2015 Commonfund Outlook€¦ · 2015 Commonfund Outlook January 2015 Table of Contents About Commonfund Commonfund was founded in 1971 as an independent nonprofit investment firm

12015 Commonfund Outlook January 2015

2015 Commonfund Outlook

Economic and Capital Market Commentary

January 2015

Table of Contents2015 Commonfund Outlook January 2015

About CommonfundCommonfund was founded in 1971 as an independent nonprofit investment firm with a grant from the Ford Foundation. Commonfund today manages customized investment programs for endowments, foundations and pension funds. Among the pioneers in applying the endowment model of investing to institutional investors, Commonfund provides extensive investment flexibility using independent investment sub-advisors for discretionary outsourcing engagements, single strategies and multi-asset solutions. Investment programs incorporate active and passive strategies in equities and fixed income, hedge funds, commodities and private capital. All securities are distributed through Commonfund Securities, Inc., a member of FINRA. For additional information about Commonfund, please visit www.commonfund.org.

ContentsReviewing 2014 ....................................................... 3

Looking Ahead to 2015 ........................................... 4

Scenario Analysis 2015 ............................................ 6

The Core Themes Underlying Our Outlook ........................................ 9

Strategies and Positioning .................................... 12

Concluding Views ................................................ 14


We begin this year as we did the last, suggesting an

overweight to U.S. equities, an underweight to fixed

income securities (particularly intermediate U.S.

Treasuries and non-dollar bonds), and an underweight to

commodities. Our asset allocation positioning may be

similar to a year ago, but our outlook highlights notable

changes in the investment environment. In a word,

the difference is oil, dramatically impacting inflationary

expectations and growth – and ultimately asset prices.

Macroeconomic concerns for 2015 can be framed by a simple 2x2 matrix – inflation versus deflation and weak versus strong economic growth. Weaker commodity prices and a stronger U.S. dollar will contain inflation longer and provide stimulus to the U.S. consumer. This supports the positive longer term structural story for a “Goldilocks” U.S. economy, one of higher employment, lower inflation, repaired balance sheets, and strong earnings. We look for the Fed to begin to normalize the Fed funds rate, but this action will likely be sparked by an increased confidence in a better domestic economy, rather than concerns on the inflation front. As for U.S. equities, good fundamental conditions, flow of funds, share repurchases and M&A activity also favor an overweight to this sector. The contrarian temptation is to look at the rally of the last few years and assume that the U.S. is overvalued versus other regions. In contrast, we believe that conditions are in place for the U.S. equity market to outperform on an extended basis

and should be looked at in the context of a 5- to 10-year secular bull market run rather than a 3-year cycle.

The deflationary factors so supportive of the U.S. are symptomatic of problems elsewhere. Europe will continue to face low growth and low inflation at best. In Japan, near term factors such as election reconfirmation of Abe’s mandate, tailwinds from low energy prices, equity purchases by public pension funds, and attractive corporate earnings are positives, making equities attractive. However longer term, demographic and structural issues are still significant. China’s near term issues remain material with the deflating of the credit and housing bubble and weak global demand. India stands as a potential winner in this new world due to lower raw material input costs. Yet emerging markets broadly are likely to face challenges from a stronger dollar and future U.S. Fed monetary policy rate hikes. Given our forecasts for lower growth and lower inflation globally, real inflation-hedging assets are less attractive. However, real estate, particularly value and opportunistic strategies, may still hold investment opportunities.

A cautionary note to investors is to be prepared for greater volatility, driven by divergent activities of central banks and patterns for economic growth. In this environment, astute investors will be well served to be mindful of macro events that can turn quickly and overwhelm fundamentals.

Commonfund 2015 Global Economic and Investment Outlook

2015: Different world — Similar positioning, greater confidence


Our global scenario outlook for 2015 places the highest probability on a stronger domestic growth path, with an above consensus outlook for U.S. real GDP, but a weaker economic picture than most for continental Europe and resource-centered emerging economies. We continue to favor an overweight to equities versus fixed income as follows:

• We favor an overweight to U.S. equities and, to a smaller extent Japanese equities, an underweight to European stocks (but are looking for an opportunity to neutralize if we see real evidence that Europe can get its fiscal, monetary, and economic house in order), and an underweight to emerging market equity resource providers. We continue to like low volatility equity strategies.

• We continue to favor an underweight to fixed income securities, via a barbell approach to Treasuries with particular underweights to Treasuries in the belly of the curve (1- to 5-year Treasuries). We favor an overweight to mortgages. We believe the current environment is a good one to harvest allocations in the high yield/distressed space and to implement more defensive fixed income positions to protect against a likely start by the Federal Reserve to normalize the funds rate in 2015.

• Among real asset strategies, we believe in an overweight to real estate and an underweight to commodities, but are looking for a bottom in input costs in 2015.

• We see greater return differential between sectors and regions of the world which should benefit active managers.

• The risk for a significant domestic stock market correction remains low; however, wider market swings (similar to what unfolded in late 1997 and 1998) are likely. We look for the road to higher stock prices to have several large potholes. Investors could consider purchasing protection, particularly if it is inexpensively priced, as market volatility is likely to be higher in the upcoming year.

The situation in Russia represents the greatest event risk. Moreover, movements in the energy sector could remain a heightened stress point for many economies in 2015 and the default risk for companies and countries centered in the energy sector is likely to rise.

Notwithstanding our positive domestic outlook, we are cognizant of the downside, particularly outside the U.S. The economic and political risks for Europe, Russia, Venezuela and Brazil are significant. We are also likely to see divergent changes in monetary policy with the U.S. starting to normalize rates and Europe trying to find new ways to provide additional stimulus in a more difficult political world. We are hopeful that India will be able to reverse course and cut interest rates after spending a good portion of 2014 fighting internal input cost inflation issues. For countries such as Japan and, to a significantly greater extent China, the push to stimulate domestic economic activity might be helpful in some areas, but might be like “pushing on a string” in others. The bottom line is that the alternate paths ahead are likely to be divergent for both countries and sectors and may require a quick adjustment in tactical, cyclical and secular forecasts. The greater political, economic, and financial market uncertainty outside of the U.S. is a risk today that at some point in the future could become an investment opportunity.

