WESCAP Group

2015WESCAP Group Economicand Investment Outlook for

Economic and Investment Outlook for 2015

2015 Outlook Summary

U.S. economy: GDP growth should remain near 3% in 2015. Inflation is expected to stay low in the U.S. and most developed economies. Countries with weak currencies may see inflation accelerate as import costs and interest rates rise.

Crude Oil: Oil prices are expected to remain depressed for the first half of 2015 with additional downside from increased supply. Russia, Venezuela, Nigeria and other oil exporting countries are expected to experience significant economic problems until oil prices recover, which could take years. India, Japan, China, and most of Europe should benefit, as should most consumers. Buying opportunities of both stocks and bonds of various energy companies at distressed prices are likely to present themselves later in 2015. Risk remains high until excess oil and gas production begins to subside.

U.S. stocks: A strong U.S. dollar may cause large multi-national U.S. companies to experience sales and earnings deceleration. Elevated valuations, the ending of QE3 and a likely modest interest rate increase would be additional headwinds to U.S. stock prices. Mid and smaller companies are less currency exposed and thus are poised to perform better in 2015.

Foreign Markets & Currencies: Non-U.S. economic conditions are expected to improve on average, especially in Japan and Europe, largely due to quantitative easing monetary programs. The capital injection should boost asset prices in Europe and Japan, though this may continue to cause the euro and yen currencies to decline versus the dollar. Low inflation and energy prices should provide a further stimulus to boost European and Japanese economies. The currency declines should boost exports at the expense of U.S. firms. China is still struggling with property lending excesses, but is expected to benefit from a loosening of its restrictive monetary policy.

Fixed Income: U.S. interest rates are still much higher than in Europe, thus attracting yield-seeking and safe-haven investors. Therefore, U.S. interest rates may continue to stay low for an extended period, despite the U.S. Federal Reserve ceasing its quantitative easing program (QE3) last October. Short-term interest rates are expected to rise this year, but very modestly. Older non-agency mortgage securities are still attractive as credit quality improves with the housing market. The recent price decline in high yield bonds has boosted yields to attractive levels and defaults are expected to remain low in 2015.

Investment Expectations: Investment returns over the next few years are expected to remain below average. Low inflation is keeping global bond yields well below historical averages. Global stock market returns are expected to be muted as economic and earnings growth remains restrained in most of the world and elevated valuations in some markets make further gains problematic. However, the world is not homogeneous and opportunities exist for those who differentiate. Overall, after adjusting for lower inflation, investment returns from most stocks and credit-sensitive bonds should be sufficiently rewarding, despite higher expected volatility.

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2015 Economic and Investment Outlook The following chart shows Gross Domestic Product (GDP) growth for the last 12 months and expectations for the next 12 months for most of the major global economies. JP Morgan’s forecast shows U.S. real (inflation-adjusted) growth staying close to 3%. While European growth (ex-UK) is still projected to be anemic, improvement is expected. Japan is expected to show strong improvement.

Both Europe and Japan have begun or are committed to very strong monetary stimulus programs, similar to the U.S. Federal Reserve’s recently completed QE3 bond purchase program.

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The European Central Bank (ECB) has finally committed to a significant bond buying stimulus program. After reducing its balance sheet the last few years (thick grey line above), the ECB has announced increasing its balance sheet by about 1.3 trillion euros of bond purchases (red dashes). This new money will enter the European banking systems and later flow to a combination of investments and spending. This should slowly stimulate the economy and is likely to boost financial assets, including European stocks. This type of stimulus will tend to put a damper on the euro currency. A weak euro currency will also boost exports, providing additional stimulus to corporate earnings and eventually to labor markets and wages.

A Greek exit from the euro and Greek bond default cannot be ruled out, but the contagion effect is no longer as big of a concern, as most European banks have trimmed their Greek bond exposure over the last few years. Nevertheless, we expect European markets to gyrate on Greek, Italian and Spanish risk headlines.

Japan has already started a similar, but more massive, monetary stimulus program, with even larger stimulus planned (black line on top of chart). The idea is to overwhelm the deflationary pressures with massive injections of capital that even the stagnant Japanese economy cannot resist. While the long-term benefits of this are still in doubt, the effect over the next few years should be to lower the yen further, stimulate exports and boost asset prices and stock market returns.

