We are surprised the markets were so strong last quarter given the negative headlines that typically cause market volatility. Our year-end expectations have been exceeded. Year to date we have double digit gains in the S&P and the Nasdaq and high single digit gains in the Dow Industrials. Even our friends across the pond have seen high single digit gains in their major indices. This quarter only added to the strength we have seen in the market all year.
This economy reacts to changes in consumer and business confidence. When uncertainty increases, confidence falls. When confidence falls, both consumers and businesses change behavior by becoming more cautious which slows economic growth. Currently, business confidence is suffering for a number of reasons, many of them political. There are three large outstanding issues that are giving businesses pause; the first is what has been named the ‘fiscal cliff.’
This cliff is the result of the budget deal made last year when Congress and the President raised the debt ceiling. It is a set of automatic spending cuts coupled with tax increases that kick in if Congress and the President do not act to address budget issues by January of 2013. The cuts are draconian and would affect multiple areas of discretionary spending raising concerns that they could lead to a recession. We are hopeful that after the election, Congress and the President will work to sort out our budgetary issues and avoid the fiscal cliff.
The second and third issues are tied to the coming election. Many business leaders have noted that they are struggling to plan or bring on new investment because they do not have certainty about the tax regime in 2013 forward and the ultimate fate of “ObamaCare”. With ObamaCare taking full effect in 2014 and the threat of a repeal looming if Republicans win the Senate and the White House, businesses are taking a wait and see approach to hiring. Health care costs and taxes are a large determinant in the cost of doing business, uncertainty in these areas or a perceived spike in their cost will limit hiring. A fear of recession also stymies hiring. Hence the resulting and persistent 8%+ unemployment rate means many consumers are struggling to make ends meet, which stifles end demand and ultimately hurts corporate sales and profits.
Our overall pessimism about the U.S. economy has grown throughout this quarter. We have seen a number of weakening economic numbers combined with tepid GDP growth (recently Q2 GDP growth was revised down to 1.3% from 1.7% which is anemic). Bloomberg recently reported that the share of U.S. CEOs planning to add employees or expand investment during the next six months declined in the third quarter. On top of this a larger share of CEOs indicated they would cut jobs and reduce spending, according to a recent Business Roundtable survey.
The Federal Reserve, with the advantage of having early economic data points, took action in their last meeting in an attempt to keep things “muddling along.” We have seen central bank problems arise all over the world this quarter. European Central Bank president Mario Draghi's promise to do “whatever it takes” to keep the euro zone together has temporarily stabilized the situation, while they continue to work on a plan to address the eurozone’s weaknesses. China, while still growing GDP by roughly 7%, is not growing fast enough to fully offset weaknesses in Europe and is actively trying to stimulate its economy via infrastructure investments.
The other headwinds we have not mentioned are the persistently high oil prices driven by instability in the Middle East, high gasoline prices due to lack of refining capacity, and a tremendous drought in our “bread basket” states which may cause food inflation. The good news is that we are now producing more oil domestically. However, our current infrastructure does not support efficient usage of this oil. We have been caught flat footed - our infrastructure is designed for oil to be imported, consequently the pipelines that transport oil are going the wrong way! This is being remedied, but will take time. Gasoline prices will follow oil as we become more dependent on domestic sources. As we further develop this domestic supply of energy the U.S. consumer will be less susceptible to the geopolitical risks that tend to spike oil prices and pinch consumption. The drought in the mid-west is transitory and we believe any food inflation based on this year’s harvest will be short lived.
On a positive note, at home the consumer continues to shop and spend, though the rise in gasoline and food prices may begin to make a dent in their other purchases. Encouragingly, Nathalie Tadena at the Wall Street Journal recently reported "the International Council of Shopping Centers projected a 3% increase in U.S. chain-store sales for the holiday season, a critical period for retailers, even though consumers face greater macroeconomic uncertainty." We would not be surprised if spending exceeded these estimates if consumers were able to see past the uncertainties we have outlined.
