The Tortoise andthe hare ISSUE 47 | January 2015

A Year in Review

Economic Review

Oil prices plummeting through five year

lows; the US dollar strengthening to a nine

year high; and ongoing divergence in the

monetary policy and growth outlooks of the

worlds major economies. These were the

main themes of 2014.

Divergence everywhere

The IMF estimate1 that global growth in

2014 was a moderate 3.3%, to which

advanced economies contributed 1.8% and

emerging economies contributed 4.4%.

Within the major advanced economies,

the US stood out as the star performer,

returning to close to trend growth rates

and with unemployment falling close

to what would typically be deemed full

employment. Continental Europe continued

with anaemic growth and structurally high

unemployment, whilst the UK matched the

strength of the US. Japan remained in the

doldrums and barely achieved any growth,

after flirting with recession mid-year, driven

by a sales tax rise.

In emerging economies, China grew by

7.4%, narrowly missing its official target

of 7.5%. Whilst one could characterise this

as a multi-year low, growth will naturally

moderate as the economy matures and

the government continues to reorient the

economy from investment to consumption.

Elsewhere in emerging economies, fortunes

were very mixed. India rode a wave of

optimism in the wake of the election of

business friendly Narendra Modi, whereas

Russia suffered disastrous fallout from the

collapsing oil price. The Russian central

bank raised interest rates in an emergency

overnight meeting from 10.5% to 17% and

still failed to immediately arrest the slide

in the rouble, which ended the year down

39% against the dollar.

Did you say disinflation?

Disinflation and lowflation entered

the mainstream lexicon, as central banks in

Europe and Japan struggled with very low

inflation, well below their targets of 2%.

The fear is that if there is an expectation

that this will eventually become deflation

(falling prices), people will stop spending,

bringing about a vicious cycle. Headline

inflation (which includes energy prices), was

particularly affected later in the year with

falling oil prices (below).

Are you still talking about QE?

Against this backdrop, Mario Draghi,

President of the European Central Bank

(ECB) prepared the ground politically for

Quantitative Easing (QE) to be announced at

the January meeting of the ECB. QE is the

monetary policy than central banks engage

in to stimulate the economy and boost

inflation when conventional tools can no

longer be used (if rates are already as low

as they can go). The Bank of Japan also

launched another aggressive round of QE,

to combat low growth and low inflation.

Meanwhile, the US Federal Reserve

concluded its latest asset purchase program

(QE3); having begun to taper new monthly

purchases of $85bn in December 2013, the

program drew to a close in October 2014.

The focus has now turned to interest rate

rises later in 2015.

Strong US economy, strong dollar

The strength of the US economy, in

particular its strength relative to other

major economies; and the contrast

between US monetary policy and that of

Europe and Japan; have led to the US dollar

strengthening to multi year highs. The dollar

index, which measures the US dollar relative

to a basket of other currencies, reached a

nine year high at the end of 2014 and had

appreciated 13% over the year.

This dollar strength was a dominant theme of

last year. In equity markets, non US equities

whilst appreciating in local terms became

losses for USD investors. Commodity

markets also struggled to make progress,

as is typically the case with a strong dollar

(most commodities are priced in US dollars

and therefore become more expensive for

foreign buyers).

Its OPEC, but not as we know it

The Organisation of the Petroleum

Exporting Countries, meeting in Vienna in

late November, took the unusual decision

not to cut production in response to falling

prices. Strong US production, weak demand

from Europe and Asia and supply ahead

of target had combined to create a large

structural surplus; and it is believed that

OPEC ministers felt that a supply cut would

achieve nothing apart from a loss of their

market share. The outcome was a continued

slide in price with ICE Brent ending the year

down 46%.

There are of course winners and losers.

Net importers such as Europe, China, Japan

and the US will gain, whereas exporters in

the Middle East, Russia, Venezuela, Nigeria

and Norway will suffer. Russia suffered the

greatest loss of confidence, given its already

precarious international standing over the

annexation of Crimea, and the MSCI Russia

index in USD terms lost 42% in 2014.

The picture above of winners and losers

does oversimplify though, as the knock on

impact of lower prices on inflation will not

we welcome in Europe and Japan. However

for the world economy as a whole, the

impact should be positive and effectively

act as a tax cut, boosting spending by

companies and consumers.

Looking ahead

In terms of our central expectations for

next year, 2015 should see global growth

continuing to accelerate modestly, with the

US economy compensating for weaknesses

elsewhere and cheaper oil providing a boost.

China will doubtless continue to slow a

little, but most likely in carefully controlled

manner.

A Year in Review

The general monetary backdrop is likely

to remain supportive and accommodative

across the globe, with recovery in Europe

and Japan being supported by additional

easing. Even the US in raising rates will

approach the issue in a measured way and

with one eye kept on weaker parts of the

world.

There will of course be bumps along the

way whether from oil price swings, US rate

rises, low inflation readings or geopolitics.

This is all part of the long term journey

and why long term investors are generally

compensated for taking some short term

risk.

What are you doing with my portfolio?

We consider the economic backdrop to

understand what has happened and may

happen in the real economy. However we

do not attempt to draw any inference for

financial markets, which march to the beat

of their own drum and believe that trying to

time markets is a futile and costly pursuit.

Instead at MASECO, we hold firm to our

strategic allocation and style biases,

grounded in empirical evidence, derived

from decades of academic research. We

now consider these styles in more detail.

References

1. World Economic Update, January 2015

A Year in Review

MASECOS Strategic Asset Allocation decisions reviewedOver the years, we have communicated on

several occasions that there is significant

research and evidence to support the fact

that investors are compensated for taking

certain kinds of risk over an extended period

of time. Last year the results were mixed, in

terms of the premia that MASECO invests

clients money into, but the long term story

remains compelling. In general we follow an

evidence based approach to investing and

believe investors can be compensated by

investing in the following premia:1

Equity risk Small cap equity risk Value equity risk Direct profitability Emerging market equity risk Credit risk in fixed income (principally

investment grade)

Duration risk in fixed income (up to a point)

In addition to overweighting these asset

classes and styles in clients portfolios, we

also act upon research that indicates:

Markets are generally efficient.2

Diversification reduces risk.3 Generally investors are not compensated

with additional return over time for

the additional risk they take when

overweighting their home country a

phenomenon known as Home

Country Bias.

That most global bond indices are market weighted and their largest

constituents are generally the most

heavily indebted government bonds

globally (Japan, US and Europe) thus not

providing investors with the best

risk-reward global bond portfolio.

Real Assets such as REITs and Commodities can provide investors with

returns above the rate of inflation and

are generally not highly correlated with

other asset classes in diversified

portfolios.

Asset classes, not managers, provide investors with return4 and most

portfolio managers underperform their

benchmarks5.

How did these premiums and Strategic Allocations perform in2014 v longer-termThe table below gives an overview of the

performance of each risk premium last

year and every year since the inception of

MASECO at the start of 2009. In each case

we consider an index representative of the

investment st