J. Andrew Concannon
Chief Investment Officer
Chief Investment Officer
Since the start of the industrial revolution, people have worked to become proficient at mining, manufacturing, financing, and selling all types of goods. It became evident this past year that our proficiency has led, at least temporarily, to too much production. As a result, much of the world now has too much of too many things.
This current condition of too much and too many can be seen in several markets. The most commonly discussed is the oversupply of oil as shown in Figure 1. In response to a sharp rise in oil prices early in the last decade, oil companies invested heavily in new production which has led to too much oil being produced. A similar situation has occurred in the metals mining industry. In an effort to supply what once appeared to be endless growing demand from China, companies opened too many new mines and created a glut of industrial metals. And the desire to supply goods to a growing middle class in emerging market countries, along with higher factory productivity, has led to too much manufacturing capacity. This is evident by factory utilization rates in the mid-seventy percent range in both the U.S. and China.
Another example of the too-much-too-many condition can be found in the retail sector where endless pressure to grow sales, combined with the ease of online shopping, has led to too many retail stores. Highlighting this problem was a recent report stating that more Americans shopped online than in stores over the Black Friday weekend.
Our final example of too much, too many is money itself. Most people do not feel as though they have too much money, but the world as a whole is awash in it. Central bankers desiring to inflate their economies have created more money than can be absorbed. In the U.S. this has led to banks holding more than $2.5 trillion in reserve deposits at the Federal Reserve throughout most of 2015. This is mostly money for which the banks cannot find qualified borrowers.
A world with too much of too many things unfortunately did not lead to too much return for investors this past year. Instead returns for most asset classes were modest to negative. The problem for stock investors was that surpluses led to lower prices which in turn led to lower earnings for the businesses affected. And for bond investors, because interest rates are the price for money, excess money in the economy meant a continuation of low rates.
Commodity traders have a saying that you should buy surplus and sell scarcity. This is just another way of saying that you should buy when prices are low and sell when prices are high. Given enough time, this will prove to be good advice, as the world grows to absorb the surplus. But this will not occur soon enough to avoid more financial losses for industries that are producing too much.
History serves as a valuable guide for predicting long-term outcomes, but it gives little insight as to timing. That is why diversification and having a long-term horizon are so important to successful investing. Speaking of the long-term, below are our thoughts on the longer-term outlook for the U.S. stock and bond markets.
The slight price drop in the S&P 500® Index over the past year combined with both higher dividends and trend earnings improves our 10-year return outlook for the index. We currently forecast an annualized rate of return between 5.3% and 7.5% for the next ten years versus our forecasted range of 4.3% to 6.5% at the end of 2014.1 The improved outlook remains below the long-term 10% annual return average for the index, but it is well above yields available on investment grade bonds, thereby compensating investors for the added volatility of owning stocks. We continue to be neutral on equity exposure relative to long-term targets.
Improvement in the long-term outlook for bond returns depends on higher interest rates. A first step in that direction came in December when the Federal Reserve raised the federal funds rate by one quarter of a percent. The current target federal funds rate of 0.25% to 0.50% is still well below the Federal Reserve’s normalized target rate of 2.0% (equal to its inflation target), so it’s bias leans toward additional rate increases. Future rate increases, however, will depend on the economy’s strength and are by no means guaranteed.
We remain defensive in our bond portfolio strategy by favoring shorter maturities relative to benchmarks. Yields on longer-maturity investment grade bonds, which are little changed versus a year ago, provide insufficient compensation for the amount of interest-rate risk attached. As shown in Figure 2, the yield on the 10-year U.S. Treasury bond is currently less than half the long-term average. Rather than reaching for yield by extending maturities, we prefer to obtain what limited yield is available through reasonable credit exposure.
1 A change to how we incorporate dividend growth in our forecasting model has raised the 10-year forecasts produced by the model. By way of comparison, our previous model predicted a 10-year annual rate of return of 3.9% to 5.9% at the end of 2014.)