Economic Conditions (Audio version)
A Pause that Refreshes or the Beginning of the End? The S&P ended the first quarter of 2014 slightly above where it began the year; 1,872 versus 1,848. The increase made it the fifth consecutive positive quarter for the S&P, a feat only accomplished five other times since 1965. Other major economic indicators, such as 10 year bond yields, the US dollar and the price of oil, also changed little from their end-of-2013 levels. However, end points can be deceiving. The past three months were anything but unexciting.
During the quarter, the bulls and bears engaged in an intense game of tug-of-war with each side seeming to dominate at various points in time. The bears took the lead with the S&P falling to a low of 1,742 in early February. Then the bulls took over and drove the index to a high of 1,888 (an increase of over 8% from the low!). All the while, the correlation among individual global equities dropped to a 16 year low. We expect both this increased volatility and the breakdown in correlations to continue, which only amplifies the need for prudent and active management of equity portfolios.
So where do we stand with regard to the question posed at the beginning of this letter… is the seemingly insignificant 1% rise in the S&P during the first quarter a pause that refreshes the upward march in US equity performance, or is it a turning point that marks the beginning of the end of an impressive bull market? Simply stated, we believe the overall US equity market will continue to move higher. There are certainly risks on the horizon, and there will be relative winners and losers, but our optimism is predicated on a few important factors:
1. The economy remains in a “sweet spot” with regard to growth and equity performance. Although it may not be intuitive, equity markets tend to perform best when economic growth is modest. The current 3% growth is strong enough to provide solid macroeconomic tailwinds for corporate performance, but not so rapid to cause inflation or engender the Federal Reserve to pursue more aggressive tightening. Some call it the goldilocks level, not too hot and not too cold. We continue to believe that despite tapering bond purchases, the Fed will be relatively accommodating until economic growth accelerates with more certainty.
2. Corporate profits and cash flow are at record levels and continue to increase which indicates that companies are performing well, despite the relatively “slow growth”
environment. Further, loan growth is just beginning to accelerate, which implies companies are becoming more optimistic about their near term prospects and are willing to reinvest in their businesses after a long period of restraint.
3. Finally, household net worth is also at an all-time high, rising by $2.95 trillion in the fourth quarter of last year to $80.7 trillion. Despite relatively low wage inflation, consumers have record free cash flow due to lower interest expense and commodity costs. The situation is translating into stronger consumer confidence, and portends a pick-up in consumer spending.
Stocks— Of course, after the 170% increase in the S&P since the low point in 2009, many of these positive developments are already factored into current stock prices. However, even though valuations are above long-term averages, we do not believe they are excessive. We expect near term equity performance to be somewhat volatile. We are not prepared to guarantee a sixth consecutive quarterly increase in the S&P (something that has only been achieved once in the past 50 years). But we believe on balance, the outlook for US equities is favorable and favor full exposure to the asset class within client investment objectives. Our more modest expectations for future returns from bonds and cash also factor into our asset allocation weightings.
You may have noticed that we are focusing much of our discussion on the outlook for US equities as opposed to global equities. While we are a global asset manager and carefully examine investment opportunities in every investable geography, for the first time since 1998, real GDP growth in the US is on pace to be faster than real growth in the emerging markets by year end. We think this is a meaningful occurrence and has potentially profound investment implications.
Between 2002 and 2011, US companies with significant foreign exposure outperformed the aggregate S&P Index by almost 40%! Very recently, this trend has reversed. Earnings from overseas operations have been disappointing and the outlook for many emerging markets, in particular, looks challenging. Countries such as Brazil, Russia, India and China are facing higher inflation, increasing debt and weaker currencies. Given the current situation, many of these so- called “emerging” economies may never actually “emerge” and, contrary to some experts, we don’t think this will have overly negative consequences for the US economy. Certain companies with significant exposure to these geographies will likely be negatively impacted. In fact, many of these companies are some of the largest constituents of the S&P 500. Therefore, these seemingly “blue-chips” may not be as safe as investors normally expect.
