With the first quarter of 2014 in the books, we were pleased with the outcome of both the stock and bond markets. After a fantastic 2013 and a rocky start to 2014, the quarter closed out on a largely positive note. Below are our thoughts on the events of the past three months as well as where we believe we are heading.
While much of the recent data has been weak, we are optimistic that the economy will accelerate into the middle of the year and raise expectations for a stronger 2015. Recent housing data has been weaker than we had hoped and the most recent purchasing managers’ surveys were below expectations. We continue to see weakness across the globe, with troubling data from China which has been at the center of world economic growth for years.
It’s hard to blame China’s numbers on the weather, but clearly the US economic data has been negatively skewed by a severe winter season. We continue to watch retail sales to test the health of the consumer. There are indications that consumers are not overspending but demonstrating moderation in new purchases. While this may hurt in the short term it typically bodes well for the long term. It is very likely that businesses are continuing to work through the large inventory additions from the fourth quarter which allowed for a larger than expected GDP. Working through this backlog will take time, especially during a season of slower demand due to weather and other factors.
On a positive note, initial unemployment claims were the lowest they have been in several months and are currently close to the best levels of the recovery. Additionally, ISI’s company surveys are on track to bounce a significant +1.7 over the past five weeks, led by truckers, auto dealers, and homebuilders. These figures lead us to believe that the economic recovery persists. As for the fourth quarter GDP numbers, they were actually recently revised upward to 2.6% from the previous 2.4% which means growth was better than previously thought. Even with some broad based weakness in housing, home prices seemed to be holding steady.
The new head of the Federal Reserve, Janet Yellen, has taken over and is sustaining the policies of her predecessor. While the market has had to adjust to her style of communication, it appears that the Fed will continue on the path of accommodation it has been on for 5 years. We believe monetary tightening is coming, but that the economy will survive as we move to a more normalized policy.
Overall in 2014 we expect the Government sector will become a net contributor to GDP. As we have discussed in prior letters, the U.S. oil and gas boom continues unabated. According to Morningstar analyst Robert Johnson, there are some signs that healthcare may contribute to growth in 2014. Ultimately, it is our expectation that we are in for another year of unspectacular, yet slowly improving, economic activity.
We continue to keep an eye on current domestic and geopolitical issues which could cause future shocks. The list hasn't changed much over the last several quarters, except for the addition of the Ukraine and less concern over European debt:
- Perceived tightening actions from the Federal Reserve
- Political gridlock in Washington
- Further conflict in the Ukraine and potential escalation within Eastern Europe
- The Affordable Care Act sticker shock and its effects on consumption and employment
- Slowing growth in China and ongoing fears of Chinese banks with bad loans on the books
The first quarter of 2014 came in like a lion and went out like a lamb. After falling nearly 6% in the first 35 days of the quarter, stocks rebounded and the S&P 500 finished up a respectable 1.8%, once again setting a new price record. The economic and geopolitical uncertainties during the quarter were not enough to cause the 10% correction that many participants were anticipating. Russia’s invasion and subsequent annexation of the Crimea region in the Ukraine along with mixed commentary from the Federal Reserve spooked investors early on. However, Moscow has vowed that it has no intentions of sending troops further into the Ukraine and the Federal Reserve made it clear that they will not raise short term rates for some time, with many Fed watchers predicting the first increase to occur in mid-2015.
During the first quarter, eight of the ten market sectors posted positive returns. The top three performing sectors were Utilities, Healthcare, and Materials. The bottom three performing sectors were Industrials, Telecommunications, and Consumer Discretionary. After being the second worst performing sector in 2013, Utilities finished the quarter up 10% (beating the sector’s performance for all of 2013). Conversely, the Consumer Discretionary sector was the top performing sector in 2013 only to fall to the bottom of the list in Q1, down 3%. We may be getting a rotation out of momentum strategies into those focused more on valuation and individual “stock picking.” We will welcome this shift as it transpires.
In a sharp reversal from 2013, long maturity bonds clearly jumped ahead of the pack during the first quarter. The 10-year and 30-year Treasuries began the year with yields of 3.02% and 3.97%, respectively. While many investors were concerned that rates would rise further, uninspiring economic data, low inflation and heightened geopolitical risk drew investors back to bonds (which pushed rates lower). The 10-year and 30-year yields closed the quarter at 2.72% and 3.56%, respectively. To put these moves in perspective, the long bond returned negative 18% in 2013, while it is up over 8% this year to date. While we are currently shying away from the longer section of the yield curve, it is noteworthy to consider the conviction many other market participants are demonstrating.
Under Chairwoman Yellen, the Federal Reserve has maintained the reduction in asset purchases as expected. What was not expected was the language she used that many interpreted as speeding up the expected start date of a Fed Funds rate increase. This caused rates to rise in the 1-3 year portion of the yield curve while long rates have actually fallen. The increase in short rates is a rational response, as the Fed controls the short part of the curve. The fact that longer dated yields have fallen is less intuitive and the “flattening” of the curve may be a signal that the move to raise short rates could potentially impact economic growth. The yield on the 3-year note increased by 10 basis points and the 30-year yield fell 41 basis points during the quarter.
The municipal market also had a strong quarter, up over 3% on a national basis. We are pleased the market remains strong in light of the almost daily headline risk with Detroit and Puerto Rico. The bankruptcy in Detroit is ongoing, but estimates are that General Obligation holders will get back roughly 20 cents on the dollar. Puerto Rico was able to issue $3.5 billion of new bonds to refund existing debt and for general purposes, allaying default concerns temporarily. Outside of these issues, the demand for high quality tax-free income remains firm, and yields have fallen this year. Most states continue to improve their fiscal health as tax receipts have now virtually recovered from the recession. The lingering pension obligation issues for many states will remain a risk for municipal bonds. We still favor municipal bonds versus the taxable market for investors who have even a modest tax bracket.
As we mentioned in our last letter we feel the market is fairly valued based on our view that the economy will likely limp along at a slow to moderate pace. Therefore, we would not be surprised if the major advance we have seen over the last five years comes to a pause until earnings catch up to the move in prices. This is especially true given the above average equity returns in 2013. Most recently we may have seen the beginnings of this with the sharp correction in the more momentum driven growth stocks. This group includes a wide swath of biotech, social media and internet companies that experienced sharp corrections toward the end of the first quarter. Much of this correction was driven by the realization that a slow growth economy will not facilitate the needed earnings growth to allow these high valuations to persist. Regardless of what manner of investing is en vogue, we are fully confident in that our investment process will meet our clients’ objectives over the long term.