Assessing the key themes in these markets, the scenarios that could unfold and the milestones which confirm the future direction are important, and provide us with the “canaries in the coal mine” which will help us manage portfolios. A short synopsis of these major areas is itemized in Table I on the following page. The “positive” and “negative” categorizations refer to whether the environment will be better for risk assets or not. The drivers cited become milestones to be monitored. These themes are not iron clad, for probabilities surround them and ultimately the investment implications have to be judged versus valuation and risk. Near term, the greatest concern we have is that some form of contagion from the drop in energy prices fuels a crisis that has a negative impact on economic activity and valuations.


Reviewing 2014World Capital MarketsA quick review of 2014 shows another great year of domestic-driven U.S. equity market returns. The “wall of worries” associated with the “frozen” winter was followed by the best domestic economic readings in more than a decade as real GDP growth accelerated at a 4.8 percent pace in the middle quarters of 2014. In fact, for four out of the last five quarters the U.S. economy has been above escape velocity with real GDP growth accelerating at a north of four percent pace. This extended period of solid economic growth provided the catalyst for strong domestic earnings, improved consumer and business confidence, and ultimately solid U.S. equity returns. S&P 500 earnings have beaten analyst estimates for earnings in 28 of the last 29 quarters. The S&P 500 Index set more than 50 new daily closing highs during 2014 and ended last year at 2058.90, up more than 210 points from the 2013 close of 1848. This produced a 13.7 percent total return

(including dividends) which was significantly higher than the consensus call for low- to mid-single digit returns touted a year ago. The S&P 500 Index ended the year at about 16 times our forecast for earnings for 2015, which is marginally higher than historical averages, but low versus the meager yield offered by Treasuries and high-grade corporate bonds. In contrast to the strong domestic equity returns, the MSCI All Country World Index ex-U.S. declined 3.87 percent last year.

On the fixed income front, the Fed ended the quantitative easing program in the fall of 2014 which, when combined with the better domestic economy, earnings, and equity performance, was anticipated to fuel a rotation from bonds to stocks. However, the ending of the Fed’s buying program was more than offset by an unexpected surge in foreign interest in U.S. Treasuries given the economic and political challenges outside the U.S. The combination of record low market interest rates in Europe and a rally in the dollar versus many currencies, especially the Euro, fueled strong

Region Near Term Long Term

U.S. Positive

• Energy tailwind

• Solid employment, improved consumer and business spending

Positive

• Industrial renaissance

• Energy independence

Europe Negative

• ECB ineffectiveness

• Structural inefficiencies

• Russia/China

Negative

• EU’s goals of social, political and economic integration create conflicts

• Demographics

Japan Positive

• Monetary and fiscal policy coordination

• Energy tailwind

• Pension plan purchase program

Negative / Neutral

• The third arrow – the ability to change long term behavior

• Debt/GDP

• Demographics

China Negative

• Moving to a consumer-driven economy

• Credit bubble

• Slowing economy

Positive

• Successful reform activities of the government

Emerging Markets

Negative

• Wage and food inflation

• Liquidity challenges

• Lower energy commodity prices create

ː export losers ː import winners

Positive

• Superior longer term real GDP growth offers opportunities

Regional Outlook for Risk AssetsTable I


buying from overseas markets in long-dated U.S. Treasuries. The 10-year note ended 2014 at a lower than expected yield of just 2.17 basis points, about 85 basis points below the nearly 3 percent yield at the start of the year. In contrast, the growing signs that the Fed will start to normalize the Fed funds rate in the upcoming year pushed the yield on two-year Treasury notes to 68 basis points by the end of 2014, up about 30 basis points from the start of the year.

A further moderation in inflation, along with a growing sign of a plentiful supply of raw materials, specifically in the energy sector as crude oil prices plunged 45 percent for the year, produced another challenging environment for many commodities. The solid gains of a year ago from Germany’s export-driven economy clearly faded with a sharp drop in exports to Russia and weaker conditions in China. Japan, which was a star performer a year ago following the election of Prime Minister Abe in late 2012, suffered the fiscal drag from the consumption tax increase in April and returned to a recession in the middle quarters of 2014. Despite this downturn, employment trends in Japan continued to improve and corporations in Japan generally met or beat expectations for earnings. Japanese officials were wise to delay the next round of the consumption tax increase that was slated for late 2015. Prime Minister Abe received a strong vote of confidence in 2014 that will make fiscal policy changes easier to implement in the coming years. Moreover, the monetary actions under the direction of Kuroda clearly show an aggressive “all-in” quantitative stimulus plan in 2015.

Many emerging markets faced added headwinds in 2014 due to either wage inflation and/or the lack of pricing power in raw materials (specifically in the energy sector), which produced an extremely difficult environment for corporate profits and equity market performance. This, in turn, forced policy-tightening measures in several EM countries, which in some cases sparked geopolitical unrest that further weakened economic activity and “currency adjusted” financial market performance, with Russia at the top of the list. Russia appears to be entering a deep recession, with the ruble plunging more than 40 percent during the last year versus the dollar and the currency weakness fueling a surge in import (primarily food) inflation. The drop in energy prices has pushed several other countries such as Venezuela into economic turmoil, while Brazil is staging a mini-

repeat of the recession challenges that unfolded in 1998 during their last major crisis. Although China recently announced that economic activity came in at a 7.3 percent pace, a closer review of the underlying components suggests that true real GDP in China was closer to six percent.

