July 15, 2016
Dear Client:
Global uncertainty plus the British exit from the European Union (Brexit) stirred market volatility and led us to maintain our focus on US large caps which pay dividends while avoiding international markets.
Governments, corporations and weather led to investor uncertainty and volatility. Investors looking for income and stability helped the S&P 500[1] and the Dow[2] post small gains. The growth-oriented, tech-heavy NASDAQ[3] fell for the third time in four quarters. The small caps topped equity returns while the developed international markets led declines. Fixed income was again positive. Commodities saw strong rallies in natural gas +49% and crude +26%, while gold was up 7% and copper unchanged.
What happened? The economy has picked up. 72% of corporate earnings beat expectations and 53% beat on revenues. Admittedly the hurdles were low. Earnings were down, but only -0.9% ex-energy and materials. Corporate revenues ex-energy were up 0.9%. A sub-5% unemployment rate and wages growing at 2.5% translated into a strong consumer. Retail sales rose 2.5% year-over-year despite a very tough first quarter. Growth was widespread in consumer-facing areas: auto dealers, internet retailers, clothing outlets, gas stations, and restaurants… The consumer continued the trend where annual department sales were down through May vs. internet and mail order sales posting 10% increases in the same period. The housing markets underscored consumer confidence. Existing home sales hit their highest annual pace since 2007, median price hit record highs and new home sales were up 9% year-over-year. Also, the ISM manufacturing index rose to 51.3 (above the all-important 50) as the service sector component rose to 56.5%, much stronger than expected. Still, business optimism remains relatively low and business spending actually declined in May, hurting technology, energy employment and banking. The energy sector saw 59 oil and gas companies declare bankruptcy this year as the industry has had over $1 trillion in equity wiped out since 2014. Our view, the economy is solid but uneven.
DC continued to disappoint. The Treasury started the quarter by unilaterally changing rules on corporate inversions instead of trying to reform corporate taxes. This gutted the M&A market and could be a reason for the dearth of business spending. Each party defeated the other party’s proposed gun-control law and Harry Reid sandbagged the Republican bill to fund Zika virus research. Americans are fed up with nothing done in Washington and blame both parties. The Fed provided dot plots, projections and press conferences, but no rate hikes. In fact, there has been one rate increase since the Fed stopped quantitative easing in 12/2014. Our conclusion, not a lot to like.
We saw two key trends in the global economy. All focus was on Brexit. Investors believed Britain would remain and invested accordingly, but exit carried the day. There were early fireworks as they rushed to reverse their positions – great volatility as markets round-tripped. Hardly noted was the global manufacturing over-capacity due to productivity increases. This hurt China and emerging markets which are trying to export their way to prosperity. This over-supply creates a deflationary bias and its workout will be a ticklish process.
Going forward – We see the economy picking up in the second half. Three economic readings support this view. Profits are the lifeblood of an economy. Earnings estimates bottomed in Q2 and have moved higher. Bank lending, a leading indicator, was up 7.2% vs. a year ago. ISM manufacturing new orders, a forward-looking component, rose to 57 indicating growth. Rising wages with a tightening labor market should incentivize business investment for productivity and long-term profits. Strong demand for housing should support prices and consumer confidence leading to a growing but different economy. As consumers continue to favor e-tailing, they will want robust offerings, accurate product descriptions with pictures and ease of purchase. This means opportunities for old and new companies. Finally, improvements in technology for renewable energy means a bright future. The future may not be now, but research and development of new batteries and smart grids will generate huge opportunities. We don’t see any signs of recession and expect this long recovery to transition to faster growth as the US takes advantage of these new technologies.
We see problems in Washington. Politicians will count coup as they block each other from any legislative victories. A recent Barron’s article stated 80% of Americans are less well off than they were in 2007. The result, we have two highly flawed candidates, promising one of the most brutal silly seasons ever. This fiscal paralysis means the Fed must do the heavy lifting. The economy’s trend shows it is strengthening and the Fed would like to raise rates to fend off bubbles. Unfortunately, international growth is not as fundamentally sound and zero-to-negative interest rates abroad will hamper any tightening.
Brexit was against a bureaucratic, mercantile EU, not anti-globalization. It is a major event, so as the shock wears off it is time for hard analysis. We see reasonable self-interest determining how this will work for Britain, Europe and the global economy. Britain has recapitalized its banks, flexible labor laws and the fastest growing economy in the Eurozone. The EU avoided needed reforms, so expect another summer of bad press and issues with Greece, Italy (especially their banks), Portugal and Spain. The global glut of manufacturing should hasten the emerging markets’ transition from command/export to consumer economies. Europe, China and the Middle East (Saudi Arabia) will continue to find it difficult to pay for their entitlement programs. Fears of a Chinese meltdown faded but monetary stimulus has been less efficient. It is supporting slow/no growth state-run enterprises which will cause bouts of economic distress and more yuan devaluations.
Our Bottom Line – We will maintain our current asset allocation because it is a departure from the traditional weighting in our portfolios. Despite a supportive Fed, fixed income markets’ returns are too low and provide no protection against inflation and rising rates. Alternative investments will provide income in our portfolios. Clearly, we continue to favor US equities and will use excess cash to invest in more cyclical, growth-oriented positions. Emerging markets have improved recently, but we want to see a stronger trend. Europe seems a value, but we need to see the Brexit process further down the road.
We appreciate your trust, especially in these turbulent times. 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] Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends.
[3] 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.