Financial Markets First Quarter 2015 Review

US equity generated minimal returns for the first quarter.  Non US markets however showed the highest performance of recent years benefitting from the impact of a stronger US dollar. In the US bond markets, the absence of any change in interest rate policy meant continued strong performance of longer term bonds while investment grade and high yield corporate bonds outperformed treasuries

US Equity Markets

After several years of extremely strong performance despite high valuations, US stocks took a breather during the first quarter of 2015. Although interest rates did not rise considerably sectors most sensitive to interest rates had declines. Most notable were utilities which attracted investors as “bond equivalents” and reached their highest valuations in history. Those yield seeking investors found that stocks are not bonds and saw a decline of 4.5% in the quarter.

After a period of underperformance, small cap stocks outperformed large caps. This is attributable to the high dependence of large cap multinational corporations on sales abroad which have declined in dollar terms as the dollar has strengthened. Small cap companies tend to be domestically oriented, hence the better performance. Those multinationals have just begun to report quarterly earnings affected by the recent sharp fall in the Euro meaning the factors affecting the small cap/large cap performance differential has a high likelihood of continuing.

Selected US Stock ETFs (Total Return)

symbol	category	1Q 2015	1 year	3 year
spy	S+P 500	0.9%	12.5%	55.9%
VTI	Total US Stock Market	1.7%	12.1%	57.6%
PRF	US Large Cap Value	0.3%	9.8%	59.6%
VBR	US Small Cap Value	3.9%	10.7%	65.5%

Non US Markets

The patient investors who maintained their asset allocation to non US stocks have begun to be rewarded as the lower valuation non US stocks have begun to outperform.

Developed market stocks showed the best performance. European corporations have seen the benefits of a lower Euro which makes exports more competitive. Signs of economic recovery, aided by exports and lower interest rates have pointed towards a bottoming of the recessionary conditions in most of Europe

 Despite the ongoing crisis in Greece there has been little or no spillover to the other “PIIGS” (Portugal, Italy, Ireland (Greece) and Spain)...another broad generalization that was more fashion than substance. Although a grexit …Greek exit from the Euro remains a possibility few see it as a likely scenario for the others in the group.

The most dramatic development in the developed markets has certainly been the Euro which fell over 10% during the first quarter. The fundamental economic factor behind this move is the aggressive monetary easing by the European Central Bank while the US has ended its easing policy and will—sometime—begin raising rates. The interest rate differential in favor of the US dollar is likely to continue and serve as a factor favoring the dollar vs the Euro.

 Additionally longer term flows such as changed in the composition of foreign currency reserves by Central Banks, hedging activity by US multinational corporations, and equity investor flows all work in favor of the dollar vs the Euro although short term reversals of the long term trend are certainly to be anticipated.

European equities had a strong performance in Euro terms. But the combination of stronger European equity markets and a weaker dollar provided extremely favorable environment for those who combined European stock positions with a hedge against a weaker dollar . The hedged European stock returned 18.3% for the quarter vs. 5.5% for the unhedged

Emerging Markets

Emerging markets also benefited from investors seeking stocks at lower valuations than US stocks. Stronger economic performance and simulative monetary politics in China helped as well. Even at “slower “rate of economic growth of 7% it still represents a large differential to the US, Europe and Japan. Emerging markets tend to attract a large amount of performance chasing investors so with the markets in an early stage of recovery flows could continue into these stocks.

I have written before that the categories “emerging markets” and BRICS (Brazil Russia India China) are not very useful investing categories.  Latin Americas largest market: Brazil along with Russia, Mexico and Venezuela are extremely dependent on oil export and are thus hard hit by the oil price drops. The stronger dollar/weaker local currency combination hurts these countries because so much of the government and private sector debt is denominated in dollars.

Thus it is not surprising to see the gaps in equity performance with overall emerging markets up .7% over the past year, overall emerging markets +.7% and Latin America unchanged.

Selected International Stock ETFs

symbol	category	1Q 2015	1 year	3 year
ACWI	Total World Ex US	2.8%	5.6%	53.7%
EFA	Total Developed Markets	5.9%	-1.2%	28.8%
FEZ	Europe Unhedged	5.5%	-6.1%	33.2%
HEDJ	Europe Hedged	18.3%	23.6%	63.2%
IEMG	Total Emerging Markets	3.7%	0.7%	4.6%
GMF	Emerging Asia	5.5%	15.9%	25.7%

US Credit Markets

Although the Federal Reserve has ended its quantitative easing policy and has indicated next move in interest rates will be higher the timing of that rate rise and its part remains uncertain. Longer term treasury bonds remain volatile but have still outperformed short term bonds. Long term Investors might not see ten year treasury bonds at yield of 2% or below as very attractive but plenty of short term players are willing to reap profits from short term declines in interest rates of by leveraging their positions by borrowing short term and buying long term bonds.

The selloff in high yield bonds ended during the quarter as oil prices, although lower, stabilized. Investors benefitted and captured the yield differential. Investment grade bond investors also benefited from the yield differential between such bonds and treasuries.

symbol	category	1Q 2015	1 year	3 year
AGG	Total US Bond Market	1.2%	5.7%	9.3%
VCSH	Short Term Corporate Bonds	1.1%	0.9%	6.5%
VCGH	Short Term US Govt Bonds	0.4%	2.3%	26.8%
HYLD	Short Term High Yield Bonds	2.0%	-14.4%	7.9%
TLT	Long Term US Government Bonds	3.1%	23.2%	1.7%