The performance – and prospects – of the world’s major economies continued to diverge last year, with equities reflecting the decoupling between the U.S. economy and U.S. equities, and other developed market economies and equity markets. Equities in the U.S. performed well, delivering another double-digit gain, while equities in many emerging and developed nations declined. To the extent that the U.S. economy sustains its momentum, similar trends may continue into 2015. The risk is that the negative feedback loop begins to drag the U.S. economy downward.

Perhaps the most surprising development of 2014 was the precipitous decline in oil prices, most of it occurring in the fourth quarter. While the implications of sharply reduced prices for this key commodity are still unfolding, we see lower energy prices as a positive for the global economy as a whole, and for the United States. Lower gasoline prices are a positive for putting more money into consumer hands, which, to some extent, should lead to modestly more consumer spending. Another generally unexpected development over the past few months has been the decline in interest rates, which helps consumers and businesses borrow less expensively, but hinders the yield that fixed income investors earn – so this is a mixed benefit.

Geopolitical tensions rose in 2014, and with falling oil revenues putting pressure on a number of oil-exporting nations, we may see more friction develop between countries that benefit from lower oil prices and those that experience hardship. The potential impacts have unpredictable paths, which depend on the depth to which oil prices fall and how long they stay there.

While the timing remains to be seen, the Fed is signaling their desire to raise rates in 2015. Although many investors and commentators seem fixated on this, the central bank is certain to move slowly when they do raise rates, and will be asset price-dependent on additional increases. The Fed does not have a desire to slow an already modest U.S. economy. Moreover, history shows that rate increases usually mean a strengthening economy, which continues for a year or more after rates start rising. Equities also typically continue to rise after a rate hike. Eventually, though, rate increases that are too fast or too strong can have the potential to slow economic activity at a later date or as part of a lag-effect.

While the U.S. is not immune to the effects of weakness in the Eurozone and slowing growth in China, so far the impacts appear manageable, but the negative feedback loop is a meaningful concern affecting the positive momentum of the U.S. economy. Instead, we see a U.S. economy that is gathering momentum in an investment environment characterized by low interest rates, low inflation, and reasonable valuations for U.S. equities – which remain our favored asset class.

We value your relationship and welcome hearing from you. If there is something you would like to discuss, please contact your advisor or portfolio manager. If I can be of assistance to you, please contact me directly at garrett.dalessandro@cnr.com.

U.S. Assets Strong in 2014, More Gains Likely

U.S. financial assets delivered another year of strong investment returns as the economy finally exhibited signs of accelerating growth. Including the weak first quarter of 2014, which was marked by severe winter weather in the east, the U.S. economy has posted real GDP gains of at least 3.5% in four of the last five quarters. Although the fourth quarter of 2014 is unlikely to match this pace, the momentum of U.S. economic activity is clearly building.

With solid economic growth as the backdrop, U.S. stocks shrugged off a number of troubling developments, including the gradual withdrawal of monetary stimulus by the Fed, Russia’s invasion of neighboring Ukraine, and continued economic weakness in Europe. The S&P 500 Stock Index gained 13.7% in 2014 (dividends reinvested), and has delivered double-digit gains in five of the last six years. If you were daring (or lucky) enough to invest in the S&P Index at its nadir in March 2009, your money has more than tripled.

Fixed income investors also experienced respectable gains. Investment grade bond portfolios delivered returns in excess of their coupon interest, boosted by last year’s surprising decline in interest rates. Bold investors who ignored consensus forecasts of higher rates and bought long-term Treasury bonds enjoyed gains of more than 25.0%. Investors in shorter-term bonds experienced returns in the low-to-mid single digits. Municipal bonds did especially well, as higher tax receipts lifted state and local balance sheets.

Equities overseas generally failed to keep pace with the U.S. Both the MSCI EAFE Index (measuring mostly European and Japanese stock markets) and the MSCI Emerging Markets Index (weighted toward large developing economies such as China, India, and Brazil) posted negative returns in 2014 (in USD). The diverging market performance of these countries versus the U.S. reflected their disparate economic trajectories.

