In our last quarterly Investment Update we posed a question: Was the relatively modest total return of 1.84% for the S&P 500 in the first quarter a pause that refreshes or the beginning of the end? We concluded that the small gain was more likely a refreshing pause. Happily for our client portfolios, market performance in the second quarter of 2014 supported the conclusion. The S&P 500 generated an impressive return of 5.23% and closed the quarter at 1,960.
Not surprisingly, while the markets continue to make new highs, many investors and analysts have turned downright bearish. Concerns have shifted. The failure of old worries to materialize have become new worries.
- Speculation that the US is facing a Japan-like deflationary era, has been replaced by concern that we are on the verge of run-away inflation.
- Fears of losing market share to fast-growing emerging markets have been replaced by worries of contagion from sharply weaker economic activity in emerging markets.
- Apprehensions about a sharp rise in interest rates have been exchanged for trepidations about the unknown consequences of a potentially perpetually low, long-term interest rate environment.
In addition, stock market technicians worry that the recent highs were achieved on relatively low volume and after six consecutive quarterly increases in the S&P 500 (a feat achieved only one other time in the last 50 years), markets are overdue for a correction. These concerns, together with geopolitical unrest and, by some measures, above-average market valuations, concern us too.
However, many of the conditions that propelled the market in the second quarter remain in place as we enter the third. The economy continues in a “sweet spot” with regard to growth and equity market performance. Despite a much weaker than expected first quarter, GDP growth for the full year is expected to be slightly above 2%, which is strong enough to provide some macroeconomic support for corporate performance, but not so strong to cause rampant inflation or engender the Federal Reserve to pursue more aggressive tightening. Additionally, corporate performance continues to largely meet or exceed expectations. Earnings growth is expected to accelerate through the remainder of the year with consensus growth expectations at a respectable 8.3% for the full year. Finally, most other liquid asset classes are either more overvalued or have lower near term return potential than the US equity markets.
Counterintuitively, we believe the most likely cause of a stock market pullback will be a broad-based and significant improvement in US economic indicators. Although a stronger economic backdrop would be positive for corporate earnings, it would also lead to accelerating inflation and higher interest rates. With higher inflation and interest rates, investors tend to pay lower multiples for corporate earnings. The decline in multiples would likely more than offset increases in earnings. Looking for signs that this is occurring, we see neither the acceleration nor deceleration that would change the near-term trajectory or our outlook.
It is becoming increasingly difficult to invest in isolated geographies. Many companies domiciled in the US generate significant sales overseas and many companies domiciled abroad have significant exposure to the US. In general, we continue to favor companies with high percentages of sales in the US. The recovery in the European Union appears to be on fragile footing, with many countries still plagued by extremely high unemployment. Further, despite recent actions by the European Central Bank, the region is still experiencing dangerous deflationary undercurrents. In Japan, Prime Minister Abe is trying to revive a beleaguered economy, but demographic headwinds and an enormous debt burden are difficult to overcome.
Many analysts have been highlighting that valuations in emerging markets are now lower and, therefore, potentially more attractive than those in the US. We believe valuations are lower in emerging markets because the economic fundamentals in many of these countries are problematic and in several of the larger markets, still deteriorating. In contrast, the US has many structural advantages, including an educated, diverse and still growing workforce, a rapidly expanding energy sector and a shrinking Federal deficit. While economic growth is not yet robust, we are further along in a cyclical recovery than most other developed markets and, as previously mentioned, a moderate growth environment tends to be conducive to positive stock market performance. Although many specific country indices have outperformed the US so far this year, from a broader regional perspective, the US is the leader. Of the 49 MSCI country indices, the US is only the 28th best performing, but many top performers are small markets without well-developed governance or transparency.
A more meaningful perspective is the US year-to-date returns versus broader MSCI indexes.
We think the fundamentals driving this relative hierarchy of performance will remain in place for the balance of 2014.