One of the few EM bright spots in 2014 was India. Although India was also pushed to raise rates during the year, Raghuram Rajan’s central bank actions appeared similar to the steps made by former Fed Chairman Paul Volcker 30+ years ago in the U.S. The hardline stance in India tempered inflation and provided the catalyst for what was ultimately a solid return from the stock market in India as well as improved prospects for economic growth in the upcoming year. As 2014 came to a close the potential for an easing in monetary policy in the upcoming year from India’s central bank was appropriately being anticipated by the capital markets.

In foreign exchange markets, the trade-weight dollar index staged a sharp 12+ percent rally, with virtually all of the improvement in the second half of the year as the better growth in the U.S. was met with weaker economic activity outside of the U.S. This fit in line with our longer term view that the Euro and Yen were both vulnerable to a significant downside correction to make both economies more competitive in the global marketplace.

Looking Ahead to 2015World EconomiesThe latest data provides further support to our longstanding view that the U.S. economy has moved to a stronger growth mode that is above escape velocity and benefiting from several positive feedback loops. The combination of strong domestic-driven growth with low inflation could be described as a disinflationary economic boom or, even better, a return to a “Goldilocks” economy for the United States. For years we have talked about the U.S. economy being the best house in a challenged neighborhood. The neighborhood today may be even more strained, but at the same time the U.S. house has been improved. Real GDP growth in the U.S. surged to a 4.8 percent pace in the middle quarters of 2014 representing the best six-month performance in well over a decade. Moreover, real growth has averaged more than four


percent in four of the last five quarters, with the only weak link being the “frozen” economy associated with the horrible winter weather in Q1 2014. A portion of the rebound in economic activity over the last two quarters was a catch-up from the weakness at the start of the year. Still the latest readings on the economy, even with some indigestion from the energy sector, are extremely favorable and will support solid domestic growth in the upcoming year. The decline in energy prices should operate like a tax cut, especially to middle class consumers and those businesses that use energy as an input cost. The 0.7 percentage point boost to real GDP from lower energy costs will more than offset the 0.2 percentage point drag that lower energy prices will likely inflict on the energy and energy-related sectors of the economy. Moreover, headline consumer inflation is likely to decelerate to less than a one percent pace over the near term, which will provide a solid boost to real disposable income, especially for middle class consumers. Although selected service price pressures were starting to accelerate from a very low level in 2014, the drop in energy costs should boost profit margins for many service industries that should help to keep core consumer inflation below the Fed’s two percent target in the upcoming year.

Internationally, the export market and production activity has once again weakened in Europe, with many of the southern Europe economies still suffering from high unemployment and weak or declining local economic conditions. In recent years European officials were often able to find creative ways/gimmicks to address the debt burdens in the region. This included a policy shift for continental Europe away from extreme austerity. Likewise, the ECB did what it could to provide additional monetary stimulus, but in recent months it has been more a story of over-promising and under-delivering, particularly when it comes to monetary policy action plans. Draghi and the ECB will attempt to implement another aggressive quantitative easing program in early 2015. However, we remain cautious that the program might not be big enough, especially given the unwind of more than one trillion Euros from the ECB’s balance sheet the last two years, legal restrictions, and the hardline stance from Bundesbank officials.

We are still concerned that if a debt problem resurfaces it would likely be centered in either a southern Europe

or an energy-centered emerging market entity. The situation in Greece is deteriorating and could be a key stress point pending the outcome of the January 25th election. The extreme left Syriza party is currently leading in the polls and its leader, Alexis Tsipras, has vowed to end the austerity programs. If a Syriza-based coalition wins the election and such action is implemented it could set the stage for a Greek exit from the Euro which could fuel additional political, economic, and financial market unrest, with the stress point centered in Europe. Recently former Greek Prime Minister George Papandreou (the former leader of the Pasok party) created a new political party called the Democratic Socialists to try to prevent a Syriza victory. However, if Syriza wins the election and is able to form a coalition to rule Greece, we could see a mini-repeat of 2011 for Europe as this action would reignite the left leaning, anti-austerity push in several other European entities.

The sharp drop in energy prices and revenues will likely fuel a major recession in Russia and to a lesser extent in Brazil that could spark a mini-repeat of the default events that unfolded back in 1998. Both countries have raised rates to defend their currency and to try to stem a dangerous acceleration in import inflation (caused in part by the currency weakness) that is putting significant pressure on consumers and economic activity in both countries. Russia, for example, could post a five percent decline in real GDP in the upcoming year. Energy intensive companies in the emerging markets that issued dollar-denominated debt could be the most vulnerable, with Russian and a few Brazilian companies at the top of the list. We also are concerned about a potential contagion effect from banks and financial institutions involved with these entities, or companies and economies that are dependent on the economic activities in these two regions as well as the energy patch in general.

On the surface, real GDP growth in China has held in reasonably well at about 7.3 percent in 2014. However, we do not believe the numbers as the underlying components do not add up. A closer review of the production, housing, consumption, trade, and utility usage data suggests that the true real GDP in China was probably closer to six percent, with signs of a further deceleration in economic activity likely in 2015. The Chinese government is trying to engineer a soft landing


and working towards an increased focus on helping the middle class. Unfortunately, economic activity from the middle class Chinese consumer has been and will likely continue to come in below expectations. We look for China to continue to “fudge” the GDP numbers higher (6 percent) to make conditions look somewhat better. We will take our clues from the underlying components of GDP and earnings to evaluate how well China is transitioning to a better balanced economy. Recently earnings growth has remained elusive, particularly for the traditional state owned enterprises, but lower energy prices may help the earnings picture in 2015. Monetary policy stimulus, along with a rotation from real estate to equity investments by Chinese consumers, fueled a nice rebound in local Chinese stocks late last year that could improve consumer net worth and spending in 2015. However, if profits don’t turn positive this could eventually become the next bubble to watch.

