This year was characterized by political unknowns, but few economic surprises. We began the year concerned about negative outcomes from budget fights and the impact of the sequester that went into effect during the first quarter. We then moved our attention to the comments from the Federal Reserve in regards to whether it would continue its bond buying program known as “Quantitative Easing.” We ended the year with a government shutdown and the implementation difficulties of the Affordable Care Act. Despite all of these issues, markets traded higher. This reminds us that in the short term, politics can impact stock and bond prices but ultimately it’s the economy that drives underlying values. Warren Buffet likes to say that in the short term the stock market is a voting machine but in the long term, a weighing machine; we strongly agree.
How is the economy? Five years into our recovery from the Great Recession, U.S. macro uncertainty is finally abating. Couple that with the deficit declining to a six-year low and it made for a bull market. In response to the economic strength, the Federal Reserve announced it would begin to taper its bond purchase program by $10 billion down to $75 billion per month. It is a great relief that we are at the “beginning of the end” of this extraordinary program. Ideally, we will continue to see incremental shifts towards a sustainable monetary policy in the coming months. Concurrent with this announcement, the Fed also pledged to keep short-term rates near zero until unemployment is below 6.5%.
The economic data supports these moves by the Fed. Surprisingly, third quarter GDP came in at a very strong rate of 4.1% and the most recent economic data has been stronger than expected. U.S. manufacturing ended the year on a high note, growing in December at its fastest pace in 11 months. The rate of job growth in that sector was the fastest since March according to financial data firm Markit. The U.S. Manufacturing Purchasing Managers Index rose to 55 in December (a reading above 50 indicates expansion). The manufacturing employment sub-index rose to 54.0, its best showing in nine months, up from 52.3 in November. U.S. manufacturing is continuing its resurgence.
Other positive economic data points like positive durable goods orders and construction spending, coupled with less government drag on GDP, implies the GDP numbers should be able to sustain a 2.5% to 3.0% rate of growth in 2014. As we’ve often stated, growth is the key to solving our economic and political issues. Confidence and stability are a large part of that growth. A shrinking budget deficit relative to GDP is very good and relieves the concern that our deficits will continue to skyrocket. Thematically, we see GDP and earnings guidance rising, more political cooperation (budget deals), stability at the Fed (via Yellen), a WTO deal, EU stability (if not growth), and Mexican economic reform, all of which are positives for U.S. growth. Additionally, it appears that our oil self-sufficiency is very quietly becoming a reality; this tidal shift had a measurable impact on energy prices which has helped to keep inflation benign.
Of course, there are two sides to every coin and the economic impacts of the Affordable Care Act and a very large public debt load are still very substantial and unsolved concerns. As of this writing, the jobs number for December was an anemic increase of only 74,000 – the lowest number since early 2011. This is an outlier relative to the other incrementally positive data we reported above and while we would not change our view of the economy on one month’s worth of data, it obviously raises concern.
The continuation of the “kick the can down the road” approach to dealing with the massive long-term unfunded liabilities of Social Security and Medicare will not be successful forever and underemployment remains a structural economic headwind. The budget deficit is declining, but is still estimated to be nearly $600 billion in fiscal 2014. Virtually half of the aforementioned 4.1% increase in GDP for the 3rd quarter was attributed to inventory accumulation. Should the holiday shopping season surprise to the downside, economic activity may slow early in 2014. Our hope is that economic expansion will solve the jobs problem and longer term, politicians will address the chronic entitlement funding issues in the years to come.
As we begin 2014, market indices are setting all-time price records; as we illustrated in our last letter we are not at all-time highs in valuation. Interestingly, according to Raymond James, the inflation-adjusted all-time high for the S&P 500 is around 2060 – that is 12% away from the current level.
During the fourth quarter all ten economic sectors locked in positive returns. The top three sectors were Industrials, Technology and Consumer Discretionary. On the bottom of the list was Utilities followed by Telecom and Energy. The quarter reflected the year as a whole, in which all ten sectors where positive. The top three performing sectors for all of 2013 were: Consumer Discretionary (+41%), Healthcare (+39%) and Industrials (+38%). The bottom three were: Telecom (+6%), Utilities (+9%) and Energy (+22%). The bottom three sectors (which have relatively high dividend yields) demonstrate the pressure of rising interest rates since the Federal Reserve meeting in May.
