Economic Conditions (Audio version)
What could go wrong? As readers of our quarterly updates know, we’ve been relatively optimistic about the outlook for US equity markets. Through the end of the third quarter, the S&P 500 Index generated a total return of over 8%. This is impressive for any nine month period, but even more remarkable given that it follows a 32% total return in 2013 and 16% in 2012. In fact, not since 2007 has the S&P gone so long without a 10% correction.
Unlike other bull markets, the current ascent has been subject to doubters all the way up. In fact, heading into 2014 most expected low-single digit S&P returns this year, at best. We looked back at prognostications published at the start of the year from a dozen of the largest brokerage firms (a notoriously optimistic bunch). Two expected the Index to be flat, ending the year at 1,850. Three expected a 2.8% rise to 1,900. Half had estimates between 1,925 and 1,975 and only one expected the Index to exceed 2,000 at year-end.
Perhaps this cynicism was still a hangover from the 2008/2009 downturn. Perhaps it was due to the relatively lackluster US equity market performance for the entire decade of the 2000’s and disbelief that we could finally break out of the morass. Or perhaps it was due to some of the myriad other reasons we catalog below. Regardless, the equity markets had indeed been climbing a “wall of worry.”
Around late August, when the Index crossed 2,000 for the first time, the situation changed. Bears became bulls, expectations rose and sentiment indicators soared to new highs. Economic statistics seemed to confirm this optimism with second quarter GDP growth surpassing 4% after a 2% decline in Q1. Many investors became convinced that the economy had finally reached “escape velocity.” We are less optimistic and thought it was an apt time to focus on “what could go wrong.”
Our caution on economic growth stems from what we believe to be significant change in US consumer behavior.
From the 1970s through 2000, debt as a percentage of US GDP grew steadily. During that time, average real GDP growth was 3.3% per annum. In recent years, real GDP growth has been substantially lower. One reason for the decline is that Americans are finally reducing their debt levels by spending less and saving more.
From a long term perspective this is quite healthy. But if it continues, which we suspect it will, those expecting that the economy has reached “escape velocity” may be disappointed. The consumer represents a whopping 70% of GDP in the US. Without robust consumer spending, strong GDP growth will be hard to sustain.
In our opinion, the most compelling argument for a prospective slowdown in equity markets, if not an outright downturn, is quite simply the following;
If US GDP continues to grow between 2%-3% per annum, it will be very difficult, if not impossible, for US equity markets to continue to post double-digit gains.
We do not believe the markets will drop anything like they did in 2008/2009. A moderate economic backdrop should lead to moderate, but positive, equity returns. However, given the duration and magnitude of the market rise, a pullback driven by lowered expectations and somewhat lower multiples shouldn’t be surprising and wouldn’t necessarily be unhealthy.
In order to be inclusive in our thinking about “what could go wrong” we consider six other potential causes for an equity market decline gathered from a variety of sources. In our opinion some of these risks are more worrisome than others.
1. Worsening prospects for the US housing and mortgage markets – Skeptics on housing cite the cessation of Federal Government purchases of mortgage-backed securities this fall and the potential dismantling of the GSEs (Fannie-Mae and Freddie-Mac) as significantly de-stabilizing forces in a market already challenged by low affordability. Housing is directly responsible for approximately 13.5 million jobs in the US and stimulates a significant amount of economic activity in other sectors such as retail and finance. Therefore, a weaker housing market would contribute to lower GDP growth. We are watching housing trends. Currently, home sales seem somewhat stable at relatively low levels. If they decline from current levels, it would concern us and potentially cause us to reevaluate.
2. Weakness in non-US developed markets such as Europe and Japan – Both Europe and Japan face significant structural challenges due to excessive leverage and declining work forces. Japan has already initiated unprecedented monetary policies to try to counter some of these impediments. Europe will likely follow suit. It is questionable whether these policies will work. Given that exports are a relatively small contributor to overall US economic growth, we are not overly concerned about moderate slowdowns in these markets. In fact, weak growth in these regions will likely keep interest rates and commodity prices low and continue to strengthen the dollar. Absent a severe contraction, these are tailwinds, not headwinds, for the US economy
3. Property and leverage bubbles in China – China’s housing stock is now over 300% of its GDP, almost double the peak reached in the US during our housing bubble. Leverage has also been increasing at an unsustainable rate with net debt expanding by approximately 30% of GDP per year. These trends can’t continue and at some point will have negative repercussions. We are cautious on China and many other emerging markets, but similar to our assessment of Europe and Japan, a moderate slowdown in these geographies should not have widespread negative implications for growth in the US.
4. Lack of innovation and slowdown in productivity growth – Some experts assert that the magnitude of productivity benefits from the computer/data revolution are far less than those generated by industrial improvements of the past. They then conclude that we are in for an extended period of slower growth and lower aggregate returns. This type of argument takes decades to either prove or disprove. Given recent breakthroughs in healthcare, technology, energy and manufacturing, we think American inventiveness is, in fact, an economic and investment driver.
5. Rising interest rates – This risk consistently ranks as the one investors cite most. If economic growth accelerates significantly, rising interest rates would indeed eventually mark the end of this bull market. However, given the slowing global economic backdrop, we don’t see this as likely. In fact, if the Federal Reserve does begin to raise interest rates in mid-2015 as widely expected, this will be the first time in history that they do so in a low inflation environment. Further, given the low level of rates, lackluster demand for credit, high cash positions and the likely very slow rate of increases, we do not expect interest rates to be the catalyst for a change in market fundamentals.
