July 15, 2014
Dear Client:
Our confidence in the economy helped us hold our investments through market volatility.
Markets were highly correlated, i.e. moved in the same direction. Global equities posted similar returns: S&P 500[1] +4.7%, the tech-heavy NASDAQ[2] +4.9%, and international equities +3.0%. Individual sectors were a different story: energy posted 12% gains, utilities up 7% while financials posted a mere 2% gain and high-hope, no-income stocks were disappointing. Bonds surprised to the upside with long and intermediate fixed income markets. Industrial commodities posted small gains…including gold.
What happened? We felt Q1’s paralyzing weather masked the real strength in the economy. Corporate earnings rose 1.2% and revenues grew 2.6%, with 65% of companies beating earnings expectations despite downward GDP revisions from 0.1% to -1% to -2.9%. Also, strong economic reports indicated the economy was quickly exiting the deep freeze. Housing starts were the strongest in five years and May’s new homes sales showed the biggest monthly gain in 22 years, which is one reason why retail sales of home furnishings hit a six-year high. Auto sales at a seventeen million annual sales rate were the highest pace in eight years. These numbers help explain why the unemployment rate fell to 6.1%, the lowest rate in six years. Also, the manufacturing ISM index hit 55, which indicates solid growth going forward. A very good quarter.
Government was a drag. Politicians seemed indifferent and perhaps hostile to business. Antipathy for banks seemed evident as redundant fines passed $100 billion during the quarter. This means $1 trillion fewer loans or bond purchases which could have had the private sector replacing the Fed’s QE. Then look at the 2,300 page Dodd-Frank reform act. This laid out a timeline for creating 300 new federal government offices and 398 new regulations, to date 48% have missed their final deadlines. Result – more confusion and friction. There has been no real effort at immigration reform. Ditto tax reform, so US corporations face the highest tax rates in the world as well as stiff state and local taxes. Result, over $3.5 trillion in corporate cash trapped overseas. Now this money is being put to work internationally instead of at home. More alarming, 5% of S&P 500 corporations have moved their headquarters overseas since 2008. It is small wonder this recovery has been the slowest since the Great Depression with a lack of quality job creation.
The global picture was mixed with elections the main story. Sparked by a desire for capitalism, the “have nots” (Ukraine, Egypt and India) voted for less government, less entitlements, freer markets and open trade. Tired of austerity, elections in developed markets (southern Europe) voted for big government, protested free trade, labor reform and entitlement cuts. Since emerging from the recession, Europe missed growth forecasts. A few reasons are: the overhang of public and private debt, euro strength curtailing exports, deflation curtailing consumer purchases,… This forced the ECB to cut its lending rate to new lows, sparking hope that interbank lending would pick up and ultimately get cash into the economy. China growth also disappointed. Key issues are weak property markets, a highly-leveraged shadow banking system, excessive local government debt and industrial capacity. We see China’s difficult transition to a consumer economy causing continued slow growth for them, the region and commodity-based economies. Though headline grabbing, the markets have taken conflicts in the Middle East and Ukraine in stride. This seems a short-term concern, but could change if global energy supplies are challenged.
Going forward – Leading indicators are showing a healthy rebound and we see the US economy picking up steam. Corporate confidence, even among smaller companies, is improving, thus the merger and acquisition boom. Increased deal activity usually unleashes corporate competitiveness. This should lead to more spending on plant, equipment and efficiency-enhancing tech; which in turn should drive further hiring and investment throughout the economy. We see this reflected in increased rail traffic, trucking, global trade and small package markets. As slack gets removed from the labor markets, wages should start to rise providing more disposable income, increasing demand and more business investment – this is the virtuous cycle.
For government, less is usually better. The trajectory of the federal budget deficit has fallen from over 10% of GDP to less than 3%. Part of this is from political gridlock, part from higher tax rates and part from an improving economy. Since we expect little from our political leaders as we approach the midterm elections, this trend should continue. Also, the Fed continues to cut its bond purchases, also called the taper. They should conclude bond purchases by the end of October, so now the question is when will they raise rates? We think late first quarter 2015. Overall, we see government a neutral factor at best.
For international markets, Europe’s slowing growth and falling consumer prices raise the question could the region fall back into recession. We feel the ECB’s recent action shows they will provide liquidity to banks. This should spur loans and consumer demand. Eurozone unemployment has peaked, so wages should increase adding to modest growth prospects. In China, the good news is falling real estate prices are starting to attract interest. Banks have been instructed to loosen lending standards for first-time home buyers. Household formation is picking up so this should help property markets and cushion slowing growth. The question is how will China’s slowing growth impact the rest of the world? Finally, global conflicts will move in and out of the headlines. As mentioned above, they shouldn’t jeopardize global energy supplies. Additionally, there remains spare capacity globally so we expect increased production away from the hot spots to reduce pressure on prices, offsetting the global risk. Overall, we see a mixed global situation.
Our Bottom Line – We see falling rates as a global quest for yield, not an economic warning. Thus we view long-term fixed income securities and high yield offerings as a poor risk/reward opportunity. There is potential for a near-term correction, but economic growth is clearly visible in the US and there are signs of the rest of the globe may participate. We continue to emphasize the US with high quality growth stocks and companies consistently increasing their dividends. We remain cautious on international investments.
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