Why are we comfortable that a slowdown in emerging markets will not have significant adverse implications for the US economy? First, slower growth in emerging markets, and specifically China, will lead to lower commodity demand and lower commodity prices. Lower commodity prices in essence serve as a tax break for US consumers and will help sustain a favorable inflation outlook. Further, the US economy did not catch a cold from previous overseas downturns, including the Japanese decline in growth and the Asian Tiger Crisis.
These trends are leading us to overweight companies with higher domestic exposure and underweight companies more leveraged to emerging markets. It is also leading to increasing caution on the energy and materials sectors.
As mentioned in our last quarterly letter, we continue to research some exciting and disruptive trends that have the potential to influence corporate performance across multiple industries. One area of particular interest is the advent of molecular medicine. Technological breakthroughs in genomic sequencing are leading to a paradigm shift in the practice of healthcare. Diagnostics are becoming more precise, enabling more targeted and effective treatments of disease. For example, we now know that a deleterious mutation in the BRCA1 or BRCA2 gene significantly increases a woman’s risk of breast and ovarian cancers. Widespread testing of women with a family history of these cancers has already saved thousands of lives. Another test called Oncotype DX quantifies the probability of disease recurrence and the benefit from certain chemotherapies for specific breast, colon and prostate cancers. This test often alleviates the need for difficult and potentially dangerous treatment protocols that are ineffective. The Oncotype DX and BRCA tests have already generated billions of dollars in revenue. There are many more molecular tests in the pipeline. While this is only good news for future disease identification and treatment, there will be investment winners and losers from this powerful trend.
Another theme of active interest is the movement out of suburbs in this country. 2011 was the first year since the widespread availability of the automobile that more people moved into US cities than suburbs. Seventy-seven percent of the millennial generation say they want to live in an urban core. Baby boomers are downsizing and opting to move to more densely populated areas for the social and cultural offerings. Urban dwellers spend money very differently than their suburban counterparts. The most notable shifts include higher levels of spending on clothes, restaurants, and education and lower levels of spending on housing, autos and gasoline.
As a result of this trend, new and rapidly growing businesses are emerging that can only thrive in densely populated areas. Zipcar and Uber, for example, are transforming automotive transportation. An urbanite who wants to go to Costco once a month to stock up on groceries no longer needs to own a car or lug groceries on public transportation to accomplish this task. Zipcar, Uber and even mobile phones provide alternatives. If the consumer prefers not to spend time traveling to and from the store, the supplies can be ordered online through Amazon or Peapod. Same day delivery will become the norm in densely populated areas. These changes in spending patterns may serve as tailwinds or headwinds depending on a company’s vision and positioning.
Another theme we will discuss in more detail next quarter is the immense growth in data and connected devices and the related investment implications. It has been four years since the number of computers connected to the Internet surpassed the number of people on earth. This is only the beginning.
Bonds— The current low-rate environment continues to present challenges for all fixed income investors. We think rates will move higher over the balance of the year, which will lead prices lower. However, we are able to use our deep research and trading capabilities to find value in specific bond structures and bond issues.
Within fixed income, we see the most value in municipal bonds. The introduction of the 3.8% Net Investment Income Tax (NIIT) increases the attractiveness of tax- exempt income. The NIIT applies to nearly all investment income earned by high income taxpayers; but specifically excludes interest on municipal bonds. Further, the financial conditions of most municipalities have improved, strengthening their credit quality and reducing their need to issue future debt. This will likely lead to a reduction in the supply of municipal bonds and potentially push prices higher given constant or increasing demand. We are further focusing on bonds callable by the issuer, enabling us to capture higher yields with shorter effective durations.
Bonds and cash continue to serve important purposes: portfolio stability, liquidity, income (albeit historically low) and as a source of funds for client needs and opportunistic investments.