Economic Conditions (Audio Version)
The over-arching theme for 2013, reminiscent of the Sherlock Holmes story, “Silver Blaze,” can be characterized as “the year the dog didn’t bark.” The US did not go over a fiscal cliff or default on its debt; the sequester did not suppress growth; the Eurozone did not disintegrate; China’s growth did not slow as much as feared; Middle East turmoil did not destabilize oil prices; and continued global central bank money-printing did not increase inflation (so far).
In the absence of negatives, equity markets responded positively with the S&P 500 having its best year since 1997, up 32%. Many safer, more defensive stocks underperformed in 2013. Bond markets were down as yields rose, and the ultimate “risk-off” asset, gold, declined almost 30%, its worst year since 1981.
Gold was not the only commodity to perform poorly. A slowdown in China’s capital spending led to declines in many commodity prices. This generalized decline marked the end, for now, of a “Commodity Supercycle,” a decade-long theme that was a very successful investment strategy for Chevy Chase Trust, until it reversed in 2013. Thus, some traditional Chevy Chase Trust core holdings in investment areas such as energy producers, mining companies and agricultural inputs were a drag on overall performance. We are deep into research in areas we believe are likely to dominate in the next decade. We will share some of that work in our next quarterly letter. Stay tuned.
For 2014, we expect inflation to continue to be muted, under the Fed’s target of 2%. While some commentators were concerned that inflation would be unleashed by three versions of Quantitative Easing, the reality is that these efforts have probably been more effective at skirting deflation than spurring inflation. Inflation in the U.S., as measured by the Core Consumer Price Index, was 1.9% five years ago and at a pace of 1.7% in November 2013. While we anticipate growth in the U.S. Gross Domestic Product (GDP) to be about 2.5% in 2014, it is worth noting that GDP growth may, for the first time in a long time, be stronger than expected given its momentum over the last four quarters.
However, continuing pressures on personal income and volatile inventory investment data in recent GDP numbers support our caution.
After the market’s “Taper Tantrum” negative overreaction last summer and overly positive reaction to the “Tabled Taper” a few months later, the market has digested the “Tiny Taper” announcement at year-end with equanimity. If nothing else, the Fed is signaling by modest and measured reductions in bond purchases and by keeping interest rates at virtually zero for the foreseeable future, its intent to continue providing monetary support until the economy is fully self-sustaining.
Stocks— With the S&P 500 having its best year in more than a decade, and up 170% from its low in March 2009, some believe the stock market is in bubble territory. While acknowledging the rise of the market and the possibility of a correction at any time, we are of the opinion that the stock market is returning to its trend from an oversold condition at the bottom of the financial crisis. Considering that U.S. GDP on September 30, 2007 was $14.6 trillion and since then has increased 16.1% to $16.9 trillion at September 30, 2013, we do not think the market’s price movement to be particularly “bubbly.” The S&P 500 rose a modest 10.1% from September 30, 2007 to September
30, 2013. The additional 8% increase during the fourth quarter of 2013, simply brings the stock market back to an historic trend relative to economic growth. We believe there is a real relationship between economic growth, profit growth, and hence, stock growth. If we get the long-term economic trends correct, we believe we will get the long-term market movements correct, even when markets overshoot or undershoot in the shorter term. Nevertheless, from a valuation standpoint, with stocks priced significantly above the bargain levels of the early recovery years, stock selection will be critical to portfolio management.
While the Commodity Supercycle may have run its course for this business cycle, we see opportunities in other sectors for new purchases. In our last quarterly investment review, we wrote about diverging middle classes in the developed world (where the middle class is shrinking) and in emerging markets (where the middle class is expanding). We see this theme yielding effective investment strategies in the years ahead. We also see opportunities in infrastructure investments in emerging economies to meet the needs of commerce and a growing middle class, as well as in the developed economies to address age and obsolescence.
Another area where we see opportunity is technology. Since the beginning of the recession, The U.S. has underinvested. For most countries, capital investment as a percent of GDP is 20%. The average for the U.S. during the period 1961-2012 was 21.1%, but as seen in the chart on the following page, U.S. capital investment has been significantly below average the last five years. Large-cap technology companies, as a group, have been performance laggards; we expect many of these companies to be beneficiaries of increased capital spending as the economy improves.
Bonds—The consequences of September’s “Tabled Taper” included a fall in the 10-Year Treasury interest rate to 2.61% at the end of the third quarter. However, the effects of improving economic growth, reflected in the third quarter GDP revision to 4.1% growth, the end of the Government shutdown, no debt default, and the much-awaited December announcement of the “Tiny Taper,” all led to the 10-Year Treasury rate increasing to just above 3%, nearly twice its May level. This upward move in rates means that the Barclays Aggregate Bond Index, the broad bond market benchmark, posted its first negative annual total return since 1999, down 2.02%. Hit particularly hard last year were inflation-linked bonds, such as TIPS, which plunged over 8.6% (the worst year since being introduced in 1997) and long-term Treasuries (20+ years) which were down 13.9%.
Municipal yields also rose with overall bond markets and were additionally fueled by selling pressure as monies exited most municipal bond funds. Unlike bond mutual funds, our portfolios of individual bonds may experience mark-to- market price declines but should return 100% of their face value at maturity. Generally, we welcome higher interest rates as they present opportunities for higher reinvestment yields. Given the significant tax benefits afforded municipal bonds and their current favorable yields relative to taxable bonds, we are finding attractive value in short and intermediate term investment grade municipals. This strategy benefits from the steepness of the yield curve without exposing portfolios to the significant volatility in longer duration and lower credit quality bonds.