As was the case a year ago, we remain more optimistic than the consensus forecast for the U.S. economy, corporate earnings and the U.S. equity market for the upcoming year. We still see significant macroeconomic challenges in southern Europe that are now being met with a weaker northern European export market, a drop in the Euro, and greater geopolitical and economic difficulties. A year ago we were somewhat encouraged that European officials tempered austerity measures, but the upcoming election cycle in Greece, Spain, Portugal, and even the UK present some additional challenges on the fiscal front, while Italy and France will likely find it extremely difficult to meet their budget deficit targets. The majority of the ECB remains committed to quantitative easing. Given the sharp reduction in the ECB’s balance sheet the last several years and the lack of support for aggressive stimulus by German monetary officials, we remain concerned that the QE program that gets implemented will come in short of what is needed to fuel a significant boost to economic activity in Europe. As for the emerging economies, the days of booming economic growth for many in this region is long gone. Several resource-oriented entities will continue to suffer from deteriorating conditions as a sharp decline in economic activity and a bad inflation mix of lower prices for their export markets and higher prices for input costs could increase social unrest. However, those countries that can take advantage of lower energy costs, such as India, should benefit from the end of the commodities super cycle.

We continue to look for a backup in market interest rates in the U.S. as the Fed begins to normalize the Fed funds rate. On the commodities and inflation-hedging front, we still recommend underweights but will evaluate opportunities to neutralize at least a portion of this allocation during the year.

Scenario Analysis 2015In formulating our projections for 2015, we calculated a weighted average of each of five scenarios below to generate our baseline overall forecast.

Our weighted average forecast for 2015 is for:

• 3.4 percent real U.S. GDP growth

• 0.6 percent real European GDP growth

• 2.70 percent 10-year Treasury note yield

• 8 percent rise in S&P 500 earnings

• P/E multiple expands to 17.4 times 2015 earnings (from 17.2 times 2014 earnings at the end of last year), which if realized would boost the S&P 500 Index to 2250 in 2015. This would represent almost a 12 percent total return (including dividends) from last year.

Each of our scenarios is presented in more detail as follows:

Core ScenarioOur core scenario, for which we attach our highest probability, forecasts the U.S. economy to expand at a 3.5 percent pace in 2015 and for the S&P 500 Index to rise to 2275. In this scenario we expect the yield on 10-year U.S. Treasury notes to increase from the current yield of 2.17 percent to 2.75 percent. Our core scenario anticipates stronger growth in the first half of the year,

Table II

Scenario Analysis 2015Scenario Probability

Core Scenario 38%

Strong U.S. Growth 30%

Growth Challenged 15%

Eurozone/Asia/Middle East Disaster 10%

Global Growth Surprise 7%


an energy-induced moderation in headline inflation to less than one percent, and a modest 1.7 percent rise in core consumer inflation. On the monetary policy front, this most likely scenario would push the Fed to begin to normalize the Fed funds rate by mid-2015 and by year-end the Fed funds target is projected to be at or slightly above one percent. Under our core scenario, European economic activity would continue to struggle with several countries still marred in rolling recessions. Economic activity in Japan would accelerate to about a two percent pace. However, a deep recession in Russia and more moderate contractions in several resource providers, combined with a continued deceleration in the real growth rate in China (to a still overstated 6 percent pace), should temper emerging market real GDP growth to 3.5 percent, which would place global real GDP growth at 3 percent. The greatest risk to our core scenario is on valuations as the fear of contagion from the problems among resource providers and in Europe could fuel a modest reduction in P/E multiples and a continuation of the “fright to quality” support for U.S. Treasuries.

Strong U.S. Growth ScenarioA continuation of the industrial production renaissance in the U.S., combined with solid employment gains, a strong increase in real income gains, a rebound in discretionary spending from the middle class, and a moderate rise from housing and business investment, should benefit U.S. economic activity. An associated rise in consumer net worth, consumer confidence, corporate cash flow, and profits, could provide the basis for a growth “surprise” in 2015, with the added boost coming from stimulus associated with the late 2014 drop in energy costs and the positive feedback loop from the strong post Q1 2014 demand-induced increase in real GDP. Under this scenario real GDP in the U.S. could increase to a 4.3 percent pace and Europe could post a positive 1.5 percent gain in real growth. Likewise, emerging economies would potentially accelerate to a 4.5 percent pace, with oil prices potentially rebounding toward $70 per barrel. S&P 500 earnings could rise to $134 (up 12 percent) and the S&P 500 index could post a total return around 23 percent, with a moderate expansion in the P/E multiple. Under this strong growth scenario we would likely see a rotation from fixed income to equities as the 10-year note could move back towards 3.25 percent in anticipation of a somewhat

faster normalization in monetary policy in 2015. We attach a 30 percent probability to this U.S.-driven growth scenario. If realized, it could also help to jump-start both economic activity and the equity markets in the non-U.S. developed and emerging world.

Growth ChallengedFor this scenario, we assign just a 15 percent probability. U.S. economic growth would slow to just 2.2 percent for the year, which given the positive tailwind since Q1 2014, would equate to a few quarters of sub two percent real growth. Under this low probability scenario the unemployment rate would stop declining, the Fed would likely delay or abandon the normalization process, the 10-year note could receive a further “fright to quality” boost that lowers the yield to 1.75 percent, the P/E multiple for the S&P 500 Index would contract, earnings would be up a meager two percent, and the S&P 500 Index would post a modest negative return for the year. Catalysts for this scenario could include a sharper slowdown in economic activity in China, a return to a full recession in Europe, a significant recession in resource-centered countries that fuels a pick-up in defaults in energy or commodity centered industries and, possibly an increase in military activity from Russia.