China has tightened its lending to reduce real estate overbuilding and speculation. Credit expansion (blue line on next graph) is near an eight year low. Inflation (purple GDP price deflator segment) has declined to 1.3% (annualized) in the third quarter 2014. Given that inflation is no longer a concern, but growth is, China has already begun to relax its very restrictive monetary policy. The Chinese central bank cut its official one-year borrowing rate by 0.4% to 5.6% in November. This may be a reason why the Shanghai market was up strongly the last two months of 2014, as stock market turnarounds tend to anticipate economic acceleration.

By Chinese standards, a 6% growth rate in 2015 would be lower than expected (and lower than most forecasts), but would still be strong growth and trigger an increase in demand for raw materials.

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Chinese oil imports in December 2014 broke a record at over seven million barrels/day. While this might just be stockpiling while prices are low, China will need more oil and other commodities as its economy expands.

Oil price

Crude oil plunged in the second half of 2014. One contributor is the surge in U.S. oil production. Due to the controversial, but effective, hydraulic fracturing and horizontal drilling technologies, U.S. oil production has almost doubled since 2008, bringing back production levels last seen in the 1970’s. The U.S. may soon surpass Saudi Arabia as the world’s largest oil producer. This has been a part of a “perfect storm” for setting up the recent oil price plunge, starting with the surge in U.S. production, adding unexpected supply from ports reopened in Libya, and weak demand in Europe, Japan and China. Additionally, a reduction in gasoline subsidies in India, Indonesia, and elsewhere reduced demand further. The largest impact may be Saudi Arabia refusing to cut production in the face of weak demand and prices. In nearly all other past cases, Saudi Arabia has been the swing producer, cutting back production during weak demand and adding supply when prices were high. However, it is different this time. Whether it is to protect market share from U.S. oil producers, to weaken the radical ISIS state, or to teach OPEC members a lesson not to cheat on their oil production quotas, it adds up to much more oil supply and at lower prices than expected.

Two-year expected U.S. oil production growth is up 20.7% (JP Morgan, EIA chart below), with an expected global supply increasing 2.9%/year.

Meanwhile, crude oil consumption is estimated to increase by only 2%/year. Macro-economics tells us that prices must drop until demand picks up or supply decreases. The U.S. Energy Information Administration (EIA) still expects U.S. oil production to grow despite lower prices (December 12, 2014, Today in Energy). Many drilling projects in progress are more economical to finish than to terminate and lose money already spent. Many U.S. oil shale fields start to have uneconomic breakeven costs at oil prices below $70/bbl as shown on the next chart.

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Therefore, we can expect U.S. drilling in shale fields to wind down, but only starting in the latter half of 2015. These kinds of shale fields have rapidly diminishing production, with production from existing wells falling by half or more within 2 or 3 years. If drilling is curtailed sufficiently in late 2015, U.S. oil production may top out in 2016 and then start to decline until oil prices get above $70-$75/bbl again.

This assumes production costs remain constant. However, with oil prices so low, suppliers of rigs, drilling equipment, supplies and services will likely cut prices and wages to remain in business. This could reduce the breakeven prices shown above and make supplies somewhat more abundant, keeping oil and gas prices lower for longer. In several years we might expect crude oil prices to stabilize somewhere between $65 and $75/bbl, which is the price range where U.S. drilling is profitable for most shale fields.

The chart on the following page shows the impact of a $25 cut in oil prices on various countries’ GDP.

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China benefits the most, with India close behind. The U.S., Eurozone and U.K. all benefit about the same. Japan benefits too, though its currency has fallen enough that the oil price decline (when priced in yen) is not as great as for dollar-based oil users. As expected, Norway and Russia, as large oil exporters, should see their economies decelerate.

Overall, this is good news for global growth, which may not be fully factored into investors’ expectations. Consumers will benefit, as they will have more money to spend on other goods and services. Lower-income consumers should benefit the most as energy and gasoline costs are a bigger part of their budgets.

Firms that should benefit from low energy prices include utilities, airlines, cruise lines and other transportation stocks. Chemical companies that use petroleum inputs should see improved margins. Discretionary consumer spending companies such as auto, home supplies, restaurants and the like should also see profit expansion. Oil companies and suppliers are not likely to do well for some time.

2015 Investment Outlook & Portfolio Positioning

Many developed country stock and bond markets are trading at the high end of their historical asset valuations. The U.S. stock market (S&P 500) is trading above the 75th percentile of its historical valuation range (bar chart next page, right hand side). European stocks are not as expensive as U.S. stocks, but tend to be close to average valuations. Japanese stocks are attractive compared to historic valuations, as are most of the emerging market stock markets.

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However, historical valuations do not show the whole picture. Low interest rates and low inflation justify somewhat higher stock market valuations. Lower inflation makes each dollar of earnings more valuable; hence higher implied stock valuations are justified.

