As we reflect on 2014, the measurable differences in returns across geographic regions, asset classes and sectors served as a great reminder that a well-diversified portfolio is often the best strategy for long-term investors. The year was characterized by many external events including ISIS terrorism, elevated geopolitical risks such as the Russia/Ukraine conflict, disease such as Ebola and plummeting oil prices. Economically, the biggest story continued to be the growth and sustainability of the U.S. economy.
U.S. stocks, specifically large-cap U.S. stocks, generated strong returns during the fourth quarter, resulting in another robust performance year for the extended U.S. bull market. Since the end of the Great Financial Crisis in March 2009, the U.S. stock market, as measured by the S&P 500® Index, has returned over 200%. It should be noted that this bull market is considered one of the strongest and longest lasting bull markets in U.S. history. Relative to the rest of the world, the U.S. economy ended the year as the primary economic driver for global economic growth, buoyed by the Federal Reserve’s accommodative monetary policy, strong corporate earnings and a much improved employment picture. This environment provided a supportive backdrop for risk-based investments such as U.S. stocks. Non-U.S. stocks, in contrast, struggled relative to their U.S. counterparts, impacted, in general, by very modest economic growth and an appreciating U.S. dollar, which served as a headwind to U.S. investors investing abroad.
Turning to the other asset classes, bonds were flat during the fourth quarter but surprised many pundits on the upside as the asset class generated mid-single digit returns for the year in response to declining interest rates and a flattening U.S. yield curve. With inflation expectations generally declining during the quarter and year, real asset returns were very mixed among underlying strategies.
Equity investments, and more specifically U.S. stocks, were by far the big winners among the three asset classes of stocks, bonds and real assets.
The information in the chart below is as of December 31, 2014.
1Proxy for real assets.
In the U.S., the S&P 500® Index returned 4.93% in the fourth quarter, bringing 2014 returns to 13.69%, well above expectations at the beginning of the year following a very robust 2013 return of 32.39%. The underlying composition of stock returns in 2014 were much different than 2013, with more return being generated through earnings growth compared to multiple expansion which is consistent with later stages of bull equity markets. Within the U.S., small-cap stocks lagged their large-cap counterparts for the year, generating quarterly and annual returns of 9.73% and 4.89%, respectively, as measured by the Russell 2000® Index. Non-U.S. stocks, as measured by the MSCI EAFE Index (Net), lagged materially with a quarterly return of -3.57% and an annual return of -4.91% in U.S. dollar terms.
Following a negative annual return in 2013 and its worst annualized return since 1994, bond market returns surprised many as U.S. Treasury yields declined across most of the yield curve from already historically low levels. For illustration purposes, the yield on the 10-year U.S. Treasury was at 3.03% at the beginning of 2014 compared to 2.17% at year-end, a decline of 86 basis points. Given the inverse relationship between bond yields and bond prices, the declining yield environment proved to be a tailwind for bond investors as the broad bond market, as measured by the Barclays Aggregate Bond Index, posted an annual return of 5.97%.
Real assets are inflation sensitive investments used by investors to provide their portfolios a defense from unexpected spikes in inflation. Despite accommodative monetary policies by central banks and historical amounts of liquidity in the markets, inflation expectations were benign during 2014, leading to a difficult environment for several real asset strategies, most notably commodities and natural resource equities. U.S. TIPS fared adequately during the year while global real estate securities performed best, posting an annual return of 15.02%.
What can investors expect as we turn the calendar to 2015?
First and foremost, an increase in volatility in the capital markets should be expected by all investors. While it may not have necessarily felt so, market volatility has actually been relatively low (compared to history) and investors have been heavily rewarded for having exposure to risk-based assets such as equities without having to absorb a great deal of volatility. Expectations are for volatility to increase due to uncertainty related to several factors including:
- The divergences in central bank monetary policies across the globe, with projections for the Federal Reserve to begin tightening in mid-2015;
- The possible disappointments in economic growth in major economies such as Europe, Japan and China (and the increased reliance on the U.S. economy);
- The elevation of geopolitical risks;
- The impact of materially lower oil prices, especially on emerging markets; and
- The length of the current U.S. equity bull market. This brings into question how much longer can the bull market last.
Secondly, and as stated last year, investors should have return expectations across all asset classes that directionally are lower compared to their respective historical norms. In the U.S., equity valuations are at the upper end of long-term averages while non-U.S. stocks face the projected headwinds of modest economic growth and an appreciating U.S. dollar. Bond yields are historically low across the globe providing limited upside for fixed income securities while inflation appears to be at bay hampering real asset strategies.
Finally, expect some exogenous events, such as geopolitical risks, to occur that are completely unexpected. The year 2014 experienced its share of events and more will take place in 2015, contributing to volatility. Therefore, we continue to encourage investors to ensure their portfolio remains diversified and corresponds with their underlying risk/return profile.
As we enter into the New Year, the team at GuideStone Capital Management would like to take this opportunity to once again express our gratitude to you, our customer, for the opportunity to manage your investment portfolios. It is a privilege we take very seriously each day as we continue to work diligently on your behalf. We wish all of you a Happy New Year.
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S&P 500® is a trademark of The McGraw-Hill Companies and has been licensed for use by GuideStone Funds. The Equity Index Fund is not sponsored, endorsed, sold or promoted by Standard & Poor’s and Standard & Poor’s makes no representation regarding the advisability of purchasing the Equity Index Fund.
All indices are unmanaged and not available for direct investment. Index performance assumes no taxes, transaction costs, fees or expenses. This update is prepared for general information only and it is not to be reproduced.
GuideStone Capital Management, a controlled affiliate of GuideStone Financial Resources, serves as the investment adviser to GuideStone Funds.