Eurozone/Asia/Middle East Disaster We attach a ten percent possibility to what we call a “Eurozone/Asia/Middle East disaster.” The upcoming election in Greece is just the first of a handful of challenging European elections slated for the upcoming year. Given the fact that Syriza is currently ahead in the polls, the risk of a Greek debt failure and/or exit from the Euro has increased. Moreover, we are still concerned about the ability of the ECB to implement a meaningful quantitative easing program, especially given the massive reduction (effectively a tightening) in the size of the ECB’s balance sheet the last two years. However, when we look at the risk for a true disaster scenario, the Russia/Ukraine situation (including the various trade sanctions, recession challenges, default risks, and additional war risks) is still at the top of the list. A bad outcome with Russia is expected to have its greatest impact on Europe. The economic, geopolitical, and inflation conditions in Venezuela, Brazil, North Korea, and the Middle East are heightened at this junction. Likewise, disruptive debt/fiscal issues, particularly in the


EM/resource-centered world, could produce a significant drag on economic activity and the performance of the equity markets. If these problems were to become the market-dominating events we could get a solid contraction in economic activity in the Eurozone (-1.2 percent real GDP), a massive slowdown in activity in the U.S., and a challenging economic environment in the emerging Asia region.

The net result would be a sharp reversal of the domestic equity market gains registered since July 2013. Internationally, we would likely see a further spike in the unemployment rate in Europe towards 13 percent and several southern European countries could face extreme debt and economic challenges that would further handcuff economic activity and produce even sharper equity market declines in Europe as well as many parts of the emerging world. We view this “worst of all worlds” scenario as being low, but the combination of weak earnings and a contraction in the P/E multiple would skew the equity market returns of this tail risk even further to the down side if it were to unfold, with the greatest declines centered outside the U.S.

Global Growth SurpriseWe place a seven percent probability on this scenario that would include a strong global rebound in real economic activity to 5.2 percent in the U.S., 2.5 percent in Europe, and 5.5 percent in the emerging markets. Should this scenario unfold, we would likely see a significant bottom in input costs and commodity prices as well as a moderate pick-up in inflation to just north of

two percent. This in turn, would likely fuel a faster and more aggressive normalization of monetary policy by the Federal Reserve that would prevent an expansion of P/E multiples in the U.S. and could fuel stronger equity market performance from foreign stocks.

Under this scenario, we would look for the yield on 10-year notes to back up to 4.25 percent and for the Fed to be a bit more aggressive in not only normalizing the Fed funds rate, but in driving this rate to at or above the core rate of inflation. The U.S. economy would likely face a moderate battle with wage inflation as the potential move towards a four percent or lower unemployment rate by year end would increase fears associated with full employment.

A year ago we talked about the small risk for a “Nirvana” outcome, which we defined as a best of all worlds outcome that would include strong growth, a continuation of low inflation, monetary policy stability out of the Federal Reserve, and stable market interest rates that would keep the yield on the 10-year U.S. Treasury notes below both real and nominal GDP. For 2015 the likelihood for “Nirvana” is extremely low but if it were to be realized the domestic equity market could become priced to perfection, possibly including an expansion in the price-to-earnings ratio toward a 20 multiple.

Table III below presents our full scenario analysis and latest probabilities and projections for 2015.

Table III

Scenario Analysis and Projections for 2015

Scenario ProbabilityGDP US

GDP Europe

US Un- employment

Rate10-Year

Note Yield

Earnings Growth

Rate

S&P 500 P/E Multiple

S&P 500 Index Level

Eurozone/Asia/ ME Disaster 10% 1.0% -1.2% 6.6% 1.25% -3% 14.5 1680

Growth Challenged 15% 2.2% -0.3% 5.7% 1.75% 2% 16.5 2015

Core Scenario 38% 3.5% 0.3% 5.0% 2.75% 8% 17.5 2275

Strong U.S. Growth 30% 4.3% 1.5% 4.4% 3.25% 12% 18.5 2480

Global Growth Surprise 7% 5.2% 2.5% 3.8% 4.25% 17% 17.5 2450

Weighted Average 100% 3.4% 0.6% 5.0% 2.70% 8% 17.4 2250

Please see Market Commentary Notes


The Core Themes Underlying Our OutlookFor the last several years we have focused on four core themes as major ingredients to our more bullish than consensus outlook for both the U.S. economy and the U.S. equity markets. These themes — a domestic industrial production renaissance, changing demographics on the employment front, a soft landing in China, and Europe muddling along — remain core issues for our outlook for the year ahead. As we noted above and address in greater detail below, we are concerned that the recent GDP readings in China do not fit with the sub-components of the Chinese economy. The net result appears to be that China is now overstating GDP growth by at least one percentage point which has economic and investment implications for many parts of the world and may explain a portion of the drop in commodity/raw material prices in the second half of 2014. As for Europe, muddling along was an accurate description for continental Europe the last several years, but the events in Russia/Ukraine, including the sanctions and the sharp drop in European exports to Russia (especially from Germany), has changed this story. Several European economies are no longer “muddling along”, but instead are either back in or on the verge of testing a recession. The type of debt issues that unfolded in the summer of 2011 are back and the ECB has unfortunately returned to an over-promise but under-deliver mode when it comes to the next round of quantitative easing programs. We hope the European leaders finally work together to do the right things to turn the tide and return Europe to a solid growth mode, but at this juncture we remain cautious and we will take our clues from actions and events that are implemented, rather than words that are touted.

Theme #1 – A Domestic Industrial Production Renaissance For several years the continued surge in energy investment in the U.S. was a long-term positive for the domestic energy, chemicals, and industrial sectors. The U.S. has dramatically reduced its dependence on foreign energy as domestic production has surged. This boost in production, combined with a shift to greater conservation, helped spark a significant reduction in U.S. energy imports. The events in the U.S., combined with a pick-up in output from many foreign markets,

including OPEC and Russia, and weaker demand from several nations, including China, has fueled a supply and demand imbalance in the energy sector that drove oil prices sharply lower in 2014, with the bulk of the decline occurring in the final quarter of the year. Effectively the success of the energy renaissance in the U.S. helped to fuel a portion, but certainly not all, of the recent drop in oil prices. The energy investment boom in the U.S. may be ending and the rise in CAPEX from this industry will likely be followed by lean months and quarters ahead. Nonetheless, the drop in energy costs will be a benefit to many domestic non-energy industries and the U.S. consumer which combined represent more than 80 percent of the U.S. economy. We may see a mini-repeat of what unfolded following the major drop in energy prices in 1986, when the energy patch suffered from a sharp drop in energy prices, while the bulk of the remaining economy (as well as the stock market) was boosted by the decline in energy costs.

