The economic and world news for this quarter has been intense. Developments in Iraq and Syria with renewed calls for military intervention have dominated headlines. The stalemate between Russia and the Ukraine continues while in Africa, a deadly outbreak of the Ebola virus has gripped the world’s attention. Most recently, Hong Kong has called for more autonomy from China through peaceful demonstrations. Economically we had a strong reversal in GDP (more below) and of course we are heading into a significant election that will impact the future of a wide range of legislation from immigration to healthcare. Below are our thoughts on the events of the past three months as well as what we see for the rest of this year.
In last quarter’s letter, we noted the negative GDP number from Q1. Since that time, the Q1 number has been revised upward from -2.9% to -2.1%. The Q2 GDP number came in better than expected at 4.6%. This volatility in GDP demonstrates why our focus is on economic trends as opposed to individual reports (that tend to be revised numerous times). Ultimately, the mixed economic data reinforces our view of a “muddle through” economy.
While the economy is not growing at the rate we would like, we continue to see signs of strength in the labor market. Employment growth has accelerated over the past five years and the unemployment rate has fallen from 10% to 6.1% currently. At this writing, the Challenger survey showed that job cuts are at the lowest level in 14 years. In the most recent jobs report, the U.S. added 248,000 jobs for September. Reviewing the trailing 12-months, U.S. nonfarm payrolls grew by 2.64 million, the largest 12-month job gain since early 2006. Combined with improving balance sheets in the household and banking sectors, these data points describe an economy that is getting stronger.
Beyond jobs, the most recent economic data has been mixed. Housing numbers continue to be volatile with new housing starts falling by more than 14% in August after rising 15% in July. However, the longer term trend remains positive. Retail sales continued to climb through the quarter which is a good sign overall. Internationally, we continue to see recessionary troubles in Europe and beyond.
We are monitoring current domestic and geopolitical issues that could negatively impact our economy. The list hasn’t changed much over the last year; however it seems we add something new each quarter. This quarter’s new addition is the Ebola outbreak:
- The uncertain timing and magnitude of fiscal “tightening” by the Federal Reserve
- Upcoming election cycle
- Conflict in the Ukraine and potential escalation within Eastern Europe
- The Affordable Care Act implementation and its effects on consumption and employment
- Slowing growth in China and ongoing fears of Chinese banks with questionable loans on balance sheet
- Civil war in Iraq and the danger of a widespread conflagration in the Middle East
- Civil unrest in Hong Kong
- Ebola outbreak and whether it can be contained
Stocks closed out the third quarter of 2014 with another gain, although it was not as large as previous quarters. The S&P 500 returned 1.1% for the quarter and is now up 8.3% year-to-date. The broad market has now posted gains in seven straight quarters. Even though the quarter was positive, the month of September, historically the worst month of the year, posted a loss of 1.4%. We are well in to the fifth year of a bull market that began in March 2009 and while we do not think the market is wildly overvalued here, we do think current prices reflect a fair valuation.
We are starting to see some divergences in performance between sectors and by company size. In the third quarter, seven of the ten economic sectors in the S&P 500 posted positive returns. The two largest detractors were Energy & Utilities, which were actually the best performers in the second quarter. The Energy sector was down 8.6%, while the Utilities sector was down nearly 4.0% for the third quarter. Energy companies were negatively impacted by falling oil prices as well as the strengthening dollar. Healthcare & Technology were the two best performing sectors during the quarter and now boast the largest gains YTD, up 17% and 14% respectively. Small cap stocks, as measured by the Russell 2000, were down 8.7% during the quarter and are now down 4.4% YTD. When correlations among stocks fall (meaning not all stocks move in the same direction or at similar magnitude) it tends to create a better environment for “stock pickers.” With recent measures of equity market correlations at the lowest readings since 2008, we believe this will be an opportunity for our approach to shine.
The Initial Public Offering (IPO) market remains vibrant and during the quarter we saw the largest IPO in history. Shares of Chinese e-commerce giant Alibaba (BABA) began trading on the New York Stock Exchange on September 19th. The company raised $25 billion, which was approximately $6 billion more than the previous U.S. IPO record holder Visa (V) back in 2008. Over 60 IPOs occurred in the U.S. during the quarter, raising approximately $42 billion in proceeds. While there are always exceptions, most of what we have seen in the IPO and M&A market has been encouraging.
Volatility has picked up in the otherwise sedate bond market. The Federal Reserve reduced their pace of purchases of Treasury and Mortgage Backed Securities by an additional $10 billion, in line with expectations. The end of “Quantitative Easing” is expected to be announced at the next Fed meeting in October, assuming no new shocks to the economy have occurred. The interest rate guidance for the short term borrowing rate controlled by the Fed is very murky. Markets do not like uncertainty, and we have an abundance of uncertainty as it relates to the strength of the economy and the resulting actions of the central bank. Janet Yellen, the Fed Chairwoman, wants the market to understand that Fed decisions about rate increases will be based on incoming economic data and not some calendar focused rule. Therefore every new economic report seems to bring wild market swings as short-term traders try to guess as to how that information will affect Fed decisions. Unfortunately, we believe this volatility will persist until it is clear what path short term rates will take. For what it is worth, the futures market is pricing in the first increase in Fed Funds by July 2015.
The 10-year U.S. Treasury note began the quarter with a 2.53% yield, dropped to 2.34%, rose to 2.62% and finally ended at 2.49%. By early October, the yield has fallen to 2.31% which is the low for the year. The economy has not materially changed during this timeframe and this volatility can only be blamed on the uncertainty surrounding the Fed. To put our 2.31% 10-year bond in perspective, keep in mind that the Euro area composite is yielding close to 1.25%. In Germany, interest rates are negative for the first three years which means investors are in essence are paying the government to hold their money. We do not think these conditions are sustainable.
The broad investment grade bond market has returned 4.1% YTD. Longer maturities have been the better performers. For retirement accounts, we are still finding value in step-up agency callable securities to lower the risk of rising rates. We have been coupling these agencies with taxable municipals in lieu of corporate bonds since the credit quality is much higher.
The rally in tax-exempt municipals is still underway and on a national basis municipals are up over 7% for the year. Similar to taxable bonds, longer maturity and lower quality bonds have performed the best. We are still finding the most value in callable structures, but it is still difficult to find opportunities. Higher coupons in the 4% to 5% range are still the focus to reduce interest rate risk. Recently, lower coupons in the 2.5% to 3.5% range are now offering better relative value and will be used on a limited basis to offset the higher premiums associated with the above market coupons.
These are extraordinary times in which we live where a confluence of factors have caused many of us to wonder what the future will bring. We have a bond market uncertain about rates and a U.S. government with as much debt as we’ve ever seen. The Federal Reserve has taken on more economic influence over the last five years and while asset prices have risen substantially, we are unclear as to how the unwinding of loose monetary policy will impact those same assets. Uncertainty is not uncommon in investing and there will always be “extraordinary” factors in play. It is all too easy to narrow our focus on plagues, wars, recessions and political unrest but we’ve found a healthy dose of rational optimism is the best approach and has yielded good results.
 Source: Deutsche Bank Research
 According to Mark Perry, Economist at the American Enterprise Institute; http://bit.ly/1rIgQB8