 30-year Treasury yields fell by 122 basis points (bps) from 3.97% to 2.75%, while 2-year yields rose by 29 bps from 0.38% to 0.67%. The 2-30 yield curve decreased by 150 bps for the year, and long U.S. Treasury and corporate bonds have posted the strongest performance in 2014 at 19.31%.
Yields on European sovereign debt hit record lows as economic growth slowed. Additional concerns surrounding sanctions with Russia and developments in the Middle East helped pushed yields lower. The 10-year German bond fell to 0.54% from 1.93% at year end and the 2?year bond had a negative yield of -0.10%. Italian 10-year bond yields fell to 1.88% from 4.13% as the Italian economy entered its third recession in six years. This compares to 7.11% yield on Italian debt at year end 2011.
Investment grade credit spreads have widened modestly since the bout of volatility in mid-October. Investment grade bond Index still returned 7.53% in 2014 compared to 5.97% for the Barclay's Aggregate Index, mostly attributed to its longer duration. High yield bonds underperformed investment grade bonds posting a gain of 2.45%. Concerns about valuations weighed on the market as the high yield index dropped to its historic low of 5.7% in June. High yield bond funds have experienced significant redemptions which led to selling pressure and tiering of performance within the index. While default rates remain about half of historic levels, market participants are growing more concerned about the future as the quality of new issuance has declined.
The U.S. stock market has outperformed other developed country markets in 2014. The S&P 500 led all indices in the U.S. year-to-date, posting performance of 13.69% (Dividends included). Large cap stocks have consistently outperformed small caps this year. The rally in stocks has focused largely in mega cap stocks and a small number of individual companies, for example, Apple. The Russell 2000 has lagged behind the S&P 500, up only 4.89% year-to-date. The stock market has rebounded strongly from a selloff in mid October to reach new highs in December.Exhibit 2: Equity Market Performance (as of 12/31/2014)
By comparison, the German DAX has returned -9.57% year-to-date and the Japanese market has returned -4.20% in U.S. dollars. The German DAX has underperformed the MSCI index, which has lost 4.48%
The U.S. dollar strengthened this year as weakness in the European economy and aggressive monetary policy in Japan led to the U.S. dollar increasing against the Euro (12%) and the Yen (14%). The geopolitical tensions in the Middle East and Ukraine only added to the U.S. dollar's perceived safe haven status. The stronger dollar also impacted the commodity and energy markets as prices fell.
WTI Crude prices have fallen from $98 to $53. The drop in energy prices comes as supply from U.S. shale production has increased. U.S. production is expected to reach its highest level since 1972. OPEC's recent announcement not to cut supply only increases uncertainty in the energy market. Other commodity prices have also dropped in 2014 with the price of gold declining by $18/ounce to $1184.
Market volatility overall has remained very low in 2014, despite showing signs of increasing in recent months. The low volatility has increased risk taking and led to gains in risk markets. The primary driver of falling volatility has been easy monetary policy and stable, albeit subpar, economic growth.
With the low volatility environment, declining number of stocks outperforming and the decline in interest rates, the majority of active managers have failed to keep up with their benchmarks, and hedge fund managers have underperformed traditional mutual funds.Index Definitions:
- S&P 500 Index - An index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.
- Barclays Capital Aggregate Bond Index - A market capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type.
- Barclays U.S. Corporate High Yield Bond Index - The Barclays U.S. Corporate High Yield Bond Index is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market. The index is composed of U.S. dollar-denominated corporate debt in Industrial, Utility, and Finance sectors with a minimum $150 million par amount outstanding and a maturity greater than 1 year. The index includes reinvestment of income.
- MSCI Emerging Markets Index - A free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.
- MSCI EAFE Index - An index that is designed to measure the equity market performance of developed markets outside of the U.S. & Canada.
- Russell 2000 Index - An index measuring the performance approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks.
- The views expressed in this material are the views of Penn Mutual Asset Management, Inc., (PMAM) through the quarter ending December 31, 2014, and are subject to change based on market and other conditions.
- This material contains certain views that may be deemed forward-looking statements. The inclusion of projections or forecasts should not be regarded as an indication that PMAM considers the forecasts to be reliable predictors of future events. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate. Actual results may differ significantly.
- Past performance is not indicative of future results. All investments contain risks and may lose value.
- Bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed.
- Corporate debt securities are subject to the risk of the issuer's inability to meet principal and interest payments on the obligation and may also be subject to price volatility due to factors such as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity.
- Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio.
- High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not.
- Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax; a strategy concentrating in a single or limited number of states is subject to greater risk of adverse economic conditions and regulatory changes.
- Equities may decline in value due to both real and perceived general market, economic and industry conditions.
- Overall, the views expressed do not constitute investment advice and should not be construed as a recommendation to purchase or sell securities. All information has been obtained from sources believed to be reliable, but accuracy is not guaranteed. There is no representation or warranty as to the accuracy of the information and PMAM shall have no liability for decisions based upon such information.
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