6. Geopolitical tensions around the world – ISIS, the Ukraine, Russia and the Middle East. Each has the potential to be a major disruptive force in the global economy with widespread implications for GDP growth. Unfortunately, these situations are highly volatile and don’t lend themselves to in-depth research. Like everyone, we’ll be watching these hotspots, but these situations tend to be event driven and are only truly predictable with perfect hindsight.
We monitor for changes in these and any new concerns. For some, such as weakness in Europe, Japan and emerging markets, the magnitude and pace of the economic slowdown is important. If they weaken gradually, the US economy will likely experience little or only minor disruption. If there are abrupt and extreme declines, economic contagion would be much more likely.
With other risks, such as a worsening housing market or a decline in productivity growth, we would be sensitive to a widening gap between GDP growth and equity market performance. If the market continues to rise as we see deterioration in key segments of the economy, we would likely turn more cautious on equities.
Despite the risks, the core fundamentals that have been driving the market higher: low interest rates, benign inflation, a healthier US economy and solid corporate earnings growth, have not changed. We just had a strong back-to-school season, which typically foreshadows a good holiday selling season, and historically, the fourth quarter is the strongest of the year. While there is risk in staying at the party too long, and we are actively watching for a change in fundamentals, on balance we think the near-term positives still outweigh the negatives and therefore we are maintaining our equity allocations.
We continue to focus on our key themes which we believe provide certain companies secular advantages that persist, even in changing cyclical backdrops. One theme that we have written about in the past is the continuing slowdown in emerging markets. China’s rapidly growing debt levels and excessive property valuations are only part of its challenges. The country has a declining workforce, aging population, extremely unbalanced economy and slowing foreign direct investment. Further, recent events in Hong Kong add heightened political unrest to this mix.
A slowdown in China is particularly dangerous for the rest of the emerging markets, especially resource rich economies dependent on China’s voracious demand for commodities. Many commodities including iron ore, corn, rubber, wheat and oil, broke down to multi-year lows during the third quarter as did the Goldman Sachs Commodity Index. We think these price declines will continue due to excess capacity built during the boom years coupled with slowing demand.
Another factor contributing to this theme is the fact that the US dollar has broken out to a multi-year high. A rising US dollar tends to hurt emerging markets because money flows out of these countries to the US to capture the currency appreciation. Also, since commodities are priced in dollars it makes commodities more expensive for the rest of the world, further suppressing demand.
There are a number of ways we are investing to benefit from lower commodity prices and slowing emerging markets. First, and most obvious, we are reducing our exposure to materials and agriculture. At the same time, we favor those commodity producers with the lowest costs that should perform better than higher cost peers in this environment. We are also investing in companies that benefit from lower commodity prices. For example, some airlines, restaurants, prepared food producers and apparel makers are well positioned to improve their margins due to declining input costs. Last, among these subsectors and companies, we focus on those with the highest mix of sales and distribution in the US and limited exposure to slowing emerging markets.
We would be remiss if we didn’t mention one of the biggest events to occur in the quarter, the IPO of online Chinese retailer, Alibaba. This was the largest IPO in history. We have chosen not to invest in Alibaba. Our decision was only partially due to the company’s namesake tale, Ali Baba and the Forty Thieves (Ali Baba may be the best of the bunch, but he is still a thief!). This IPO, like most, is someone’s exit strategy, diluting shareholder value while profiting those exiting. Our decision was also due to a combination of a high valuation, aggressive accounting tactics and our expectations for a slowdown in China, with the second being at least as important as the first and third. We tend to stay away from companies that exclude certain expenses by saying they are one-time in nature (especially when they occur every quarter). We also tend to avoid companies that exclude operating costs from their consolidated financial statements by funneling them through unconsolidated subsidiaries, which is the case with Alibaba. The stock may perform well, but we feel more comfortable elsewhere.
One of our current investment themes is that interest rates will stay low by historical standards for several years. Even when the Fed begins to raise rates, with consensus being mid-2015, we do not believe it will cause the entire yield curve to rise proportionally. We think the primary move will be in short-term rates and the yield curve will flatten. This is already beginning in the certitude of anticipation. Nevertheless, if long rates move up at all, they may not be high by historical standards, but the percentage increase will hurt bond prices. With money-market rates hovering near zero and real long-term rates only slightly better, we still favor short to intermediate average durations, individual bonds over bond funds and high credit quality issuers.
Within what has been a persistently challenging fixed-income environment, we spend a lot of time researching and buying bonds where we find added value. Premium “cushion” bonds provide higher yields and a degree of protection in a rising rate environment. They have higher than market coupon rates, and are priced to a call date rather than their maturity date. This makes them more resilient and less sensitive to interest rate fluctuations. Similarly, taxable municipal bonds have provided return premiums over corporate equivalents. On the tax-exempt front, problems in Detroit, Puerto Rico, and Illinois, have caused us to spend more time analyzing credit worthiness and bond covenants. Our goals are to preserve principal and generate a real return. The latter is important but pales in comparison to the former.