For 2015, we look for low oil, gasoline, natural gas, and overall energy costs to continue to provide stimulus to a domestic industrial renaissance for many industries outside the energy sector. Production plants are still being moved to the U.S. to take advantage of the lower domestic operating and shipping costs. The domestic chemical industry is receiving an added windfall as the low natural gas costs have helped to make U.S. companies low cost producers. The drop in energy costs has been the equivalent of a massive tax cut, with the greatest benefits being received by traditional manufacturing companies and the middle class U.S. consumer which is now in the process of boosting discretionary consumer spending.

Energy capital expenditures (CAPEX) are likely to fall in the upcoming months as this sector adjusts to the sharp drop in prices. Although the boom from the energy sector has been a source of growth in recent years total energy-related CAPEX is only about 10 percent of total CAPEX in the U.S. economy. And with the ages of the average factory, plant & equipment in the factory, and factory worker all at all-time highs, the need for an infusion of capital into many plants outside of the energy sector remains strong.

The improvement in factory employment has been impressive. Factory employment, for the first time in modern history, has expanded for 50 consecutive


months, and based on upcoming production schedules for the auto industry, we look for domestic manufacturing activity to be a source of growth early in 2015. The weakness in the energy sector will present some challenges for the mining and energy industry and for those factories that support the energy industry. Despite the fears in the energy sector, we believe that it is important to remember that oil and gas related employment currently represents less than one percent of the total jobs in the U.S. economy.

On a positive note, the likely rise in overall real disposable income (in part due to lower energy costs) should fuel a more than offsetting positive feedback loop that benefits several aspects of the industrial sector as well as discretionary spending at retailers, restaurants, and hotels. A back-up in market interest rates could make the housing sector a bit more volatile in 2015, but this may be partially offset by strong pent-up demand, favorable demographics associated with net household formations exceeding available supply, and the positive benefits of stronger employment, higher job confidence, a rise in real wages, and a further gain in consumer net worth.

Theme #2 – Changing Demographics on the Employment FrontFor several years, the eternal doom and gloom economists and strategists have incorrectly argued that the decline in the participation rate was a sign of structural weakness in the economy. In contrast, as we discussed more than a year ago and continue to emphasize today, the data supports our long-standing view that the bulk of the reduction in the participation rate, as well as a portion of the drop in the unemployment rate, reflects demographic changes that are unfolding as the baby boomer population starts to age out of the workforce. Interestingly, the latest research out of the Federal Reserve’s research staff confirms our view that the bulk (about 75 percent) of the reduction in the labor force participation rate in recent years has been structural, rather than cyclical. This is a different assessment than many Fed officials, including Chair Yellen, had been touting, and suggests that the U.S. economy is probably within a year or two from testing “full employment”. Many economists have touted that the economy needs to generate about 150,000 net new jobs per month to hold the unemployment rate steady. However, as we have

stressed for years, a closer review of labor demographics still shows that the economy needs less than 100,000 net new jobs per month to keep the unemployment rate steady. This slower growth rate in the size of the labor force has important implications for the near term direction of monetary policy which should push the Fed to start to normalize the Fed funds rate in the upcoming year.

The U.S. economy added about 2.7 million jobs in the first 11 months of 2014, pointing to the best year for employment growth since 1999. Nonfarm payroll employment surged 321,000 in November (its biggest increase since January 2012), with the bulk of the increase centered in a 314,000 advance in private payrolls. Moreover, the September and October payroll readings were revised upward by 44,000, which boosted the three-month average gain in nonfarm payroll employment to 278,000. November marked the 10th consecutive month that payroll employment increased by at least 200,000, the longest such stretch since the 19 month period that ended in March 1995. The bulk of job gains, as has been the case in recent years, were full time jobs. In the upcoming year, we look for employment gains to taper a bit, especially in the second half of the 2015 as it will become a bit more difficult for corporations to find people with the skill set necessary to continue the recent job-hiring pace. We look for a modest rise in wages, particularly in real terms, but the increase will likely be fueled from the benefits of stronger corporate profit-sharing plans and not the start of a wage cost inflation cycle.

Theme #3 – A Soft Landing in China For several years we have been touting a “soft landing” for the Chinese economy that would go beyond simply the magnitude of a lower GDP number, as the shift from fixed investment to consumption unfolds. Although the most recently reported real GDP for China was 7.3 percent, a closer assessment of the underlying components suggests that true GDP was closer to six percent. For years China’s electricity consumption was a good proxy for industrial production, but recently electricity consumption has been running five to six percentage points below the stated production readings. We have a hard time believing that China has suddenly gotten a massive dose of energy efficiency. A more plausible explanation is to assume the production


numbers are overstated. Similarly, nominal retail sales in China were reported at up 12.4 percent on a year-over-year basis in November, which was a slowdown from the more than 18 percent equivalent pace about four years ago. In contrast, retail sales among the top 200 retailers in China were basically unchanged on a yearly basis in the most recent period, versus about a 20 percent pace four years earlier. The advent of internet purchases, specifically from Alibaba, can explain some but not all of this discrepancy. Likewise, car sales and discretionary purchases of luxury goods have been weak. We believe that this unexpected slowdown in Chinese consumer spending is one of the most overlooked headwinds for the economy in China. However, it does help to explain the drop in input costs and the trimming in the production sector that has been felt in a variety of raw materials markets, including the iron ore and energy sectors.

