The third quarter of 2014 (and subsequent few weeks into October) presented a more volatile environment for global markets. As anticipated by our prior blog posts, a mid-term election correction of roughly 10% hit the broad US stock market, bringing the streak to 14 straight occurrences. We saw this sell-off as part of a normal market pullback and as an opportunity to add equity exposure. Therefore, we utilized our new high-powered rebalancing software to put reserve cash to work. After accumulating new stock positions at attractive prices, all portfolios are positioned for new highs in the markets.
The highlights (or lowlights) of the third quarter that culminated in a market pullback were led by events in Europe and Asia. Mounting evidence of an economic slowdown in the Eurozone led the International Monetary Fund (IMF) to reduce their global growth estimates. Likewise, the German Economic Ministry cut its 2014 and 2015 growth estimates. This has clearly been influenced by geopolitically motivated trade sanctions severely declining exports to Russia. Meanwhile, slower GDP growth of 7.2% in China has become a reality, as weak demand for Chinese capital and luxury goods continues. Such economic growth reductions have led to decreasing interest rates worldwide, with the US 10-Year Treasury yielding 2.0-2.5%. While historically low, this government backed risk-free yield over the next 10 years is relatively high when compared to other developed markets, such as Japan and Germany, at less than 1%. This divergence in economic outlooks has caused the US dollar to appreciate quite significantly against global currencies. In the third quarter alone, the US dollar gained 7.7% against the Euro, 7.6% against the Japanese Yen, and 5.2% against the British Sterling. We are clearly monitoring global economic events and metrics, as this has been and should continue to produce most of the investment uncertainty for the markets.
Moving closer to the end of 2014 and into 2015, there are several news items that we are closely watching, including the mid-term election results, US economic metrics, and Federal Reserve policies. According to a recent Fidelity Investments Capital Markets Update, “the U.S. is doing better than you feel.” They continue by stating that the global struggles are actually helping the U.S. by benefiting domestic assets and that the US economic recovery remains firmly intact. The current round of corporate earnings has supported this thesis, as corporate health remains strong and earnings are mostly better-than-expected. Most importantly, profit margins remain high and steady. This is thanks to continuing efficiency gains, reasonable input prices relative to consumer prices, low interest expenses, and extended debt maturities. The result has been mid- to high-single digits earnings growth. As a nation, GDP is trending upwards and the labor market is improving. Some companies have even noted a shortage of skilled labor, which should promote wage growth in those industries. Regarding consumers, the continuation of low rates has been positive for home buying and improving credit conditions have shown that banks are now more willing to make residential loans than they have been over the past few years. Simultaneously, the strong dollar and slowing global demand has resulted in a substantial drop in oil and gas prices. This assists consumer discretionary spending by providing a de-facto tax cut (i.e. lower gas prices) for families.
Active Management of investments will remain ever more important as sector correlations break down. This allows for us to pick the best stocks as opportunities arise. We recently bought high-quality stocks and exposure in our favorite sectors during the latest restorative correction and are well positioned to take advantage of the year-end rally that we are expecting. One of those favorite sectors, Technology, tends to do well in this phase of the economy because software and hardware producers typically pick up momentum once companies gain more confidence in the stability of the economic recovery and are more willing to make capital expenditures. As discussed earlier, stable economic fundamentals support stocks moving forward and these better entry point prices reflect opportunity for long-term investors. Regarding the foreign markets, our exposure is currently low, but we expect to scale into positions over time due to attractive valuations as compared to domestic stocks. Conservative option strategies will remain a key component for additional income. Lastly, employment of proper asset allocation and diversification will continue to smooth out volatility, providing for better risk-adjusted returns for our clients.
We would like to take this opportunity to wish everyone a Happy Thanksgiving.