2014 2nd Quarter Commentary

Overview
At the halfway point for the year, the markets have continued to surprise investors.  Below are our thoughts on the events of the past three months as well as what we see for the second half of this year.

Economy
In what seems to be becoming a pattern, our economy has managed to make forecasters and economists look foolish.  During the last full week of June we received the third quarterly revision for Q1 GDP.  Economists were looking for a slightly negative GDP number when instead we saw a massive -2.9% contraction. Please understand this is still only an “estimate” as the government continues to compile and sift through the available data.  We were understandably surprised by such a number when the jobs data has been consistently strong despite the terrible weather in Q1.  So what was the biggest outlier? Healthcare spending seemed to be the biggest issue affecting the GDP number. A large portion of the downward revision was the result of a change in the estimate by the Bureau of Economic Analysis as to the impacts of the Affordable Care Act (ACA) – and we thought healthcare spending would be a growth driver in 2014!

We see the first quarter as an aberration for a couple of reasons.  First, we think the healthcare spending that did not show up in Q1 will show up eventually.  These numbers are likely skewed when it comes to estimating healthcare spending because of so much transition and confusion over the ACA.  This will work itself out with time.  Secondly, weather was most definitely a factor in the negative GDP number and that is transitory in nature. Ultimately, we are not calling for a huge rebound from Q1 and glowing GDP growth this year.  However, mixed economic data seems to reinforce the “slow growth” environment that investors have been grappling with as we continue to recover from the lingering effects of the financial crisis.  If we could somehow achieve 2%+ growth this year we believe asset prices in general are justified.

A bright spot in the economy is the ongoing resurgence in manufacturing growth. We have now had eleven months of improvements in manufacturing activity and employment gains. The overall reading of 57.5 for the Markit Purchasing Manager’s Index (PMI) in June was the highest reading since 2010. Any reading above 50 is considered expansionary relative to the previous month.

Outside of the US, we see signs of stabilization in Europe even while emerging markets, notably Russia and Brazil, are struggling. Brazil’s manufacturing sector has been deteriorating for three months running while Russia’s manufacturing sector contracted for the eighth consecutive month. It appears China’s economy may have bottomed and is in a stabilizing pattern. Ultimately the U.S. economy is a major driver of worldwide growth, but these smaller but significant economies bear watching.

We are keeping an eye on current domestic and geopolitical issues which 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 civil war in Iraq:

  • 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 balance sheet
  • Civil war in Iraq and the danger of a widespread conflagration in the Middle East

Stocks
Market indices added to their advance in the second quarter of 2014.  After finishing up 1.8% in Q1, the S&P 500 added 5.2% during Q2 and is now up 7.1% year-to-date (YTD).  The markets continues to “climb a wall of worry”, as is a normal characteristic in bull market environments.

As bond prices rose and bond yields fell, investors once again flocked to higher dividend paying stocks, including Utilities.  All ten economic sectors posted positive returns in Q2, with Utilities as the second best performer, up 7.8% for the quarter.  This sector is the best performer YTD, up 18.7%.  Energy was the best performing sector in Q2, up 12.1%, as concerns over ISIS insurgents in Iraq pushed the price of oil up across the globe.  Current earnings and earnings estimates did not noticeably improve in these two sectors during the quarter, but the multiple investors were willing to pay for utility and energy company earnings did increase.  Conversely, as seen in the adjacent chart, Screen-Shot-2014-06-18-at-9.39.38-AMtwo of the worst performing sectors during the quarter, Telecom (+3.8%) and Consumer Discretionary (+3.5%), underperformed in large part due to multiple contraction.  Overall, earnings growth so far this year has kept up with the increase in the market, but some sectors have gotten more expensive while others have gotten cheaper.

