2015 1st Quarter Commentary

With the first quarter of 2015 in the books, the domestic stock and bond markets managed to post a (barely) positive return.  After another positive year in 2014 and with economic uncertainty increasing as investors weigh the actions of the Fed, we have plenty to watch as the year unfolds.  Below are our thoughts on the events of the past three months as well as where we believe we are heading.

We ended 2014 on a decent note with a 2.2% expansion in GDP.  The New Year has not started with much fanfare as the most recent economic data has been on the weak side.  U.S. manufacturing posted weaker numbers which is sensible after last year when the industry benefited from increased oil exploration (although low oil prices have now cured that).  Additionally, the strong auto industry seems to have caught up with pent-up demand.  Exports are weakening with the growing strength of the dollar and a slower pace of consumer spending during the quarter.  The net effect has been that many forecasts for Q1 GDP have been reduced.  Similar to last year, we suspect weather related issues have likely caused some of this weakness.  Should that prove accurate, we will likely experience some snapback in the spring and summer. Our expectation is that the U.S. economy should expand in the 2.5-3.0% range, if not lower.

Consumer income continues to improve with a month-to-month increase of 0.9% in February.  The economy added 265k jobs in February which was well ahead of expectations of 240k. The jobs number for March, however, came back down to earth with a lower than expected number of 126k. That was the first time job growth did not exceed 200k since February 2014, and it was the smallest increase since 109k jobs were added in December 2013.  With consumption contributing to 70% of GDP, employment and subsequently rising incomes are necessary for economic growth. However, in the short term it appears that rather than spending, consumers have increased their level of personal savings.  This is good for the balance sheet of consumers but certainly impacts the economy in the short term.  Stronger job growth is imperative if we are to continue to pull out of the doldrums and see accelerated GDP growth.

On the housing front, residential housing indicators have slowed which impacts construction-related employment. The numbers continue to be volatile at this time of year and we know weather can impact those numbers substantially.  We are still waiting for this housing leg of the economic recovery to play its part in adding to GDP.  We would be happy to see 2015 as a breakout year for housing; especially if manufacturing struggles.  The economic multiplier effects from this sector are substantial.

To summarize, this economic recovery continues its irregular character with uneven GDP growth and persistent low inflation. Slower growth seems to be likely for the first quarter.  We are hoping to avoid an outright contraction, although we wouldn’t be surprised if that materializes. Regardless, we think 2015 has a good chance of ending up like 2014 – modest yet unspectacular growth.

Below is our list of concerns that we continue to monitor in 2015:

  • Instability in Russia and the threat of more aggressive military action from Putin
  • Slowing growth in China and ongoing fears of Chinese banks with questionable loans
  • Growth of terrorist groups in the Middle East
  • Recession in Europe and the resulting strong Dollar
  • The impact of falling oil prices on OPEC and other oil producing countries in the world
  • The threat of “hackers” who seek to control multinational companies through threats and blackmail

Equity investors have taken a breather after several years of solid gains.  The S&P 500 returned 0.95% for the quarter.  Earnings expectations for the market have been trending down, mainly due to the Energy sector and the impact on sector earnings from lower oil prices.  The S&P 500 currently sells for around 17x end of year 2015 earnings expectations.  As mentioned in previous commentaries, these P/E levels are not cheap, but by no means excessive either.  Recall that over the last 20-years the P/E ratio peaked at around 25-26x in the “dot.com” era of ‘99-‘00, and troughed at around 10-11x after the “financial crisis” of ‘08-‘09.  Additionally, given low interest rates we continue to think that equities are a good place to invest for the long term.  The chart below shows the current forward P/E for each sector.

In the first quarter of 2015, six of the ten economic sectors in the S&P 500 posted positive returns, with the remaining four posting negative results.  Healthcare was the best performing sector up 6.5% for the quarter.  Healthcare companies continue to benefit from new drug discoveries, mainly in the BioPharma area, along witP/E Ratiosh continued M&A activity.  During the quarter M&A activity announced in the sector totaled $75 billion. If that pace continues through 2015, it will top 2014’s record volume of $220 billion.

Utilities, after being the best performing sector in 2014, were the worst performing sector during the first quarter, down 5.2%.  Utilities and other “bond proxies” were impacted by the Federal Reserve’s “rate hike” talk.  Utility companies would be impacted by higher interest rates as it could cause investors to shift money out of Utilities to bonds and higher rates would impact the sector’s debt financing costs.  The Financial sector, down 2.1%, was also impacted by the talk of higher short term rates, as longer term rates remain low.  If longer term rates fail to move higher with short term interest rate hikes, banks and other financial institutions could see their borrowing costs increase while the rates they charge customers for loans stays the same.  This could impact bank profitability (or net-interest-margin in industry terminology).

The U.S. dollar remains strong and those companies with a significant overseas presence continue to be impacted by negative foreign currency translation effects.  F/X not only impacted revenues and profits for many companies, but also hurt relative stock price performance.  The chart below shows that those companies based in the U.S. with a majority of sales outside the U.S., underperformed during the quarter.  Roughly a quarter of the profits for the S&P 500 are earned in foreign currencies; a stronger dollar makes these earnings immediately less valuable.

