This is a quarterly update of economic conditions and investment strategy.
Economic Conditions (Audio Version)
As we entered 2013, Chevy Chase Trust analysts estimated U.S. GDP growth of 2% for 2013. In the face of the initial fourth quarter GDP number, which was a negative 0.1% (final revision 0.4%), and a pending sequester, this seemed optimistic. However, housing, auto production, and consumer spending since then have been more positive, giving us more confidence in our 2% projection. Still, make no mistake, the overall performance of the U.S. economy is sub par. It grew by 2.2% in 2012 and 1.8% in 2011, not impressive by historical standards, and discouraging—there is no better word—considering the unprecedented Government stimulus and debt build-up. Moreover, as noted, we expect continued anemic growth in 2013.
The story of the U.S. consumer remains surprisingly positive. The consumer, despite being hit with such negatives as the payroll tax hike, slower income tax refunds, and rising gasoline prices, continues to spend. December 2012 retail sales rose 4.7% compared to the previous year, and January and February have seen similar increases of 4.4% and 4.7%, respectively.
Helping the consumer is an improvement in housing. The S&P Case-Shiller index in January posted its largest year-over-year rise in eight years, while new home sales in January jumped 13%, the largest increase in five years. February housing starts at 917,000 units were the second highest since June 2008, surpassed only by December 2012 housing starts of 982,000. The consumer side of the economy, which accounts for approximately 70% of the US economy, benefited from a slowly improving job market. Weekly jobless claims have been on a downward trajectory: the four-week moving average now stands at 339,750, the lowest level since February 2008. The unemployment rate, at 7.7% in February, has been below 8% for six months running, and shows modest improvement from a year ago when it stood at 8.3%. Yet, again, this is not the whole story. Scratch the surface and the underlying data present a different picture: February’s unemployment rate of 7.7% masks a real unemployment rate near 15% when counting the “exclusions.” Dig down and other labor data are similarly not reassuring, especially the labor participation rate, near a three decade low. These are leading indicators of future demand for housing, autos, and other consumer cyclicals.
The rest of the developed world seems unable to match even the modest vitality of the U.S. economy. The U.K. is headed toward its third recession in four years as its fourth quarter 2012 GDP shrank by 0.3%. The Eurozone economies continue to be battered by rolling crises, the latest being Cyprus. While Cyprus itself is not economically significant, the treatment of its depositors may encourage future runs on banks in the weaker Eurozone countries. We do not believe Cyprus marks the end of the Euro crisis; it is merely another chapter. The next chapter may well be Italy (again). Other countries are dangerously weak. Unemployment is about 27% in Spain and Greece, depression era levels. Economic conditions in France and the Netherlands are weakening and Germany’s export market is tied to China (see China comments below).
In Asia, Japan has decided to aggressively attack deflation by following the U.S. playbook. This has led to weakening of the yen by 15% relative to the dollar since mid-November. The Abe administration has publicly talked down the yen
to revive the export-led Japanese economy. By appointing Haruhiko Kuroda as the new central bank governor, the administration is signaling its desire to spur growth by promoting inflation. Mr. Kuroda, reminiscent of Ben Bernanke, is expected to start buying trillions of yen bonds, joining the global brigade of liquidity-creating central banks.
We are concerned, too, about economic growth in China and the stability of its system. China has been the growth engine of the world, and trouble here would have pervasive adverse effects.
In sum, economic conditions continue to point to cautious investment allocations.
Stocks—The U.S. stock market has been a prime beneficiary of central bank money printing. The Dow Jones Industrial Index hit record highs in the early part of this year and the more important S&P 500 also hit a record high at the end of the first quarter. Interestingly, the stock market not only benefits from more demand from money-printing, but also from less supply as the number of public stocks in the U.S. dropped dramatically. The Wilshire 5000 index, which is designed to measure all publicly traded stocks, no longer has 5000 members. There are now only 3678 companies in the Wilshire 5000, down one-third in the last ten years. What happened? A number of companies have been bought out, as we have seen in the past year, with the announcements of purchases of Heinz, Dell Computer, American Airlines, and OfficeMax. At the same time, company creation is down, evidenced by the slow Initial Public Offering (IPO) market. This overall decline in the number of investable stocks occurring at the same time central banks are creating excess liquidity, produced a demand-supply condition so obvious that even an economist can see it: increase in demand occurring during a decrease in supply leads to higher prices. This is a fundamental consequence without a fundamental foundation.
One view is that the supply/demand environment outlined above is the best reason to own stocks. The second best reason is the better-than-expected news coming out of the U.S. And a third reason may be relatively better valuations in stocks compared to other asset classes. While the first reason remains in effect, the second and third are close to being fully priced in the market. Resulting market volatility and the better performing sectors of late being health care and consumer staples fully point to nervous investors looking for investments less tied to economic cycles. Valuations are stretched in a number of sectors. Consequently, we are rebalancing and trimming in extended sectors and purchasing securities in sectors offering better long-term values.
Another thought that we have gleaned and acted upon is that the world is moving beyond traditional categorizations. The important distinction is no longer developed markets versus emerging markets; rather the more important distinction should be between growth economies and austerity economies. We believe some of the best opportunities are in companies that operate in or benefit from growth economies, like some of those in Latin America and Southeast Asia, and lesser opportunities in companies concentrated in austerity markets, like some in Europe. Where does the U.S. fit? Since there is no austerity plan under serious consideration in the U.S., the U.S. tilts to the growth category and continues to be a favored investment market for us.
At Chevy Chase Trust, we examine long-term themes and trends to find attractive investment ideas. One theme that we are farming is agriculture. (Sorry, couldn’t pass that up). The need to provide food to a growing global population and the need to provide better food to those growth economies that are becoming wealthier should weather most economic storms. (Last one). Earth Policy Institute studies and United Nations reports strongly indicate the long-term serious shortages of food. Soil erosion, water shortages, and changes in weather patterns continue to reduce food supply. Arable land per capita is decreasing at an alarming rate. At the same time, global food production will need to increase 70% to meet demand in 2050. The agriculture sector is one of our most promising investment areas.
Bonds— As noted in our last letter, central bank stimulus to keep interest rates low across the yield curve creates potential problems in markets as cash tries to find a return. We see this return-chasing effect in many asset classes. In fixed income, longer dated maturities offer limited value at current low rates. Also, some investors chase down the quality scale to obtain returns on “high yield” (or as we prefer to call them, “junk”) bonds. At the end of March, average junk bond yields hit all-time lows of 5.56%. A wise investor once said, “More money has been lost chasing incremental yield than in all of the financial scams in history.” We agree.
We continue to maintain bond investments, on average, at the shorter end of maturity ranges as a capital preservation strategy. At current interest rate levels, the risk one takes to move to longer maturities seems higher than the reward, and with the Federal Reserve continuing to interfere in pricing, we prefer to stay short. Also, we prefer to maintain our positions largely in higher quality bonds because the return on lower quality bonds is too low for the risk for us and for most of our client portfolios.