The big story roiling markets during the last half of 2014 was the stunning 46.0% decline in oil prices. Led by energy, the broad commodity index fell by 17.0%, the fourth straight year of decline. While we believe lower energy prices is a net positive for the U.S. economy, the speed and magnitude of the decline will likely have some unanticipated consequences. One such consequence may be the increase of geopolitical tensions between energy-consuming nations (e.g., U.S. and Europe) and energy-producing nations (e.g., Russia, Venezuela, and Middle Eastern countries).

After the outperformance of U.S. stocks over the last several years, conventional investment wisdom might be to rebalance portfolios toward asset classes that have lagged. Our philosophy is based on a diversified investment approach with modest tilts toward asset classes that are expected to deliver above-average risk-adjusted returns in the future. On that score, we continue to find the best combination of supportive economic fundamentals and reasonable valuations in U.S. equities. We are not abandoning other parts of the world; we simply believe the trends that propelled U.S. stocks strongly in 2014 are likely to remain in place for the foreseeable future. Of course, should our Equity Market Scorecard or Economic Monitor indicate a change in direction, we will adjust portfolios accordingly.

For those worried about the high valuations of U.S. stocks, it should be noted that the S&P 500 is still below its inflation-adjusted high of 2,120 set in January 1999, according to J.P. Morgan.

With the Fed expected to begin raising U.S. short-term interest rates this year, we anticipate lower returns in U.S. stocks than last year, accompanied by bouts of higher volatility. Still, we anticipate better returns from U.S. stocks than their European counterparts. We expect only a modest rise in U.S. long-term interest rates, as low European bond yields anchor U.S. rates at low levels. Among other asset classes, we believe the decline in energy prices has created some attractive opportunities in certain sectors of the high-yield bond market.

We wish our clients and friends a safe and prosperous 2015, and we thank you for your continued support.

2015 Economic Theme: Sailing Ahead in Choppy Seas

U.S. financial assets delivered another year of strong investment returns as the economy finally exhibited signs of accelerating growth. Including the weak first quarter of 2014, which was marked by severe winter weather in the east, the U.S. economy has posted real GDP gains of at least 3.5% in four of the last five quarters. Although the fourth quarter of 2014 is unlikely to match this pace, the momentum of U.S. economic activity is clearly building.

Even including last year’s first quarter, when unseasonably severe winter weather played a big role, economic growth has been notably stronger since mid-2013. After averaging just a 2.0% pace over the first four years of the expansion, average growth has picked up to a 3.1% rate over the past five quarters. Notably, this has all occurred before the recent decline in oil prices, and suggests we were correct to believe the strength in underlying fundamentals of the economy were being held back primarily by the lingering effects of the financial crisis and the unprecedented degree of fiscal tightening.

As those headwinds fade and allow the traditional cyclical drivers of expansion to take hold, economic growth should naturally accelerate. Indeed, now that government spending has finally turned the corner and private sector deleveraging has largely wound down, businesses and households are beginning to enjoy the fruits of an economic recovery that appears to be stronger and more widespread. For households, in response to the strength of job growth over the past year, measures of employment compensation have begun to accelerate, and other survey-based evidence suggests that further increases in wage gains are just around the corner.

At the same time, rising equity portfolios and sustained home price appreciation continue to boost household wealth to all-time record levels, providing consumers the freedom to spend more freely and obtain additional credit. This powerful combination of improving fundamentals has, unsurprisingly, sent consumer confidence soaring, and looks set to finally usher in a sustained period of faster spending growth. Similarly, capital investment has also recently begun to show long-awaited signs of improvement as business owners, emboldened by improving sales, are becoming more focused on how to meet rising demand, rather than on how to hold down costs.

Topping it all off, this is occurring under the best of circumstances, as sluggishness in most other global economies is helping keep inflation, oil prices, and interest rates low. Lower commodity prices, especially for energy, provide particularly strong support for the consumption-centric U.S. economy, generating new purchasing power for consumers and businesses. In fact, the 46.0% plunge in gas prices is expected to add between 0.4% and 0.8% to annual GDP growth in 2015.

If we are correct, the combination of improving domestic demand, rising wages, and a stable core inflation rate should persuade the Fed to begin lifting policy rates by mid-year. While some Federal Open Market Committee members recently hinted at a potentially earlier start, international conditions and the potential for further declines in headline inflation suggest that “patience” is a virtue, and that the pace of Fed tightening will be slow, measured, and as undisruptive to economic activity as possible.