The rail freight readings from China have been much weaker (down almost seven percent) than the export readings which were reported at up almost five percent. It seems unlikely that China suddenly found a new way to transport exports. A better explanation might include some form of double counting on the export side of the equation. Finally, the consumer in China appears to be feeling the changes of a weaker labor market, the continued decline in the housing sector, and the weakest consumer confidence readings in almost five years. All this is adding up to an economy that is probably on its way to decelerating towards four to five percent in the coming years. However, if recent history is a guide, we expect that Chinese officials will continue to overstate the true economic picture for the next several years. The net result could be a continuation of the recent difficult period for profits of state-owned enterprises and areas at the center of excess capacity. Eventually the development of the consumer middle class should unfold and we see the best opportunities in businesses that can provide true costs savings to China, including healthcare, which may be best approached through the private sector.

Beyond China there are impacts of this “lightening” of GDP, as less infrastructure spending means less demand for commodities and hence for the commodity producing emerging markets. While the new government appears to be tackling these longer term challenges, as we stressed a year ago, commitment

and execution warrant ongoing monitoring. China is beginning to address longer term issues and move further away from the sole production-oriented economy that was the engine of China’s growth boom in the last decade. On a demographic basis China is decelerating dramatically. In the upcoming years the working population in China will peak and the structural deceleration in overall economic growth is anticipated to continue for several decades.

As we enter 2015, market participants are likely to debate whether emerging market equities will face another year of underperformance to the developed world or whether valuations are cheap enough to invest in this region. In contrast to a few years ago, several key emerging market economies have been challenged with wage inflation pressures, a deceleration in productivity, a rise in market interest rates as monetary policy was tightened to fight internal inflation and/or currency weakness, and a lack of pricing power. The net result of these events has created a more difficult period for business profits and, in several cases, equity market returns. Several EM central banks have been forced to tighten monetary policy which has hurt business conditions, while Russia has become the epicenter of geopolitical tension. Those countries (like India) and businesses that can navigate through this difficult period will likely be rewarded, but the path to prosperity in this region is likely to be a volatile one. We believe that these conditions may provide benefits to active managers, notably those engaged in private markets, that can navigate in a more volatile period and avoid the value trap of placing too much emphasis on backward looking valuations..

Theme#4 – Europe Muddles Along For several years Europe has been challenged by rolling recessions in the southern-European countries and at best very weak growth in the North. A bright spot has been Ireland. In the early part of 2014, the potential for a lift-off from Europe seemed possible but the Russian/Ukraine crisis pushed several countries back into a recession test, with the previously slow growth German economy in the mix as exports to Russia declined sharply. On balance, most of Europe is once again at best muddling along. Continental Europe is in desperate need for aggressive monetary policy action that to date has been a story of over-promising and under-


delivering. During the last two years the ECB’s balance sheet has declined by more than one trillion Euros. Despite all the talk by Draghi and company, reserves have actually been drained by the European monetary system. The cost of money in Europe is clearly cheap, but the demand for loans from credit-worthy borrowers has been lackluster at best. Southern Europe still faces a rough road ahead from high unemployment, low productivity, and high unit labor costs that will receive some additional tests from the next round of elections beginning with Greece later this month. A Greek exit from the Euro is a real risk if Syriza gains control later this month. It is clear that most of the European leaders understand the challenges of the southern European entities, but more aggressive monetary policy moves need to be implemented in the coming weeks and months to return Europe to a favorable economic growth story. From an investment standpoint, we still see a significant benefit for those businesses in Europe that can take advantage of the evolving global consumer, rather than focusing on the demand within Europe. We also see a benefit to Europeans from the drop in energy costs and the decline in the value of the Euro. However, for the last two years corporate profits in Europe have failed to meet even low end expectations. A weaker export market to both Russia and China may continue to hinder business activity and the potential return to normalized profits. Near term, we continue to worry that the ECB will not be able to obtain a big enough boat (QE program) to navigate through the difficult storms in Europe.

Strategies and Positioning In large part 2013 was a straight line up for equity markets. For 2014, the equity market was driven by strong returns in the U.S. that coincided with the structural improvement in U.S. economic activity and solid earnings. It was a year where declines in the U.S. stock market offered buying opportunities for investors. In contrast, the majority of the foreign markets had a difficult year, with European equities and resource-oriented EM entities suffering the greatest loses. As we enter 2015, we remain constructive on U.S. equities but cautious on many markets outside of the U.S. We expect higher volatility as the year progresses and more opportunities to allocate capital tactically to take advantage of changing market sentiment. We believe

2015 will also be a good year for active managers as return differentials should remain wide for both various regions of the world and sectors.

Equity StrategiesFor 2015, our assessment of opportunities and managing risk still favors active managers with an overweight to equity allocations in the U.S. and to a lesser extent Japan and an underweight to Europe and emerging market resource entities. Although Japan was technically in a recession in the middle quarters of 2014, the bulk of this downturn was due to the consumption tax increase from the prior Administration. In contrast to Europe, corporate profits in Japan have held up reasonably well and the labor market is solid as witnessed by the extremely low 3.5 percent unemployment rate. The economy in Japan will benefit from the drop in energy costs and, compared to Europe, is less sensitive to the economic challenges in Russia. Favorable aspects in Japan include the vote of confidence that Abe recently received, the strong coordination of monetary and fiscal policy actions, the recent decision to dramatically increase the equity allocation for pension funds, and the strong pent-up demand from the Japanese consumer.

In the emerging markets, we favor an underweight relative to ACWI. We see greater opportunities in utilizing managers that are focused on investing in companies positioned for the developing global consumer middle class, rather than the resource providers and industrial entities that are being challenged by limited pricing power and redundant capacity. These factors, combined with selected wage inflation pressures, capital constraints, currency challenges, and a lack of pricing power for resource providers, will continue to be evaluated by our investment teams in the upcoming months to potentially adjust our allocation and approach to emerging markets.

