Buckle Up for a Wild Ride in 2015

By E.S. BROWNING

The experts said 2014 would be wild. They were right. They think 2015 will be wilder.

 

Stocks scared investors five times in 2014, with sudden pullbacks in January, April, July, September and December. Each time, the market soon recovered.

This year, with stocks more expensive than a year ago and with the market backdrop murkier, money managers are bracing for more and potentially bigger pullbacks.

“We have the view that investors need to buckle in,” said Lori Heinel, chief portfolio strategist at State Street Global Advisors, which oversees $2.42 trillion in Boston.

Few money managers anticipate a recession, not in the U.S., at least. Most expect U.S. stocks to finish the year with gains. Ms. Heinel and others do, however, expect stocks to face a series of hurdles. Among the most prominent:

The Stern Parent: Until 2014, the Federal Reserve was an indulgent parent, showering investors with easy money and lots of support, notably in the form of massive bond-buying. Many believe that mix of low rates and cash-injection was the single strongest driver of stock prices. Now, the Fed is becoming a little stricter.

Barring an economic setback, the Fed will start raising interest rates this year. While the changes should be slow and mild, there is no getting around the fact that rising rates aren’t as good for stocks or bonds as lower rates.

One problem is that investors don’t know how much rates will rise, or how soon. This uncertainty is likely to fuel some market swings in 2015.

“The continued focus in the market is still very, very much on the Fed,” Ms. Heinel said. If investors get the sense the Fed is being too aggressive or not aggressive enough, “it could wreak havoc with the market. It has for the last few years and there is no reason for that to change,” she said.

Europe’s Flirtation with Recession: “Europe has significant problems,” said Tony Roth, chief investment officer at Wilmington Trust, which oversees $80 billion.

While U.S. economic output has surpassed its prerecession high, that of the economies using the euro hasn’t, Mr. Roth notes. A number of them are again flirting with recession.

That will hurt U.S. multinationals because so many of them have extensive European business. Those multinationals dominate big U.S. stock indexes. More trouble in Europe, be it energy-related, Russia-related or just demand-related, will affect U.S. markets.

For now, U.S. stocks have been beneficiaries of the European uncertainty, which keeps investors from shifting toward less-expensive European stocks. Foreign and U.S. investors have been keeping money in U.S. stocks, partly because they think it is safer and partly because they expect the dollar to appreciate against other currencies.

U.S. stocks could lose this advantage, however, if investors become less worried about Europe in 2015.

China’s Slowing Growth: China no longer can generate the 10% economic growth it enjoyed as recently as 2010. A December working paper by Chinese central-bank economists indicated growth likely will miss the country’s 7.5% target for 2014 and fall to 7.1% in 2015.

“The slowdown in Chinese growth is not priced in” to stock expectations, especially not in the Chinese market itself, said Anwiti Bahuguna, senior portfolio manager at Columbia Management Investment Advisors LLC, which oversees $358 billion.

China is far from recession, but the growth slowdown is significant. If Ms. Bahuguna is right, slowing growth could make waves in China, in the rest of Asia and in developing countries elsewhere that export commodities to China.

Moreover, Ms. Bahuguna said, stocks in developing countries could be hurt more than in the U.S. by Fed rate increases. Developing countries have been significant “beneficiaries of liquidity from the Fed,” Ms. Bahuguna said. “The Fed can stop raising rates if it hurts the U.S. economy, but emerging markets are not their mandate.”

At the same time, falling oil prices could provide significant help to economies such as India and China, said Mr. Roth at Wilmington Trust. He hasn’t made the move yet, but if there are signs that those economies are benefiting, he said, he could shift some money there.

Russian Instability: Russia is a source of concern on two levels.

With an economy dependent on energy exports, Russia has been devastated by falling prices. Ms. Bahuguna says it isn’t unimaginable that it could have to turn to the International Monetary Fund for aid.

There is the risk of a default “by Russia or a Russian corporation,” said Ms. Heinel at State Street. “That isn’t our core call, but you can’t ignore the possibility.”

At the same time, no one knows how aggressive Russia could become in places such as Ukraine if its economic woes worsen. That uncertainty is part of the reason some investors are wary of investing in Europe, especially Eastern Europe.

High Stock Prices: The S&P 500 trades at 17 to 18 times its components’ profits for the past 12 months, Mr. Roth calculates, “which is expensive by historical standards.” Going back to the 1920s, the average is closer to 15 or 16.

Mr. Roth still expects U.S. stocks to have a good year, in part because alternatives such as bonds are even more severely overpriced. “Where else is the client going to invest?” he said.

Still, high prices contribute to pullback fears and make it harder for stocks to rise much more quickly than corporate earnings. That makes Mr. Roth think about shifting some money to the developing world.

“Because of valuation we will at some point have to go to emerging markets,” he said.

If others think the same way and shift more investment dollars abroad, that creates another obstacle to U.S. market growth.