Like me, many investment counselors attempt to map out return expectations and places to allocate capital. We spend a lot of effort trying to assemble a macro view and apply it in an investment thesis. In my decades in this business I have learned that often times the consensus is wrong, as unforeseen events happen that completely change actual results.
In going through this annual process I dutifully read, listen and study many different sources of information and interpretation available in the market. Emotion tends to play an enormous part in markets and I think it is important to drain out as much of it as possible. In my opinion, emotion is the biggest enemy of investment returns. It causes rational people to do irrational things that are almost always self-destructive to one's wealth. Finally, I try to understand consensus and filter it with just a bit of common sense. I would hope that nearly 30 years of experience might add a bit of common sense tempering to our forecasts.
So, noting that free advice is always worth what you pay for it, here are five outcomes in 2015 that likely are not expected but I believe are more likely than the investment community believes.
1. European equities will have a huge year
We are all painfully aware that economic growth has stalled in Europe. Interest rates are at historic lows for sovereign debt, which indicates a very ill economy suffering from bouts of deflation. The European Central Bank has employed negative deposit rates to stimulate lending and now is about to embark on asset purchases to counteract the deflationary pressures. We think that each time QE (quantitative easing) was implemented (in the United States, England and Japan) equity prices rose. We don't believe this time is any different. The time to buy equities is when
recession is feared and there is blood in the streets. Don't fight the ECB! We think this will prove to be the winning strategy in 2015.
(More: Europe and Asia may be a mess, but long-term investors can find opportunities)
2. Inflation is not dead, but begins to show its ugly head
As I write this piece, the 10-year U.S. Treasury note has dipped under 2%. Yields all over the globe are settling in at some of the lowest on record. Global central banks are outwardly employing every means known to generate inflation expectations. The United States has literally printed well over three trillion “new” dollars and used them to purchase debt securities in the open markets. England, Japan and now the ECB are doing the same thing. Liquidity is abundant, yet we see little sign of price and wage pressure. Have no fear, the laws of nature still work. If you dilute the currency supply enough, you will eventually succeed in a de facto devaluation of the currency. It may take time to manifest the results, but history shows a perfect record for those governments that have watered down their currency. Last year Alan Greenspan compared the recent American QE to a similar effort taken by the 1775 Continental Congress where the result of a greatly increased population of currency was followed by devaluation. The devaluation of the Continental Dollar did not begin to show up until 1778, and by 1781 the currency had lost ostensibly all of its value. The point Mr. Greenspan was making was that any time you significantly increase the currency in circulation it is only a matter of time until the currency loses value and inflation ensues. Some refer to this process as currency debasement. QE ended in 2014. Is it reasonable that we begin to see the effects in 2015? We think so.
(More: Inflation may stay low this year but that won't keep Fed from raising rates)
3. The best performing government bond in 2015 will be TIPS (Treasury Inflation-Protected Securities)
In 2014, U.S. Treasury bonds took the cake for performance. Just when yields were thought to rise, the opposite happened as Europe and Japan slipped into recession. TIPS, which compensate the investor for increases in the Consumer Price Index, had lousy performance, noting the rise of deflationary pressures globally. It seemed that even the stellar U.S. economic recovery was not enough to thwart the downward pressures on prices. Oil's dropping 50% over the final months of 2014 only exacerbated the pricing pressures. TIPS have the same government backing as any other Treasury bond, but trade more on inflation expectations rather than current interest rates. The TIPS market is pricing in almost no inflation return at all, which seems like a bet against the Fed. We have learned over and over to never fight the Fed as that may lead to almost certain failure. We won't start now as we would take the other side of the inflation bet and buy TIPS at current prices. When inflation returns so will the value of the TIPS bonds.
(More: Bond ETFs defied pundits in the fourth quarter)
4. Precious metal and basic resources are winners
Nearly all precious metals miners and commodity-related producers are selling at multi-year lows. The list of these multi-year losers includes gold, silver, copper, iron ore and coal, just to name a few. These resources have floundered because of lower prices paid for the material as global demand has ebbed. Global monetary stimulus is in high gear. Inflation targeting, as we have already pointed out, is very likely to begin to show results. Just as deflation favors debt investments and punishes real assets, inflation pressures favor the tangible stuff. Real assets will likely rise from the ashes showing the world that growth is not dead and demand for mined materials is really worth something. The gold bugs should have their day in the sun as currency devaluation gives way to inflationary pressures.
5. Emerging equity markets will outperform the U.S.
The success of emerging market economies in Asia and Latin America are largely dependent on the prices paid for their commodities. Commodity-producing countries have suffered greatly as prices and demand has deteriorated. The same trends that we expect will begin to generate inflationary pressures in developed economies should act as tailwinds to reverse the downward pressures. As economic demand is stimulated by monetary easing, so will the demand for materials and commodities. Those developing countries will benefit from low interest rates for borrowing, and low energy and input prices for manufacturing should prove a winning combination. Price inflation can only occur in the face of rising demand. Globally, trough economies beginning the business cycle again will provide for the increase in demand. We think this begins in 2015.
Overall, we are not calling for anything that hasn't happened in the past. Economies cycle through growth and troughs. We call it a business cycle and it happens over and over. Some cycles are long, some are short. Some are shallow and some are deep. Inflation and deflation trends cycle just like the business cycle. Just when people believe that inflation is dead and buried we find that it has merely been hibernating, not vanquished. Even though central banks believe they can smooth out the cycles, reality is that they can't do much. What they can do is to alter the speed at which the cycles begin and end. Creation of currency, such as we have seen with QE, will work if done long enough. Central banks have unlimited tools and seem aggressively resolute at doing whatever is necessary to return the world back to an inflationary cycle. Common sense begs us to get out in front of the cycle rather than trail it.
Bonds have been the asset of choice over the past five years. We have observed the greatest flow on record of investment funds into bonds and bond mutual funds. Flows out of equities have been coincidentally noted, even as U.S. equity prices hover around record highs. We believe common sense would tell us that this cycle will reverse as the expected returns for the bond markets are the lowest on record.
As you may have deduced, our bent is toward contrarian value. Going against the crowd is not what we believe produces significant returns. Recognizing value at a time when markets overlook it is what we are focused on delivering. We like to buy when prices are low. That generally happens when the crowd is selling. We will be interested to see if 2015 rewards our outlook.
Scott Colyer is CEO and CIO of Advisors Asset Management
