This is a quarterly update of economic conditions and investment strategy.
Economic and Market Conditions
As we entered the year, Chevy Chase Trust was looking for growth of 2% for 2013. After an initial consensus estimate for first quarter GDP of 2.5%, growth came in at 1.8%, in line with our projections. With the full effect of the sequester’s across-the-board cuts occurring in the second quarter, we expect continued tepid economic growth despite recoveries in the housing and auto markets.
Of course, the economic story of the quarter had little to do with statistics and more to do with Federal Reserve Chairman Bernanke signaling in late May that the third round of Quantitative Easing (QE3) may start winding down by year-end. Since the start of this program in September 2012, the Federal Reserve has been purchasing $85 billion of bonds each month, providing liquidity to the economy and to global markets. From September 2012, when QE3 began, the economy has benefited from an improving job picture with a monthly average of approximately 200,000 jobs being created.
As noted in our last two quarterly letters, central bank moves to keep interest rates low across the yield curve create potential problems for markets, as demonstrated this quarter. With the announcement of the pending end of QE3, the quarter saw a melt-down in bond prices, and corresponding melt-up in yields, with the 10 year Treasury yield rising to 2.66% from 1.97% in a month. More importantly, for consumers and the housing market, 30 year mortgage rates increased 1%, 3.4% to 4.4%, creating fears that the nascent housing recovery would be derailed. US corporate bonds suffered their worst quarterly performance in nearly five years with quarterly returns in the minus 3.5% range as average yields on high grade debt jumped from 2.7% to 3.4% during the quarter. One of the highlights, or lowlights, in the corporate bond market during the quarter was the issuance of Apple bonds; those who bought 30 year Apple bonds at the issuance ended the quarter with a 13% loss. The bond market reaction to the QE3 announcement was so severe that by the end of the quarter Fed officials were busy on the talking circuit in an attempt to calm markets. The President of the Dallas Federal Reserve, Richard Fisher, was quoted as warning of “feral hogs” in the financial markets.
Historically, equities do well when interest rates rise, because rising rates usually reflect a stronger economy. However, this was not the case in June; the S&P 500 dropped 6% from its May highs before partially rebounding in the last week of June, finishing with a mid-year return of 14%.
This period of rising rates and declining equities is similar to the summer of 2003, when the S&P 500 rose 15% to mid-year, then proceeded to lose 5% in the summer, while the 10 year Treasury yield exploded from 3.1% to 4.6%. After digesting the bond move, the S&P started rising in September and finished 2003 with a gain of 26%. We do not expect a repeat of this gain in 2013.
Gold has been in a major bear market this year, hitting multi- year lows as inflation fears subsided and yields increased. Holding gold earns no interest or dividends. Consequently, its price is vulnerable when interest rates rise. For the quarter, gold prices dropped 23%, the largest quarterly decline since modern gold trading began in the 1970s.
The US Federal Reserve was not the only central bank creating turmoil in markets. In China, its version of our central bank, The People’s Bank of China, removed liquidity at the short end in an effort to cool speculative fevers.
The result was a spike in overnight interest rates in China in late June. One rate, the Shanghai Interbank Offered Rate (SHIBOR) hit 13.4% for overnight lending on June 20, up from 4.8% on June 17. Seeing the effect of this liquidity removal, China policy makers, similar to officials at the Federal Reserve, backtracked, and SHIBOR fell to 4.94% by the end of June.
These central bank efforts and the resulting higher yields harmed yield-based investment strategies across asset classes. Junk bonds and emerging market debt were hit especially hard during the quarter. Equities that were viewed as bond substitutes due to their yields, such as utilities and Real Estate Investment Trusts, also suffered. However, domestic equities as a class outperformed other asset classes. The S&P 500 had earnings growth of a respectable 5%, giving a fundamental base for the equity market price rise this year. But, importantly, corporate top line growth was negligible, increasing by about 1%. This revenue weakness means that margins and profits improved through cost- cutting, which does not contribute to enduring economic growth and sustained higher equity values.
We believe that the recent volatility in equity and bond markets will continue. Central banks have almost guaranteed volatility by making future liquidity dependent upon economic data. That is, the Federal Reserve’s QE3 policy will be dependent on the economy growing as it projects. Deviations would cause the Fed to move either more quickly or more slowly as conditions dictate. Therefore, every economic data release will take on increased importance and potentially unleash market volatility, as investors adjust portfolios to match expectations of central bank policy. Market psychology will be much like a Washington DC summer: highly changeable, with periods of sunshine interspersed with violent storms.
Stocks – While we watch a liquidity-driven market flow in and out of asset classes, we continue to invest along a few key precepts. The first is, that in the developed world, the US will continue to outperform (even with a modest 2% expected growth rate). Europe is still in a different part of the economic cycle (the part that still looks like recession), and the Japanese experiment in “Abenomics” is unproven as to its ability to sustain economic growth, and may have unintended consequences. Other international markets may prove challenging in the near term, particularly the BRIC countries of Brazil, Russia, India and China which provided much of the global growth in the last decade. Each has witnessed slowing economic conditions and we do not see improvement any time soon. As noted in prior quarterly letters, we continue to invest in sectors where we project strong relative growth in a world-wide slow growth environment. For example, we are interested in income producing real estate associated with medical facilities, as part of our focus on the growing medical needs of aging populations. We are also adding to our positions in domestic natural gas pipelines, a sector where we expect substantial growth and increasing demand. From a valuation standpoint, some quality European multi-nationals have been unfairly tarnished by association with their home country location and present compelling long- term prospects. And, we are always looking to add to our food and water positions when valuations make sense.
Also, we will be focusing on select “growth” economies. In addition to the US, countries falling into this category would include the Andean countries where growth remains strong. Recent economic releases in Colombia show retail sales up 5.7% and industrial production increasing 8.4%. In Peru, GDP is growing at a 6% rate and recent retail sales were up 7.5%; and in Chile, retail sales increased 14.8%.
At the sector level, an area of emphasis despite its underperformance this year continues to be energy. Not only do we like energy because of its demand in growing economies, but oil is the one commodity whose price can jump overnight, no matter what the growth in China (or any place else) may be. We have witnessed a series of unrest around the globe, starting with the Arab Spring and the Egyptian uprising, followed by the Syrian civil war, protests in Turkey and Brazil, conflict in Nigeria and more upheaval in Egypt and Yemen (which borders Saudi Arabia).
We have tensions between China, Japan, Taiwan, Korea and the Philippines over ownership of various islands (holding potential energy reserves), and of course Iran’s nuclear ambitions are a major wildcard. Escalation of one or two or three of these issues could cause a spike in oil prices. We view oil as a hedge against international risks as well as a valuable commodity used in global economies. Consequently, we maintain core positions while we trim and reallocate within the energy sector.
Bonds – We continue to maintain our bond investments, on average, at the shorter end of maturity ranges as a capital preservation strategy. With the end of QE3 now visible, the question of liquidity removal from the bond market is now a question of “when”, not “if”. As discussed in previous letters, we continue to focus on higher quality bonds because we view the return on lower quality bonds to be too low for the risk involved.