October 17, 2014
Dear Client:
Q3 saw major global macro threats such as the Russian/Ukraine conflict, ISIS, slowing global growth, Ebola and the Fed winding down quantitative easing, and yet the markets held relatively steady. Our confidence in the economy helped us stay with our portfolios while the markets traversed the wall of worries.
Markets were mixed, volatility returned and correlation dropped. US large cap equities advanced with the S&P 500[1] +0.6% and the NASDAQ[2] +1.9%, as small caps fell 7.6% and international equities dropped 6.4%. Individual sectors were mixed – health care and tech posted gains, while energy and utilities had modest losses. Bonds saw gains in the long and intermediate markets, while losses occurred in short-term and high-yield fixed income. Commodities were the big losers with crude -13.5%, gold -8.4% and natural gas -7.6%.
What happened? Despite the global turmoil, the US economy experienced solid 4.6% growth. Q2 saw the best earnings in seven years as 61% of companies beat on the top line and 66% beat on the bottom line. This helped corporate confidence and led to hiring in most industries. The unemployment rate fell to 5.9%, a six-year low, and the hours worked rose for the first time six months. During the quarter, the US became the world’s biggest producer of oil and natural gas liquids. This plus OPEC cheating on production quotas pushed energy prices lower and the world was awash in oil. Another big change, drought worries changed into record harvests in corn, wheat and soybeans lowering input costs for food production. Since energy and food costs are nearly 30% of the average budget, this is a big pay raise for consumers. Add in overall improvement in Q3 economic data, and the private sector did its part for the economy.
Washington, DC played the same song. Elected officials took credit for good news while avoiding the tough issues. They cheered the fiscal year ending in September with only a $483 billion deficit, the lowest since 2008. Only one problem, they never passed a budget, only spending resolutions. Also, no action was taken on the three Rs: entitlement reform, tax reform and immigration reform. No one wanted to deal with companies changing domicile out of the country. So, the Treasury Department changed tax rules to make these moves onerous and painful. The Fed continued the taper and should be out of the bond business by the end of October. They have pledged to maintain low interest rates for a considerable time despite increasing descent among voting board members. Government at best has been neutral for GDP growth.
The international picture was a muddled, mixed bag with major economies sputtering for different reasons. Europe was stuck in a slow growth cycle. Their leaders have not dealt with key structural issues: aging population, rigid labor laws and zombie banks loaded with bad debt. ECB President Draghi’s control of the financial situation came into question with the collapse of the Espirito Santo bank in Portugal and Italy slipping into its third recession in five years. The Ukraine/Russian conflict made things worse as Europe had to put sanctions on Russia, one of their largest trading partners. Japan’s economy back-tracked due to the April tax hike, then improved as the effects faded and the government applied economic stimulus. The falling yen helped their large exporters. All-in-all, there are signs of improvement vs. expectations. China seemed to be off to a solid start but things started to deteriorate as industrial production in August posted the worst reading since the financial crisis. However, recent data came in better than expected suggesting stability. The Middle East was hit with falling oil prices and ISIS. Neither will help the region’s growth.
Going forward – We believe positive Q2 GDP translates into a lower recession risk in the short and medium term. The ISM Service Index hit the highest level since 2005 and the ISM Manufacturing Index rose to a three-year high. Both of these readings, plus the new orders component spiking, gives a clear indication of broad future growth. Consumer confidence hit the highest level since 2008. Increased confidence, more credit availability at low rates and tight rental markets should help housing activity as well as consumer balance sheets. Strengthening labor markets with solid growth and low inflation should make the private sector a positive going forward.
Moving on to DC. The House and Senate are back in session, but not for long as they will leave to campaign for the upcoming midterm elections. As we have said in the past, lots of sound and fury signifying nothing. Normally the Fed would fill the void, but investors will only guess at the timing of future rate hikes. Big government will hopefully be neutral for the US economy.
We expect the international scene to be more of the same. The ECB will continue to fight the good fight, to hold the line until the elected officials deal with the structural issues. This means cautious consumers and corporations will hold demand down, translating into continued slow growth. Japan will continue to face their three demons: deflation, debt and aging demographics. This will translate into conservative consumers and corporations holding cash and hampering spending and investment. China faces a demanding balancing act. They need less investment, especially housing, and more consumption. The government has a plan for long-term reforms. The key going forward is can they hold fast in the face of slowing growth. In the Middle East, ISIS has grabbed territory and headlines but had little impact on oil production. We expect this to continue. Our conclusion, the international picture is a story waiting to improve.
Our Bottom Line – Bear markets don’t occur with a recession. Markets usually experience volatility in September and bottom in October. Also, cyclically-oriented sectors tend to do well during the first rate hikes. Our first choice would be large-cap, cyclical stocks with strong balance sheets and dividends. We are waiting for a washout of excess optimism before we increase small cap positions. Global interest rates, including US Treasury and investment-grade rates bonds, are too low in our view. We continue to limit our fixed income positions to short, intermediate and floating-rate issues. Due to the volatility in the international arena we do not feel comfortable with the emerging markets at this time.
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
[1] S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.
[2] NASDAQ is a market-cap weighted index of more than 3,000 companies listed on the NASDAQ Stock Market and does not reflect reinvestment of dividends.