Of course, despite all of these positive developments, clear skies and smooth sailing are not ensured. Though the U.S. is much less exposed to the effects of slowing global growth than other foreign economies, weakening demand around the world and the stronger dollar can be expected to negatively impact U.S. multinational company earnings, the manufacturing sector, and exports. Likewise, geopolitical risks posed by events in Russia, the possibility of another Eurozone crisis, violence in the Middle East, and other unforeseen circumstances have the potential to disrupt financial markets and shake confidence. Nevertheless, with the powerful tailwinds of stronger consumer spending, business investment, and an ending of fiscal drag filling the economy’s sails, we remain upbeat about the voyage ahead.

2015 Outlook for U.S. Equities: Continued Gains, Increased Volatility 

We believe 2015 will produce mid-single-digit returns for U.S. equities, along with increased volatility. Nevertheless, we believe investors should stay the course and that we should exit 2015 with the secular bull market intact. Below are some of the factors supporting our view:

> Favorable economic backdrop in the United States. A virtuous cycle of stronger consumer fundamentals reinforces a sustainable expansion, supporting our view that GDP is expected to grow 2.5% to 3.0% in 2015.

> Lower oil and commodity prices – if sustained, they have the potential to boost GDP by an additional 0.4% to 0.8% in 2015. While there are clearly negatives from reduced energy production and lower capital spending, the positive benefits from enhanced consumer spending on non-energy products and higher profitability for corporations outweigh these negatives.

> Lower inflation is a good thing. As demonstrated by the recent decline in five-year inflation expectations to 1.2%, lower oil and commodity prices can certainly ease inflationary pressures.

> S&P 500 EPS should grow 7.5% in 2015 to about $127.50. This reflects our forecasts for U.S. GDP growth of 2.5% to 3.0%, inflation growth of 1.5% to 2.0%, international economies growing 0.5% faster than the U.S. economy, a 2.5% reduction in shares outstanding, and 0% profit margin expansion.

> We recently raised the upper end of our price/earnings ratio (P/E) range to 17.5x from 17x, due to a lower inflation outlook and increasing confidence in the U.S. economy. Based on our forecast of $127.50 in S&P 500 EPS, we expect the S&P 500 Index to trade in a range of 2,040 to 2,231, with 2,136 as the likely midpoint.

> Several swing factors could change our EPS assumptions. On the positive side, these include lower commodity prices, corporate cost-control efforts, and an extension of the profit cycle. On the negative side, slowing global GDP and a stronger dollar produce headwinds, and recent increases in wage gains and higher depreciation and amortization expenses could dampen margins in the second half of 2015.

> Several swing factors could change our P/E ratio assumptions. These include lower-for-longer inflation (which could keep P/E multiples higher for longer), the positive historical pattern of stocks after sharp drops in oil prices, and the U.S. election cycle. All of these factors could result in significant stock price gains, and the status of the U.S. as the “best house in an okay neighborhood,” should also support demand for domestic equities. On the other hand, a 100-basis point increase in the Fed funds rate implies a 1x lower P/E ratio, or a 6.0% EPS headwind. Finally, geopolitical risks remain elevated and an unexpected exogenous shock could also negatively impact P/E ratios.

> The tug of war between these swing factors should increase volatility. Volatility has been below average for several years, but, as the fourth quarter in 2014 demonstrated, the market’s calm may be ending. We expect a return to normal levels of volatility in 2015. Additionally, intra-year market declines could return to a normal range of 10.0% to 15.0%.

> Stocks remain on an upward trajectory, as the chart below indicates. Sideways actions, periods of lower annual returns, and higher volatility are normal occurrences, and we believe 2015 will feature them all. Even so, we expect to come out of the year just fine and with the upward trend of equities still intact.

The bottom line is that we believe investors should stay the course, despite an expected increase in volatility. We believe that we are still in a secular bull market, and we remain overweight U.S. equities.