Private equity markets pose potentially attractive opportunities to supplement the public markets, as we expect that the long term illiquidity premium will continue to be earned, albeit at slightly lower levels than the past. This is particularly so in emerging market economies where the best investment opportunities are in developing consumer sector, information technology and healthcare – all sectors underrepresented in public equity markets. Private opportunities exist in Europe as well and distressed purchases are likely in the years ahead.


Hedged equity strategies in 2015 will be important to dampen portfolio volatility and generate alpha from long and short positions. Our emphasis this year will be to make greater use of equity market neutral strategies in portfolios to provide a more flexible approach to manage market exposure while still maximizing opportunity to generate uncorrelated returns, given increased uncertainty and the likely start of the neutralization process by the Fed.

Despite the strong multi-year U.S. equity market returns, the expansion of P/E and P/B multiples in 2014 was limited and U.S. equity market valuations are still within striking distance of long-term historical parameters. Moreover, many stocks are actually cheap relative to the extremely low earnings yield on U.S. Treasuries and high-grade corporate bonds. Moderating domestic input costs associated with improved production efficiency, cost advantages from the decline in input (energy) costs, and strong productivity gains in the business sector are expected to produce another increase in earnings in 2015. In a similar fashion to 2014, it is generally anticipated that the bulk of the domestic equity returns for 2015 will be driven by earnings, dividends, and buybacks, rather than an expansion in the P/E ratio. However, when we look at longer term cycles for the economy and the stock market, the current environment of better growth with lower inflation is normally met with a modest increase in the price earnings multiple. We remain bullish on domestic U.S. equities, but given the challenging events overseas and in the energy sector, we expect to see more market volatility. Moreover, uncertainty associated with the likely start of the normalization in the Fed funds rate in the upcoming year could spark either new challenges or new opportunities in 2015.

Fixed Income StrategiesThe recent regime of very low absolute and relative interest rates in the U.S. should finally come to an end in 2015 as the start of the normalization process is likely to boost the yield on 10-year notes to 2.70 percent, from roughly 2.17 percent at the end of 2014. We anticipate that this action will fuel a rotation out of the belly of the Treasury curve and if it is met with stable to slightly better economic conditions abroad we could see a global investor reallocation away from Treasuries that might be difficult for the fixed income market to absorb, especially given the cutback in the primary dealer community.

On the other side of the coin, low inflation, the economic problems in Europe and in several resource-oriented emerging markets, combined with business difficulty with high-cost energy providers, could fuel a continuation of the “fright-to-quality” buying in longer-dated U.S. Treasuries. Moreover, at some point the early believers in equities that bought stocks several years ago when the S&P 500 Index was hovering between 700 to 1100, may get the desire to cash in some of their winnings and rebalance back into foreign stocks, possibly even commodities, or cash.

We continue to take a cautious approach to duration and our general point of view calls for an underweight to Treasuries and TIPS. We see an opportunity to harvest gains from the high yield and distressed area and see better risk-adjusted value in high-grade corporates and mortgages. We do not like the negative real yields in intermediate Treasuries. Over the next several years, we believe that the yield on 10-year notes will back up but the terminal center of gravity will probably be in the mid three percent range. Similarly, we anticipate that the next cycle in monetary policy from the Fed will ultimately take the funds rate towards three percent, which is lower than the terminal rate touted by most Fed officials.

Inflation Hedging StrategiesInflation in the U.S. continues to be largely missing in action and will likely continue to be so in 2015. The sharp drop in energy costs will continue to hold down headline inflation while the core CPI and core consumption deflator components should remain in check below the Fed’s two percent target. In the early part of 2015, the sharp drop in energy prices could temporarily push year-over-year headline inflation below zero, we believe this would be temporary and do not see a protracted period of deflation in the U.S. We have favored an underweight to inflation hedging strategies for several years and this has been beneficial. We and our managers see greater opportunities in private real estate and voice concern that a back-up in market interest rates could create continued indigestion for selected areas of the REITS market. Although we begin the year still favoring an underweight to commodities, we will evaluate opportunities to neutralize at least a portion of our underweight to this sector in 2015, possible through allocation to other asset classes.


Concluding Views Despite our long-standing favorable view towards the domestic equity market, we are mindful that macro and political events could turn quickly and overwhelm currently favorable domestic fundamentals. As such, as we work through 2015, we will be looking for opportunities to take some equity chips off the table, particularly in Japan and selectively in the U.S., as we anticipate future moves from the Fed.

Globally, the situation in Russia as well as the Middle East is far from stable and geopolitical tension is high in many parts of the world. Downside risks associated with debt problems that drastically hinder economic activity could resurface and potentially challenge equity valuations. Thus, being nimble to adjust as conditions change will be important in the upcoming year.

The key questions to focus on for the upcoming year have not changed dramatically and include the following:

• Will the recent rebound in U.S. economic growth, employment, and industrial production continue in 2015?

• Will the U.S. remain in the current disinflation economic boom? What other entities could join this party?

• Is the growth in earnings in the U.S. sustainable?

• Will the third year of a presidential cycle be the charm that it has been historically for the last 60+ years?

• Are we only midway through a decade of U.S. economic and financial market dominance?

• Will Russia, China, Japan, Brazil, Venezuela, and Europe be able to successfully navigate through their current economic and geopolitical challenges?

• Will the general lack of liquidity in fixed income assets become a problem for capital markets, particularly emerging market debt?

• Can Europe successfully return to economic growth and ultimately profitability or will a Greek exit be tested, fueling a repeat of the strains last seen in the summer of 2011?

• Can the financial markets handle unexpected events from Russia, Europe, the developing world, or the Middle East?


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