We are less concerned about “all-time highs” than we are about valuations. Valuations seem reasonable at current levels assuming continued GDP growth of 2.5% to 3.0%. We certainly are not calling for a repeat performance of 2013 in 2014. It would come as no surprise if we experienced a meaningful correction in the upcoming year simply because this rally has been going in only one direction. This is always a possibility in our view, but ultimately we see corrections like brush fires – important to the overall health of the ecosystem but not ultimately destructive. While much of the market advance in 2013 was due to multiple expansion, we believe that earnings and revenue growth (i.e. fundamentals) should finally become a more critical driver of stock performance. We will welcome this transition as it materializes.
2013 saw the reintroduction of volatility into the bond markets. In May the 10-Year Treasury yielded a rather uninspiring 1.6%. By the end of the year, the yield was 3.0%. This increase in yield equated to a total return for the year of negative 8% for the 10-Year Treasury (price moves inverse to yield). The 30-Year Bond had an even more dismal negative 15% total return as longer bonds are more sensitive to interest rate fluctuations. The bond market overall, as measured by the Barclay’s Aggregate, was down 2.0%. The main driver of this correction was the Fed’s decision to begin “tapering.” The concern that the largest buyer of U.S. government bonds would decrease their purchases led to dealers, hedge funds, institutional and retail investors fleeing the market. Retail bond mutual funds reversed the inflow of funds in place since the financial crisis and witnessed over $70 billion of net outflows for the year, according to Lipper.
While the Fed’s tapering is real and clearly has an impact on interest rates, we cannot overlook the fact that the economic backdrop has improved. As employment increases, wage pressure could theoretically increase, which could lead to inflation. This would clearly be a negative for the bond market. It is difficult to discern if and when this employment (and thus inflation fear) may materialize.
We continue to find value in Federal Agency step-up bonds. We are able to purchase these securities at a substantial discount to par while having the defensive structure of higher future coupons. Corporate bonds are still attractively positioned on the short end of the yield curve. However, the extra yield (or spread) investors receive for holding a corporate bond versus a risk free government bond is historically low. We are investing in corporate bonds out to five years as we see opportunities. In aggregate, this strategy provides higher current income from the corporate bonds on the short end and provides interest rate protection on the long end of the yield curve. An example of a common step-up schedule would be a 2% coupon until 2016, 3% until 2017, 4% until 2018, etc. until a final coupon of 6% to maturity.
Municipal bonds were not spared the rate correction experienced by their taxable counterparts. Credit risk concerns also played a role. Detroit filed for bankruptcy and how the courts handle the recovery for bondholders is being closely watched. General Obligation bond holders are being asked to accept 20 cents on the dollar to allow the city to emerge from bankruptcy. This would be somewhat unprecedented for a large municipal issuer like Detroit. Additionally, the severe pension problems in many U.S. states (most notably Illinois) and Puerto Rico (a U.S. territory that is tax exempt at both the federal and state level) combined for a perfect storm to drive down prices. The municipal market on a nation-wide basis was down a little over 2.0% as measured by the S&P Municipal Bond Index. However, the mutual fund peer group was down over 4.0%. It appears that many mutual fund managers “reached for yield” by taking undue credit and interest rate risk and are now feeling the backlash. The types of municipal bonds we are purchasing are yielding 2.5 to 3.5% to an intermediate call and up to 4.0 to 4.5% to a longer final maturity.
We would like to reiterate the benefits of having a customized portfolio of individual, high quality securities. With the level of uncertainty and “groupthink” that is leading to higher interest rates and redemptions from bond mutual funds, it is comforting to know that the characteristics of a portfolio of individual securities do not change and a set maturity date exists for each holding.
Last year at this time we wrote, “Ultimately, this self-inflicted [political] crisis will fade to the background and the real economy will determine how the stock and bond markets perform in the long term.” We continue to hold to this view – politics can affect the short-term thinking, but ultimately the economy and company fundamentals determine where prices settle. We are encouraged by economic progress and continue to think we are on the ground floor of a multi-year expansion. Stocks and bonds are beginning to reflect this view as stock prices rise and bond prices have declined due to slowly rising rates. We continue to believe an appropriate asset allocation that reflects your long-term needs and goals will be successful in the years to come.