April 10, 2014
Dear Client:
Harsh atmospheric conditions and international events didn’t shake our belief the economy was strong. Thus, we chose to hold our portfolio allocations and ride through the first quarter volatility.
Markets held strong despite Mother Nature, the Fed’s taper and an unfriendly international climate. Global stocks generally experienced 5% declines in January, answered by a February/March rally. The S&P 500[1] set record highs, yet only managed a 1.3% gain. Mid and small caps saw minor gains, but the Dow[2] never reached positive territory. International markets ended unchanged while emerging markets fell slightly. Long government bonds were up 7.5% and gold 6.8%. Industrial commodities fell, led by copper down 11%.
What happened? Mother Nature hit the economy with one of the worst winters in memory – in Pittsburgh we had more sub-zero days in January than the previous decade combined. This hurt growth in many ways. For example, nationally 49,000 cancelled flights with another 300,000 failing to leave on time cost roughly 30 million fliers over $2.5 billion in lost work and out-of-pocket expenses. Other disappointing economic stats were: industrial production fell, unemployment ticked up, and new home sales dropped. There were winners – natural gas soared 17% with seven of the ten biggest demand days on record. Fortunately, corporate earnings rose 8.5% which offset some of the negatives. 62% of companies beat revenue expectations and 70% beat earnings expectations. This helped February/March post better than expected construction spending, ISM manufacturing and personal income. Possibly because of these good numbers, consumer confidence rose to its highest level in over six years. We feel a good quarter under tough circumstances.
The overall public sector was positive. Washington DC actually got things done. Both parties worked together to basically eliminate government shutdowns through the November elections. Republicans sponsored, and both houses passed, a delay of the small business mandate of the Affordable Care Act until 2016. With no new major mandates, the federal deficit declined from $1.1 trillion in 2012 to $680 billion in 2013, a record decline. Across town, the Fed was the picture of stability. The taper continued, we saw a smooth transition to new Chairman Yellen, and she indicated short-term rates would be near zero until mid-2015. Truly the transparent, no-surprise Fed continues. We now see state and local governments as a growth driver. Rising housing markets led to strong revenue increases. This allows for more spending on roads, infrastructure and repair of under-funded pension plans. All the above are positive for growth.
International markets were mixed. Eurozone PMI beat forecasts and closed at a 3-year high as former PIIGS Ireland, Italy, Greece and Spain returned to growth. Deflation is a concern but progress is clear. On the other hand, emerging markets have problems. We see two camps: those with stable current accounts, limited foreign debt and leadership focused on reforms vs. those with current account deficits, large foreign debt and weak leadership. We put China in the first camp despite issues surrounding their slowing growth. They have positive trade balances, large foreign currency reserves and political leaders focused on reforms. We place Brazil and India in the second camp. They are more interventionist in the private sector. They are not focused on fixing structural issues and their foreign debts leave them susceptible to fallout from the US Fed taper. Finally, Russia is squarely in the second camp. They are suffering from stagflation, stubbornly high inflation and flat growth. Perhaps their Crimea annexation is an example of the “Wag the Dog” syndrome. Whatever the reason, Russia and the emerging markets have stirred the pot and are an impediment to global growth.
Going forward – We feel private sector growth will accelerate. We disagree with naysayers who worry companies are not investing for growth. Instead, they are increasing debt to fund dividends and buybacks – combined they reached $214.4 billion in Q4 (second highest on record). The facts show global-listed company capex increased 26% to $2.6 trillion and US non-financial capex is up 44% from 2010-2013. We expect growth from two sources. First, established industries need productivity to stay competitive. Just look at any retail chain and see how old their cash registers are. Consumer loyalty programs and data tracking demand investment in new equipment and software. Second, fast-growing, emerging industries need capital. An example is mobile computing. iPhones are less than seven years old and the iPads less than four years old. Now there are many competitors and in 2013 smart phone shipments surpassed one billion units, a 38% annual growth rate. New advances in power generation, biotech, cloud technology, 3D printing,… are giving rise to companies which are re-investing profits and any money they are getting from venture capitalists. All the above could generate a 3%+ US growth rate by year end.
For the public sector we expect a repeat of Q1. Politicians will keep a low profile and avoid contentious votes as they prepare for November elections. So expect bipartisan progress in small steps. We expect the Fed to maintain a “no surprise” course. They want to end QE by year end and change interest policy around mid-2015. Expect lots of data and communication. Local governments should continue to see improved revenues and hopefully clean up their fiscal issues.
The Eurozone should see continued improvement. Despite criticism that austerity wouldn’t work, it helped improve the PIIGS’ financial positions. Now economic growth should restore faith in government, help reduce unemployment and lead to continued investment. Emerging market leaders should heed this lesson. China will suffer slower growth as they continue their reforms. This will impact in commodity-driven economies – look at iron ore and copper. We hope some of the countries, specifically Russia, will get the message. A variety of important elections are scheduled to take place in several key emerging markets this year. At best we expect international markets to be neutral for global growth.
Our Bottom Line – Slack labor and well-capitalized banks should support US growth. We favor equities but feel enthusiasm for emerging industries has pushed valuations ahead of fundamentals. We favor value over growth. We like Europe and the developed economies vs. China and the emerging markets where we need to see evidence the fundamentals are near bottom. Finally, we don’t see inflation; but US fixed income was seen as a safe haven and rallied. We need to see yields back up before investing.
As always, we appreciate your trust. This letter provides our outlook of the most probable events, but at best is a summary. If you have any questions, please call us. Better yet, we would enjoy meeting with you to discuss our outlook and your current situation.
Yours Truly,
George Bernard Doug Woods
President Director of Research