Cheap Oil Represents a Net Benefit to Global Economy

The stunning collapse of oil prices has led investors to examine the reasons for the decline and the potential impacts on economic growth and financial markets. This reflects worries about the impact of lower oil prices on energy companies, as well as renewed fears that continued weakness in oil prices is an early signal of a sharp slowdown in global growth. While we share some of these concerns and are closely monitoring the implications of an extended period of lower prices, for now we expect the boost to overall global demand from cheaper oil to be a net gain for the world economy.

Price declines in any commodity can reflect a positive supply shock or weak demand, and the current oil situation has elements of both. The U.S. shale oil boom has added to overall supply, while weak global growth has curbed energy consumption. In addition, speculation in the energy futures markets has increased substantially in recent years – complicating matters as long positions are unwound, putting additional downward pressure on the price of oil.

Still, for now the weight of evidence points to increased supply as the primary driver of price declines, rather than, as suggested by some media reports, a more concerning deterioration in global demand. On the contrary, current data shows only a fairly gradual loss of global momentum recently, not an abrupt slowdown, with the latest December Global PMI reading consistent with world GDP growth – not much slower than the average rate of about 3.0% experienced over the past three years.

Likewise, industrial metal prices, which are more responsive to changes in global demand, have held up better than oil prices, suggesting this is more of an issue of greater supply. On the simplest level, lower oil prices are beneficial for consumers and harmful for producers, and, because the former outnumber the latter, the drop in prices should be a net positive for the world economy. Indeed, we believe the potential boost to global demand that cheaper energy provides will help ensure that the world economy continues to grow at a steady, although highly uneven, pace.

For the U.S. in particular, where the economy is strong and energy capital spending makes up only about 1.0% of overall GDP, we believe the sharp decline in oil prices represents a meaningful benefit. A potential temporary period of deflation will increase the purchasing power of American households and businesses, prompting more spending and investment. In fact, if oil prices remain near current levels, estimates of the boost to U.S. economic growth range from 0.4% to as much as 0.8% of GDP in 2015.

There are risks associated with lower oil prices. One risk is that lower oil prices will exacerbate persistent deflationary pressures elsewhere, making it even harder for heavily indebted economies, such as those in the southern Eurozone with already poor growth prospects, to achieve a sustainable recovery. There are also concerns regarding increased political risks in oil-producing countries spilling over into the wider global economy, as well as worries of financial fallout if some are forced to default or sell assets.

These risks are likely to build if oil prices fall further, and could weigh disproportionately on sentiment, both in the financial markets and elsewhere. However, this is not our current expectation, and we believe the benefit from cheaper oil should outweigh these negatives. Indeed, the potential boost to global demand is one important reason to expect prices to level out soon.

For investors, the impacts of declining oil prices on financial assets are diverse and nuanced. In general, the decline in oil prices should be a plus for equities outside the energy sector. Lower inflation historically has meant higher equity valuations. For fixed income assets, the impact on the bond market, outside the energy sector, should also be heavily driven by lower inflation, which will keep downward pressure on interest rates. Clients and advisors can be confident that City National Rochdale’s experienced group of portfolio managers are managing the unique risks of each asset class and positioning portfolios proactively.

Lower Oil Prices Have Widespread Impacts on Emerging Markets

The economic and political ramifications of the steep and unexpected plunge in oil prices, which gathered momentum in the fourth quarter of 2014 and continued into 2015, are still unfolding. Some effects are readily apparent – oil-importing nations will spend less on energy, while oil-exporting nations will earn less. Since some emerging market (EM) economies are net importers and others are net exporters, the impacts of lower oil prices will vary widely by country. Nonetheless, with the caveat that both the extent and the duration of lower oil prices have yet to be revealed, here is a look at what we believe is likely to happen.

The largest EM economies – China, India, and South Korea among them – stand to gain the most from the decline in crude oil prices. In terms of absolute oil demand, China and India are the second and fourth-largest countries in the world, respectively. China imports more than 60.0% of its crude oil requirements and India is as much as 75.0% import-dependent. Among those countries most negatively impacted by lower prices are Russia and Venezuela, both of which are heavily reliant on revenues from oil exports. The sudden shift in the fortunes of oil-importing versus oil-exporting nations may be accompanied by a rise in geopolitical tensions as well.

