Divergence: The major theme for 2015
Russ Koesterich, BlackRock’s Global Chief Investment Strategist
Out With the Old and in With the New
Last week, stocks ended 2014 and began the new year on a lackluster note. The Dow Jones Industrial Average fell 1.18% to close the holiday-shortened week at 17,832, the S&P 500 Index dropped 1.39% to 2,058, and the Nasdaq Composite Index slipped 1.56% to 4,726. Meanwhile, the yield on the 10-year Treasury fell from 2.24% to 2.11%, as its price correspondingly rose.
As we turn the page on another year and survey the global landscape, one important theme stands out: The various regions of the world are starting 2015 in very different positions. This has important implications for investors in the new year.
Strong US Outlook, But Beware of Some Sectors
Starting with the United States, the economy seems to have ended 2014 on a strong note, and leading indicators suggest that growth should continue.
Third-quarter US gross domestic product (GDP) was revised higher to 5%, the best pace we’ve seen in 11 years. More importantly, forward-looking indicators suggest the momentum should continue. The Chicago Fed National Activity Index (CFNAI)—an indicator with a particularly high correlation to future growth—just registered its best reading in eight years.
Stronger growth buoys corporate earnings and generally should support stocks. However, there are exceptions to this. Most notably, it may put pressure on defensive stocks, many of which outperformed in 2014. This is particularly true for utilities companies, often viewed as a bond-market proxy.
Last year, the utilities sector benefited from the unexpected drop in interest rates. In 2015, yields are likely to remain low, but we do expect some increase in rates, a process which has already begun for shorter-term Treasury bonds. Rising interest rates are a negative for dividend plays, like utilities, as higher rates have historically been associated with lower valuations. This is particularly problematic today, with the sector trading at a premium to the market; historically, utilities have traded at a steep discount.
Risks in Europe, Opportunities in Asia?
In Europe, the situation is very different. Markets are caught between the counterforces of growing geopolitical risk and the upside potential from further easing by the European Central Bank (ECB).
The geopolitical risk in Europe is once again focused on Greece, where the parliament failed to secure the necessary majority to elect a new president. Another election is scheduled for Jan. 25, with the far-left Syriza party enjoying a lead, albeit a diminishing one, in the polls. The potential for more political turmoil has sent Greek stocks and bonds tumbling.
For now, contagion to other markets has been limited. The lack of panic outside of Greece is largely based on faith that the ECB, in an effort to combat a growing deflationary threat, will expand its asset purchase program to European government debt.
Meanwhile, in Asia, the focus is on supporting growth through whatever means are necessary and available. In China, this is taking the form of more central bank easing, which has helped to push that market to its best level since early 2010.In Japan, the emphasis has shifted to structural reforms. The Japanese government plans to split the nation’s Post Holdings Co. into three listed companies and sell shares in August. This will effectively privatize Japan’s biggest bank. We expect to see more structural reforms over the course of the year..
Investment Themes for 2015
Against this backdrop, we would point to a few key themes to start the year. First is the relative economic strength and less accommodative central bank policy in the US in contrast to weaker growth and more aggressive monetary policy in the rest of the world.
This has several investment implications, including the prospect of a stronger dollar. Should the dollar continue to appreciate, that would exert more downward pressure on commodities prices. Last week, oil traded at its lowest level since 2009, natural gas traded below $3 per million BTUs for the first time since 2012 and copper hit a four and a half year low.
Second, with defensive stocks already at high valuations and vulnerable to any rise in rates, we would favor a more cyclical stance within U.S. equities. We continue to see opportunities in “old technology” firms and in financials.
Finally, look for markets with tailwinds, either in the form of monetary stimulus or structural reforms. This includes both developed Asia (i.e., Japan), as well as emerging markets within Asia.