Merger and acquisition (M&A) activity was alive and well in the second quarter. It seemed there were new deals announced almost every week. Deals focused on tax inversions, buying companies domiciled in foreign countries and using the tax advantage to shield earnings, were a common theme. We are beginning to see large, strategic deals as well, like the combination of AT&T (T) and DirecTV (DTV), which are designed to increase competitive advantage in a changing industry landscape.  Healthy M&A activity is a good indicator for the health of American business and the low cost of money and debt financing.  When we start seeing silly deals that are poorly priced then we will raise our caution flag on the market. For now, that has not been the case.

Bonds
The interest rate market rallied along with stocks in the second quarter, with the broad market up 2% for the recent period and 3.9% year to date.  The longer the term to maturity the better, as the 30-year U.S. Treasury bond has returned over 13% so far this year.  While stocks shrugged off the economic contraction of the first quarter, bonds took it as a cue for lower yields.  The 10-year Treasury note began the quarter at 2.71%, rallied to a low of 2.44% in May, and settled at 2.53% at the end of June.  Geopolitical risk has increased, putting further pressure on yields as a result of a “flight to safety”.  Additionally, the European Central Bank (ECB) began an unprecedented negative deposit rate for financial institutions.  This would be the equivalent of the Federal Reserve charging domestic banks to hold their deposits versus paying the Fed Funds rate of 0.25%.  This negative deposit rate may have the effect of driving deposits to the U.S, potentially putting additional pressure on rates to fall.

While we have seen the outsized returns in the long end of the bond market, we are not interested in investing in this sector.  The interest rate risk is far too high for most investors.  As an example, if rates in the 30-year sector increased by 1.5 percentage points in a six month time horizon (a move from 3.36% today to 4.86%) the price of the bond would drop by approximately 40%.  We think that earning a yield of 3.36% with the potential for significant capital impairment is not a well thought out plan.  We are continuing our strategy of buying step-up coupon federal agency bonds as a way to reduce this risk.  This allows us to earn a decent initial yield of approximately 2-2.5% while having a higher coupon and income stream ahead if rates rise.

Corporate bonds have returned over 5% this year, above our expectations at the beginning of the year.  The spread over comparable Treasury bonds, or the extra yield investors receive to invest in a lower credit corporate bond has steadily decreased.  Relative to Treasury bonds, we do not see any value.  Consequently, in lieu of corporate bonds we are finding similar credit exposure at better spreads in the taxable municipal sector.  We are finding AAA and AA rated bonds that yield more than the corporate equivalent, with less credit risk in our view.

Tax free municipal bonds countrywide have returned north of 5% this year, ahead of their taxable counterparts.  Credit conditions for most municipalities continue to improve with rising tax receipts, and credit upgrades are outnumbering downgrades by a wide margin. The market appears to have absorbed the default of Detroit.  The financial situation in Puerto Rico, however, has deteriorated further and a default on this triple tax exempt credit looks increasingly more likely.  The good news is the overall municipal market has not been impacted in a negative way and the problem appears isolated.

While it is getting more difficult to find attractive yields in municipals, we still believe this sector is the best relative value in bonds for those in a high tax bracket.  We are investing in high quality, high coupon structures with a long to intermediate final maturity with a short to intermediate call date to maximize the income to the portfolio.

Conclusion
The stock market this quarter rallied right through the surprisingly weak GDP number on the idea that the contraction was based on dated information that was largely written off to severe winter weather and a downward revision to health care spending.   The bond market has also marched right along in the face of the Fed’s continued move to slow bond purchases. We are not so sanguine.  Investors looked past the first quarter GDP report because they continue to believe the long term outlook is going to provide much better economic news and earnings growth.  While we are not predicting terrible economic data going forward, we think the economy is going to be hard pressed to make up for the negative print in Q1.  However, in the end we think the economy will grow enough and we will see positive GDP growth for the year.

So in the near term we are cautious given the increase in stock and bond prices along with a slow growth economy. We continue to believe that prices will correct at some point so that earnings can catch up to the move in prices.  Neither would we be shocked if bond yields begin to tick upward as well.  Even with our caution however, we still believe carefully picked high quality equities and bonds can provide a good return in the years to come.

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