Because much of the decline in oil prices came in the final quarter of 2014, many economists are still working to determine how much to increase their 2015 GDP growth forecasts for EM economies that are net importers of crude oil. However, based on the hypothesis of sustained softness in oil prices at current levels, we can make some tentative assessments. For example, if oil prices in 2015 remain $40 a barrel below their average 2014 prices, we can – conservatively – expect to see an additional 0.8% to 2.3% in GDP growth in 2015 across emerging Asian* economies such as China, India, and the Philippines. We expect consensus GDP growth estimates for these and other EM nations to rise in the weeks ahead.

There are other impacts that will likely be felt in most of emerging Asia as 2015 progresses and the effects of lower energy costs work their way through these economies. Lower crude oil prices will likely reduce import bills, improve government budget balances, and also bolster corporate profitability and household disposable incomes. In addition, lower oil prices may help to contain imported inflation, which could allow central banks in China, India, and other countries to pursue more accommodative monetary policies.

If sustained, lower oil prices could have a positive impact on government budgets in emerging Asia. For example, nearly a third of India’s subsidy bill ($45 billion in U.S. dollars) goes toward fuel subsidies, with a similar burden shouldered by the state-owned oil marketing companies. In 2013, Indonesia’s fuel subsidy expenditures topped $20 billion. Both India and Indonesia took advantage of the steep fourth-quarter declines in global oil prices, moving aggressively to cut fuel subsidies with pricing reforms. Their subsidy bills are expected to shrink by some 50.0% to 60.0% in 2015.

Consumers in EM nations will also likely be key beneficiaries of lower oil prices. Increases in disposable incomes, lower import prices, and lower interest rates should boost consumer demand. We expect the consumer goods area to reemerge as the strongest sector in EM Asia in 2015.

 
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Important Disclosures

The information presented does not involve the rendering of personalized investment, financial, legal, or tax advice. This presentation is not an offer to buy or sell, or a solicitation of any offer to buy or sell any of the securities mentioned herein.

Certain statements contained herein may constitute projections, forecasts and other forward-looking statements, which do not reflect actual results and are based primarily upon a hypothetical set of assumptions applied to certain historical financial information. Certain information has been provided by third-party sources and, although believed to be reliable, it has not been independently verified and its accuracy or completeness cannot be guaranteed.

Any opinions, projections, forecasts, and forward-looking statements presented herein are valid as on the date of this document and are subject to change.

All index returns include reinvestment of dividends. The MSCI index returns include the reinvestment of dividends net of withholding tax. International Index returns are stated in U.S. dollars. Indices are unmanaged and one cannot invest directly in an index. Index returns do not reflect a deduction for fees or expenses.

There are inherent risks with equity investing. These risks include, but are not limited to stock market, manager, or investment style. Stock markets tend to move in cycles, with periods of rising prices and periods of falling prices. Investing in international markets carries risks such as currency fluctuation, regulatory risks, and economic and political instability. Emerging markets involve heightened risks related to the same factors as well as increased volatility and lower trading volume.

Bonds and bond funds are subject to interest rate risks and will decline in value as interest rates rise. High-yield bonds off er a higher yield and carry a greater risk of loss of principal and interest and an increased risk of default or downgrade than investment grade securities. Investments in EM bonds may be substantially more volatile, and substantially less liquid, than the bonds of governments, government agencies, and government-owned corporations located in more developed foreign markets. The yields and market values of municipal securities may be more affected by changes in tax rates and policies than similar income-bearing taxable securities. Certain investors’ incomes may be subject to the Federal Alternative Minimum Tax (AMT) and taxable gains are also possible.

As with any investment strategy, there is no guarantee that investment objectives will be met, and investors may lose money.

Investing involves risk, including the loss of principal. Diversification may not protect against market loss or risk.

Past performance is no guarantee of future performance.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. & Canada. As of June 2007 the MSCI EAFE Index consisted of the following 21 developed market country indices: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Greece, Hong Kong, Ireland, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

MSCI Emerging Markets Index is a free float-adjusted market capitalization index that is designed to measure equity market performance in the global emerging markets.

The Standard and Poor’s 500 Index (S&P 500) is a market capitalization-weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.