US Company Foreign SalesWe continue to seek out and find high quality, durable businesses, with sustainable competitive advantages, selling at a discount to our estimate of fair value.  Though the market could face increased volatility in the year(s) ahead, we like the businesses in which we are invested.

It’s like déjà vu all over again.  Every year in recent memory it has started with professional forecasters prognosticating a virtual “certainty” that bond rates will move higher and inflict pain on fixed income investors.  While that may prove to be true one day, it certainly did not happen in the first quarter of 2015.  The broad market, as represented by the Barclay’s U.S. Aggregate Index, returned 1.61% for the quarter.  No surprise then that the longer the maturity, the higher the return.  Benchmark 30-year Treasury bonds returned 5.1%, 10-year notes returned 2.6%, while 2-year notes and shorter were up less than 1%.  These are fairly strong returns given the broad pessimism surrounding fixed income investments.  We would be remiss if we did not address that pessimism; are our rates really that low and unattractive?

While many would have an automatic response to this question as “yes”, we believe that from a global perspective we have some of the highest rates in the developed world.  The U.S. 10-year note closed the quarter with a yield of 1.92%.  On its own we agree this yield is quite low relative to history but for some perspective, below is a chart of the historical inflation and yields (represented by the 10yr Treasury):

q1 15 graph3When people refer to today’s “low rates” it is important to remember that historically speaking the period from the 1980s to the early 1990s may actually turn out to be the anomaly.  Going back to what many investors consider “normal” from their personal experience will most likely not mirror that period.

Globally, the German 10-year equivalent is yielding 0.18%, or about 90% less than our bonds.  France 10-year bonds closed the quarter at 0.47%, Portugal (which is rated “junk” and needed a bailout from the EU/IMF in 2011) yielded 1.68% at quarter end.  In fact many of the Euro Zone sovereign issuers have negative yields out to 5 years.  The point here is that we do have a global investing environment, and if we look across other developed markets we actually have the most attractive rates available.  Couple this with inflation that is running lower than the Federal Reserve “target” and longer rates appear fairly valued in our view. The Personal Consumption Expenditure index, the preferred inflation measure watched by the Fed, came in a 1.3% year over year in March versus the stated goal of the Fed of 2.0%.  We are also watching how much of an impact a 50% decline in oil prices will have on inflation moving forward.

From a currency perspective, this global interest rate divergence has resulted in the appreciation of the U.S. Dollar.  As mentioned in the “Stock” section above, a stronger dollar puts U.S. multinationals (i.e. companies that export products) at a disadvantage.  Very simplistically, if the Fed raises rates it will most likely make the dollar appreciate further which in turn dampens the profitability of U.S. companies, and therefore threaten our economic expansion.  This is the dominant headwind to the Fed raising rates.

It is also important to consider how a Fed rate increase would influence the shape of the yield curve.  The Fed only controls the shorter end of the yield curve; the market (inflation) dictates what an acceptable rate of return is for longer maturity debt.  In our opinion, if the Fed raises rates too quickly, it is possible that the longer part of the yield curve stays relatively unchanged.  Raising rates in a period of economic weakness means slower growth which would justify lower long term rates.  The basic message is that if/when the Fed raises rates it does not mean that the entire yield curve shifts up proportionately.  A “flattening” of the yield curve seems likely and this possible scenario is driving our current strategy.

We continue to invest in “step-up” Agency callable notes to hedge our interest rate risk. In most cases we are purchasing 2% starting coupons which give the bond a higher percent chance of being called.  We are complimenting these agencies and managing duration with non-callable taxable municipal bonds.  We can still invest in taxable municipals with higher yields than comparably rated corporate bonds.  We are focusing on the 7-year part of the yield curve in this sector, achieving yields north of 2.5%, capturing virtually the entire yield curve (the 30-year Treasury yielded 2.57% at quarter end).

Municipal bonds also turned in a positive return for the quarter, with the S&P Municipal Bond Index (which is not state-specific) up a little over 1%.  Municipal investing is a story of the haves and have nots, with many states improving from a fiscal perspective and some not faring as well.  Pension obligations continue to be a concern for many states, with pensions funded at less than 60% for many issuers.  We avoid municipal credits where we do not believe their pension obligations are being managed in a fiduciary manner.  We still see value in the above market coupon (4%-5%) structure with final maturities in the 2026-2029 with call dates in the 2021-2023 area.  We do occasionally invest in longer final maturities, but only with 5% coupons at these levels.  This strategy still produces yields in excess of 100% of the U.S. Treasury equivalent.

As we mentioned repeatedly over the last few years, we feel the stock market is fairly valued based on our view that the economy will likely continue along at a slow to moderate pace.  Therefore, we would not be surprised if the major advance in stocks we have seen over the last six years comes to a pause, especially with earnings estimates trending downward. That said, we are not short term forecasters, but rather long term investors.  Looking a bit further down the road, innovation is still strong and we believe that trend is only going to accelerate.  We continue to find assets worthy of investment, regardless of what the short term holds; the long term view continues to be attractive.