As always, our themes lay the foundation for our investment strategy. As highlighted in our blog post, A New Paradigm for Investors, the world is changing at an ever increasing pace. One of the best examples of disruptive innovation can be found in the technology sector. Over two decades of cost declines in computing power (from $527 per 1 mm transistors to $0.05), bandwidth ($569 per gigabyte to $0.02), and storage ($1,245 per 100 Mbps to $16) have stimulated an explosion in connected devices. Over 10 billion phones, computers, cars, watches, meters, vending machines, televisions, iPads, medical devices, and industrial machines are now connected to the Internet and analysts expect that number to grow another five-fold by the end of this decade.
The management and processing of all of this data is increasingly being facilitated by a handful of companies that operate “the cloud.” Amazon (despite being better known for its retail operations) and Google are two of the largest cloud services providers. And while this concentration of power may be scary to some, the productivity improvements created by widespread, low-cost access to their infrastructure is profound. Clients who outsource to Amazon’s web services include Netflix, NASA, and Shell, to name a few. Entrepreneurs can start new businesses with virtually no start-up capital, consumers can access a much wider variety of goods and services with totally transparent pricing, doctors can remotely monitor patients, and companies can improve workflows by tracking assets and information in diverse locations on a real-time basis.
All of this computing power and connectivity is leading to an explosion in data creation. Ninety percent of all of the data that exists today was created in the past three years and two-thirds of the data produced today is user generated. User generated data extends far beyond the notorious cat videos on YouTube. Consumers are increasingly sharing their opinions about items as diverse as restaurants, laundry detergent, plumbers, and cars, and their views matter to others. User generated data creates opportunities and challenges for businesses. Businesses no longer have total control over their marketing message because anyone and everyone can easily critique products and services online. We see evidence of this when brand value built over years is quickly eroded by a flurry of online content.
On the positive side, companies that adjust can capitalize on user generated data and gain market share while preserving profitability. Banks can gather detailed information about a loan candidate by analyzing information the applicant willingly shares on Facebook and other social media sites. Auto insurers may offer lower premiums without increasing risk by collecting and analyzing driving data through in-car connected devices.
Our investments in the “Data Inundation” theme fall into two main categories. We invest in enablers of data creation and data management who have pricing power and limited competition. These companies are often highly specialized technology companies with deep expertise and scale that is difficult for new entrants to replicate. Our second category in this theme includes companies that capitalize on the explosion in connected devices and data. These companies are in industries totally outside of the technology sector, including financial services, consumer products, retailers with superior online offerings, and healthcare companies that use patient data to better structure clinical trials and/or diagnose disease. These companies often meaningfully outperform while they are gaining market share. However, we know competitive advantages can be transient. Over time the ultimate advantage often accrues to the consumer and not the provider.
During the second quarter interest rates around the world continued to decline to unprecedentedly low levels. Somewhat stronger economic data in the US did cause US short rates (as measured by 2 year Treasury bonds) to trend higher during the quarter. However, long rates (as measured by the 10 year Treasury bond) declined from 2.73% to 2.52%. These opposite movements caused a flattening of the yield curve. This, combined with an overall low rate environment, makes investing in bonds challenging.
Typically, low long-term rates are associated with weak economic environments. And while economic growth in the US has not been particularly strong, historic correlations would suggest that at the current level of growth, interest rates should be moderately higher. We think one of the main reasons for low interest rates is that the psychological impact of the Global Financial Crisis of 2008 is greater and longer lasting than other recent recessions. This has caused investors to seek the perceived safety of bonds over the volatility of equities. Since the beginning of 2009, net inflows to bond mutual funds have exceeded $1.4 trillion. There is some concern that, in aggregate, bond mutual funds have become “shadow banks,” where investors have parked funds that can be withdrawn on demand. In the event of rising rates and falling bond fund prices, a high level of withdrawals could accelerate falling prices and exacerbate illiquidity in underlying bonds.
For many reasons, we favor individual bonds over bond mutual funds and believe bonds play an important role in client portfolios. Asset allocation between stocks and bonds is one of the most important portfolio decisions in aligning risk, return and client objectives.
Moreover, we believe our fixed income research and trading capabilities enable us to find value in specific bonds, bond structures and bond pricing. This is particularly important in this low rate environment where supply is constrained and demand is high. On balance, we are keeping durations in the short to intermediate range to preserve principal, protect against rising rates and provide a source of funds to extend maturities when the time is right.