These lower interest rates make most global fixed income markets even more expensive than their stock market counterparts. High quality bonds in Europe, Japan and the U.S. are close to the most expensive they have ever been (dark green bars above). Only the more credit-sensitive fixed income assets—U.S. high yield, non-government U.S. and U.K. bonds—are priced close to their long-term averages, and only emerging markets dollar-denominated bonds appear historically attractive.

Short-term interest rates in many countries are near or below their own inflation rates due to government intervention to keep interest rates low in order to stimulate economic growth. As government intervention eventually wanes, interest rates should rise. Short-term interest rates would be expected to rise more than long-term interest rates and the result would be these fixed-income investments declining in price.

The following table shows current fixed income interest rates and the effect of a 1% change. For example, the current U.S. 30-year Treasury bond has a yield of 2.75% (12/31/14). An increase in the yield by 1% to 3.75% would cause the 2.75% bond to decline 17.8%. This is the decline in price necessary for the old 2.75% yield bond to compete with a new 3.75% yield bond.

Short maturity and higher-yielding credit sensitive fixed income investments are much less sensitive to an interest rate increase, which is why we have allocated more to these investments.

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The U.S. Federal Reserve (Fed) has kept the short-term Fed Funds interest rate very low. The current 0.13% rate is well below inflation due to the Fed’s intervention. However, by its own admission, the Fed expects this rate to be allowed to rise in 2015 (next table) and beyond and begin to exceed inflation again in 2016.

Therefore, interest rates will be allowed to return to a more normal relationship to inflation. Ostensibly, rates will be allowed to rise because the economy is doing well and too much low-interest rate stimulus for too long can engender asset bubbles in real estate and other leveraged assets, as well as cause over-consumption and eventually higher inflation.

The following chart shows that “high beta” stocks can do better in a rising interest rate environment when compared to “low beta” stocks.

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These low beta (ie. low volatility) stocks include utilities, other stocks paying high dividends, such as many pharmaceutical, telecoms and other “defensive” stocks. Their dividends become less competitive as bond yields rise, and many of these firms will also experience higher borrowing costs.

The high beta stocks would include cyclical, industrial and financial firms benefiting from strong economic growth and technology stocks, which benefit from expansion in capital expenditures. As interest rates rise, we will make changes to portfolios to emphasize sectors that will benefit and deemphasize sectors that are expected to lag.

Overall, U.S. stocks can do well during an environment of gradually increasing interest rates associated with good economic and profits growth. Nevertheless, there will be headwinds to U.S. corporate profit growth over the next few years. These headwinds include a strong dollar reducing U.S. export competiveness. Additionally, higher interest rates will begin to reduce profit margins for some companies. Therefore, our strategy is to select U.S. stocks and sectors less impacted by a strong U.S. dollar and higher interest rates.

The biggest issue for U.S. stock market performance is that U.S. stocks had such high returns over the last few years that stock prices have moved far ahead of earnings growth. As valuations move from inexpensive to expensive, future return expectations diminish. Nevertheless, the momentum trade and capital flight to the U.S. could propel U.S. stocks to even greater heights in the short run. Until we see other markets overtake the U.S., we plan to stay modestly overweight U.S. stocks.

Many of the headwinds for U.S. stocks are tailwinds for European and Japanese stocks. Additional monetary stimulus by non-U.S. central banks should keep interest rates extremely low for a considerable period of time. Also, the growth in money supply should boost asset prices, including foreign stock and bond prices. Currency devaluation should boost foreign exports at the expense of

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U.S. firms. Ongoing monetary stimulus measures are likely to cause the yen and euro to decline further, increasing their export competitiveness. Stock market valuations are also more attractive in these markets. Therefore, we plan to maintain (and perhaps increase later) our allocation to these foreign stock markets. The majority of our developed markets foreign stock investments will be currency-hedged back to the dollar, reducing one of the largest risks of these investments.

China is in the early stages of a modest stimulation of its economy. Its currency has declined very little against the dollar. China manages its currency with tight controls and has been able to use this currency control to balance export growth with import costs and inflation. While some further currency decline is likely, the bulk of China’s economic stimulus is likely to occur with additional interest rates cuts and other monetary measures. Thus China can reinvirgorate growth with these measures rather than through inflation-inducing currency devaluations. This sets the stage for strong stock and bond performance in China, while allowing the real estate bubble to continue to deflate.

