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What Wall Street missed: The market’s biggest surprise in 2014

Markets React To Federal Reserve Policy AnnouncementMarkets React To Federal Reserve Policy Announcement

Be wary when Wall Street calls something a safe bet.

About a year ago, Bob Doll, a well-followed strategist at Nuveen Investments, put rising interest rates on his list of top 10 projections for 2014. Given that the Federal Reserve was tapering from its bond-purchasing stimulus program (otherwise known as quantitative easing), Doll said, you had to be crazy bearish to not believe interest rates would fail to reach 3.5% in 2014. And he wasn’t alone. A year ago, it seemed, everyone was saying that 2014 would be a lousy one for bonds.

Wrong!

The economy did improve in 2014, and the Fed tapered its bond buying. Yet, interest rates didn’t rise. Instead, they dropped dramatically. The yield on the 10-year bond started the year at just under 3%. It’s now around 2.3%.

As a result, bonds, which rise in price when yields drop, had a very good year in 2014. Granted, it didn’t have as good a year as the stock market, which is up 15% for 2014, but few were predicting a stock market plunge. Bonds, as measured by the Barclay’s Aggregate Bond Index, have risen 5.8% in 2014, including interest payments. That was much better than 2013’s 2% slide for bonds, again including dividends.

So will interest rates surprise again in 2015? Once again, with the economy improving and the Fed looking closer to raising interest rates, high yields and lower bond prices seem to be the obvious bet. Indeed, Randell Moore, who survey’s economists as the editor of the Blue Economic Indicators, says the current consensus is for the yield on the 10-year Treasury bond to rise to 3.25% by the end of 2015.

But not everyone is so sure. For Fortune‘s annual investment roundtable in our current issue, I talked to Russ Koesterich of Blackrock, Henry Ellenbogen of T. Rowe Price, Sarah Ketterer of Causeway Capital, Rajiv Jain of Vontobel Asset Management, and Mario Gabelli of Gabelli Asset Management about what they expect for the next year. The consensus was that interest rates could indeed surprise again in 2015. Here is the portion of our discussion where we discussed what bonds might do in 2015:

Fortune: We came into 2014 worried that Fed tapering would disrupt stocks. It hasn’t. Will we be surprised again by interest rates in 2015?

KOESTERICH: I think so. We have a very different rate environment from the last 30 or 40 years. One, you’ve got lower nominal GDP growth, and long-term rates correlate with nominal GDP. Second, you’ve got a lot of demand from institutional investors at a time when there’s just less supply. Third, demographics. It’s not discussed very much that the population in all developed countries is aging. As you get older populations, the equilibrium for real rates tends to be lower. So I think rates are going to edge up a bit, but I do think for investors you’ve got to get conditioned to the environment in which long-term rates stay much lower than we’ve all gotten used to.

What does that mean for the market, Henry?

ELLENBOGEN: What you’ve seen is there’s a premium for growth. The companies that can grow because of their own structural advantage, because they’re innovative, deserve a premium. The market went overboard on that in 2013. But if you look at what happened this year, small-cap growth stocks have underperformed the market. So a little bit of that financial pressure has come out, and I think it’s now at a point where you really want to go out and understand the changes going on in the economy and buy the right companies.

Sarah, what do you think about small-cap growth companies underperforming?

KETTERER: They have in the U.S. It’s a little different in Europe and Asia. Small-caps tend to do better in the early stages of economic recoveries.

Does it suggest we’re in the later stage of the recovery if people stop buying small-caps?

KETTERER: It says that they’ve just outrun their valuations temporarily, but they’ll catch up. What I find fascinating is that we’re in a prolonged period of low interest rates. That means we have a low cost of capital. That means that stocks can trade at higher valuations for longer. And that helps to add a bit of confidence, because there’s nothing worse than buying at the top.

But interest rates eventually have to go up. Don’t investors have to price that in?

JAIN: I think so. If you look at a 10-year forward basis, lower interest rates lead to lower equity returns. High interest rates lead to higher equity returns 10 years out. Because, as you said, interest rates do eventually go up. If we look at Japan, it’s a perfect example. Interest rates have been low for a long time there. And it hasn’t really been great for investors. The underlying things matter.

Read more: Investing Roundtable: Where is opportunity lurking?