Low mortgage rates and pent-up demand in the U.S. is allowing the housing industry to come out of its six-year downturn. CoreLogic, an excellent source of real estate data, states that “Home prices nationwide, including distressed sales, increased on a year-over-year basis by 2.5% in June 2012 compared to June 2011. On a month-over-month basis, including distressed sales, home prices increased by 1.3 % in June 2012 compared to May 2012.” CoreLogic also notes that home prices are up 9% since the lows we saw in March. According to Briefing.Com, distressed properties accounted for only 22% of existing sales in August, down from 31% a year ago. The drop in distressed sales has led to a meaningful increase in the median existing home price. This should be a welcome relief to homeowners who have seen their equity values fall for nearly six years, and could further stimulate consumption by aiding confidence.
Stocks performed very well again this quarter. The overall stock market is not as depressed as it was at the beginning of the year, but there are still cheap stocks to be found. With interest rates on bonds at historic lows it is easy to see why investors would want to own stocks, especially those with a dividend. The dividend rate on the S&P 500 (north of 2%) is now nearly 30% higher than the 10-year U.S. Treasury note (1.63%). On top of the competitive yield, you also have the opportunity for growth in the value of stocks in contrast to Treasuries.
During the quarter, nine of the ten sectors of the S&P 500 were positive with Energy and Technology leading the way. The only sector that was down was utilities. This doesn't play well into the “yield chasing” perception of the market to have utilities down this quarter and essentially flat on the year, however mild weather has restrained power demand. The flip side is the top performing sector for the year is telecommunications which is also a high dividend sector.
We think the “easy money” has been made this year for stocks. During the most recent earnings reporting period we consistently heard from CEO’s of the companies that we own that they didn't make their revenue goals, but made their earnings goals. For the last few years companies have cut costs and streamlined businesses in order to become quite efficient. We believe the low hanging fruit has been picked. We are at a point now where metrics we use to measure the overall market are at a valuation where one of two things happens: If the economy improves then these streamlined companies will be very profitable and may even begin to hire; if the economy turns down there is very little left to cut and earnings expectations will need to be revised downward and the valuation of the market will begin to look more expensive than it does today.
The fixed income markets understandably lagged the above average returns from the equity markets during the quarter, with the Barclay’s Aggregate Index up 1.6%. This advance brings the year to date return for this bellwether index to just shy of 4% for the year. Corporate bonds, and more specifically financial related corporate bonds, have fared much better. The corporate index has returned 6.5% year to date, while intermediate financial credits have experienced a total return north of 11%. We view this as a reflection of the efforts banks have made to shore up their balance sheets due to the many new regulations and capital requirements that are on the horizon. We still like the financial sector as the yields are favorable compared to Treasury bonds.
The 10-year and 30-year Treasuries closed the quarter with 1.63% and 2.82% yields, respectively. Our view is that rates will fluctuate in a relatively tight range until we get more clarity on the effects of the recently announced monetary stimulus from the Federal Reserve. The Fed intends to purchase $40 billion of mortgage backed securities each month in an effort to foster full employment, and they reiterated that rates will stay low at least until mid 2015, and potentially longer. Those who expect rates to move higher are indeed “fighting the fed”, an approach that we do not advocate. Our portfolios in most cases have less interest rate risk than the overall market, but only to a small degree. We continue to like step-up callable agency and corporate debt at these levels in the taxable market.
Municipal bonds continue to be favored by investors, as illustrated in month after month of retail contributions into tax free bond funds. Municipals have marginally outperformed their taxable equivalents with many credits up north of 5%. The yield curve is steeper (investors get more yield for buying longer bonds) in this sector than the taxable sector, therefore longer dated maturities appear “cheaper” than shorter maturities. We find bond structures with long finals (2025-2030+) with short to intermediate call dates to offer the best value, where we are finding yields to call from 1.9-2.5% and corresponding yields to maturity well north of 3%.
All told the economy faces many issues, many that have not changed for several years. European budget and austerity issues, Iranian war drums, a slowing Chinese economy, a U.S. election that will decide the fate of tax increases and healthcare to name a few. Even with these issues and with a somewhat dysfunctional government, our imperfect system will manage to survive, and if history is any indication, to thrive. We look forward to it.