Commodity-producing companies and countries around the world are likely to remain weak and therefore we will largely avoid them until raw materials demand begins to pick up. This may occur more quickly than expected. With a relatively strong U.S. economy, a still fast-growing China and expected modest acceleration in the European and Japanese economies, industrial commodities and oil prices may stabilize and turn upward again in 2015. When this turnaround point is reached, we would expect to see a large initial recovery in energy and commodity-sensitive stocks and currencies. However, due to high inherent risks, we prefer to see some price recovery before increasing our allocation to these distressed areas.

Assets that are indirectly linked to oil, such as high yield bonds and MLPs, appear to have overreacted to the oil price declines. We intend to largely maintain our modest exposure to MLPs. High-yield bonds offer some attractive opportunities as well. Defaults are still low and most firms have refinanced their bonds so that repayment risk is pushed out for several years.

Asset Class Return Expectations

As mentioned previously, yields from most bonds are near or at historic lows. The U.S. stock market has had very good returns, but that the resulting premium valuation and developing “headwinds” suggests lower returns going forward. Other global stock markets should show improved returns due to additional monetary stimulus and growth-accelerating currency devaluations. Given low inflation in most major countries and sluggish economic and earnings growth expectations, we expect low nominal returns for some time. Nevertheless, this can still translate to decent “real” inflation-adjusted returns. For example, in the past when inflation was of 3.5%, we might have expected a 9% annual return from stocks, translating to an inflation-adjusted rate of return of 5.5%. However, with inflation closer to 1.5%, a 7% total stock market return still yields the same inflation-adjusted rate of return of 5.5%. With inflation being lower, the “new normal” return for stocks and bonds is expected to be about 2% lower than in the past. In addition to the impact of lower inflation, a still fragile global economic growth picture combined with somewhat elevated global stock market valuations may result in even lower returns. It would not be surprising for U.S. stocks to deliver an inflation-adjusted return of 4% for the next 3 to 5 years. This translates to a nominal (before inflation) 5.5% annual expected rate of return for the average large company U.S. stock. High-quality bonds typically yield slightly more than the inflation rate, but central bank actions in most countries are keeping bond yields close to (or even under) the inflation rate, depending upon maturity. Thus, the 4% to 6% high-quality bond yields of the past have been replaced with 2% to 3% annual expected returns.

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The next chart shows the historical and expected total returns of some major asset classes.

The “future” expected returns are from BCA Research, a respected economics and investment research firm. We might quibble whether the U.S. returns shown above might be too low, but BCA’s future expected returns shown are not inconsistent with low inflation, low current but gradually rising interest rates, a modest recovery in global growth, developing “headwinds” in U.S. corporate earnings and some “tailwinds” elsewhere, and with most major asset classes not being particularly inexpensive. An equally weighted portfolio of the above asset classes (20% allocation to each), would generate a 5.2% average annual rate of return, or about a 3.7% real inflation-adjusted return, assuming inflation averages 1.5%/year. This is a respectable inflation-adjusted return, even if it is somewhat lower than in the past. A portfolio with no foreign stock market allocation (60% U.S stocks, 40% bonds) would only generate a 3.8% annual return (2.3% inflation-adjusted). If BCA is accurate in their expectations, this suggests that a U.S. stock market centric portfolio is not a good orientation for the future, regardless of (or perhaps because of) recent very strong U.S. stock market performance. Because global growth and inflation may end up slightly higher than BCA expects, stock market returns may be somewhat higher than these conservative estimates. However, higher inflation and growth will not boost expected returns for fixed income assets. Hence, we remain very underweight U.S. and most developed economy high-quality fixed income investments. There are many niches and subsectors within fixed income and equities that offer prospective returns and risks different than shown above. Earlier, we discussed higher yielding credit-sensitive bonds, non-agency mortgages, MLPs and others that are expected to yield 2% to 3% more than the fixed income assets shown above. Therefore, it is important to analyze and own these niche investments when the pricing and conditions are right. For stocks, higher returns are expected when focusing on firms and industries with solid fundamentals and good valuations. Foreign stocks offer an even more diverse array to choose from. Adding currency hedging to both foreign stocks and bonds, which we are emphasizing, allows ownership of attractive non-U.S. securities and markets, while avoiding the risks of depreciating currencies. Therefore, it is reasonable to think that diversified portfolios that include niche asset classes and strategies can offer attractive returns higher than what BCA expects over the next 10 years. We will endeavor to find these attractive assets—core and niche—and to include them in your portfolios, with the intent to deliver solid risk-adjusted returns. Please contact your WESCAP Group advisor if you have questions or wish to discuss this further.