This is a quarterly update of economic conditions and investment strategy.
Economic and Market Conditions (Audio Version)
As we entered the year, Chevy Chase Trust projected 2% growth for 2013. The first quarter came in lower than expected at 1.1% while the second quarter finished with 2.5% growth. We continue to forecast growth of around 2% for the year, significantly below what it should be at this point in the recovery. Offsetting continued downward pressure from the sequester’s across-the-board cuts, exports and business investment contributed positively to the second quarter’s improvement in growth. Despite this, there is little evidence of accelerating growth as evidenced by sales growth averaging a mere 1.1% for the first half of the year. In addition, the Conference Board’s Consumer Confidence Index declined in September to 79.7, its lowest reading since May, suggesting that consumer spending will continue to be problematic.
The economic story of the second quarter had less to do with economic performance than it did with the “Taper Tantrum” when Federal Reserve Chairman Bernanke signaled in late May that the third round of Quantitative Easing (QE3) might start winding down. The economic story of the third quarter was the “Tabled Taper”. While Chairman Bernanke had signaled that “Taper” might start by year-end, the markets had built in expectations of a “Tiny Taper” starting in September which would be a reduction in bonds purchased monthly from $85 billion to $70-75 billion. Instead, at the September meeting, the Federal Reserve chose not to taper and to keep the $85 billion of monthly bond purchases. Weak employment numbers were the main reason for its decision. Even though the unemployment rate has dropped from 8.1% to 7.3% since the start of QE3 in September 2012, much of the improvement has been due to a falling labor participation rate as more people stop looking for work. The labor market is far less robust than the headline unemployment rate indicates.
In another case of not learning from history, we end the quarter with concerns about the US budget process and debt ceiling. Gold is still in a major bear market as the price remains substantially below the beginning of the year price of $1675. After hitting a multi-year low of $1212 in July, gold rebounded late in the quarter to $1326. This volatility in the price of gold is a reflection of the uncertainties with US monetary and fiscal policies. If this sounds familiar, August 2011 saw similar turmoil as a debt ceiling impasse raised the possibility of a US government default before a last-minute compromise. Not coincidentally, gold hit a record high of $1923 on September 6, 2011.
Stocks – The emergency economic conditions in the aftermath of the financial crisis have produced emergency economic policies that have distorted asset valuations across the board. In our view, it is important to be skeptical of a liquidity-driven market. We continue to invest along a few key precepts. First, within the developed world, the US will outperform (even with a modest 2% expected growth rate). Europe is starting to see glimmers of emerging from recession as its unemployment rate dropped in June for the first time in two years, but is still a long way from healthy economic growth. The Japanese experiment in “Abenomics” is unproven and with increasing energy costs and a necessary tax increase, the ability of the Japanese economy to maintain its current trajectory is questionable. Other international markets may also prove challenging in the near term, particularly the BRIC countries of Brazil, Russia, India and China that provided much of the global growth in the last decade. Each has been a beneficiary of central bank created liquidity, but has also experienced large portfolio outflows during the summer on fears that tapering would remove liquidity. With volatile currencies and slowing economies, we do not see substantial improvements any time soon.
Second, we look to invest in sectors where our research projects better relative growth in an otherwise slow growth environment. For example, we are interested in segments of technology that are associated with productivity enhancements, infrastructure improvements and in the expanding use of mobile technologies. Associated with the growing mobility trends and increased smart phone usage globally, we are identifying mobile payment system companies for investment. We are also interested in cloud technology providers, an area where we expect substantial growth and increasing demand over the next few years. Third, from a valuation standpoint, some international companies have been unfairly tarnished by association with their home country problems and present compelling long term prospects. Finally, we are always looking to add to our food and water positions when valuations make sense.
We also find the changing composition of the middle class globally to be an area of special interest. In the United States, for example, we have been witnessing a “hollowing out“ of the middle class over the last four decades. With consumption driving 70% of the US economy, trends involving the middle class have great economic importance. At the heart of this squeeze are stagnant wages led by the effects of automation, globalization and deleveraging. For example, in the US during the 2007-2012 period, wages for the bottom 70% of earners fell even as productivity grew 7.7%. Over a longer period, from 1979-2012, the median worker saw a real wage increase of 5.0% while productivity grew 74.5%. Hidden within this statistic is what was happening at the margins: the top 20% of wage earners saw their incomes rise 17.5% while the bottom 20% had their wages decline 0.4% (from the Economic Policy Institute). With listless incomes, we have been witnessing a “trade down” effect as US consumers look to do more with less and seek the best value for their dollar. From an investment standpoint, we see the beneficiaries of this trend being companies such as discount retailers, dollar stores, and generic consumer product and drug manufacturers. Additional beneficiaries include internet marketplaces and technology companies that empower the consumer and remove the middleman.
In contrast to what is happening to the middle class in the US, there is a growing middle class in emerging markets. From 1990’s total of 250 million, this middle class had grown to 400 million by 2005, and according to World Bank estimates, it will grow to 1.2 billion people by 2030. Just as a squeezed middle class has implications for consumption in the US, a growing middle class has very positive multiplier effects in the emerging markets. Studies by Accenture show that as a household’s annual income grows above $5000, spending on goods such as televisions, mobile phones and motorcycles increases. In 2010, 40% of emerging market households earned less than $5000 per year. By 2020, this number will drop to 20%. Likewise, the number of emerging market households making more than $15,000 a year will increase from 36% in 2010 to 54% in 2020, an additional 240 million households worldwide. This movement of a quarter billion people into the middle class over the next few years provides significant opportunities for companies involved in financial services, beverages, consumer products and healthcare, to name just a few.
In addition to these seismic shifts in middle classes around the world, technology is changing the nature of employment. In Race Against the Machines, co-authors Brynjolfsson and McAfee postulate that technology in the form of artificial intelligence is decoupling productivity growth and job growth. This creative destruction is poised to turn many areas of the global economy upside down with new winners and losers emerging. We will explore some of these in future updates.
Bonds – While the “Tabled Taper” brought bond yields down in its aftermath, for most of the quarter bonds sold off (with yields rising). The 10 Year Treasury yield closed the quarter at 2.61% after hitting 3.01% at the height of Taper Talk. The third quarter saw many borrowers rushing to market in order to avoid the rising rates anticipated from the taper. Verizon sold a record issuance of $49 billion, nearly triple the previous record debt deal issued by Apple in the second quarter.
The third quarter also saw increased activity in the municipal bond market. A heavy new issuance calendar, combined with significant bond fund outflows pushed municipal bonds to near record relative values compared to taxable bonds. The issue of quality continues to have prominence in our strategy. With the recent municipal bankruptcy filing of Detroit (and before that, Jefferson County, Alabama and San Bernardino, California) and questions surrounding the quality of Puerto Rico’s bonds, we continue to focus on higher quality bonds. As discussed in previous letters, we favor these bonds because we view the return on lower quality bonds to be too low for the risk involved. Additionally, we continue to maintain bond investments, on average, at the shorter end of maturity ranges as a capital preservation strategy.