Second Quarter 2013 PerspectiveJune 2013
OVER A THOUSAND TRADING DAYS, UP 141%...AND COUNTING
Since we last wrote in March, global markets have continued their rise in response to worldwide recovery. The title says it all. There have been 1,065 trading days since the S&P 500’s March 9, 2009 recession low. Any who doubt we are in a bull market—and there are some—should consider the record. The National Bureau of Economic Research judged that June 2009 marked the US economy’s recession trough. It took the US until September 2011, a little over three years, to fully recover to its immediate pre-recession level measured by GDP (adjusted for inflation). Since then, GDP has grown by 3.3%—$443.2 billion—through March, the latest reading.1
From that recession low, US equities are up +141% in successive rallies (CHART 1). The latest run starting on November 15 has taken the US market up +20% and is approaching the moves of +33% and +22% in 2010 and 2011, with brief but sometimes painful corrections in between. Global stocks followed a similar but more muted pattern. The MSCI All Country World (ex US) Index, a representation of global markets outside of the US, is up +92% from a March 2009 low. The impacts on investor confidence of Europe’s banking turmoil and China’s slowing economy are no doubt responsible for the 49% US outperformance of global markets.
BOND YIELDS MOVED HIGHER AS ECONOMIC ACTIVITY INCREASED
The centrally important 10-year US Treasury bond hit a low yield of 1.39% last July 24 and has been working higher ever since, closing at 2.13% on June 1, 2013 (CHART 2). A rising 10-year rate is not necessarily bad because it signals that economic activity is increasing. Certainly the positive impact of the Fed’s actions is being felt.
ECONOMIC MOMENTUM IS GROWING
Validating these market signals is the real economy of jobs, housing, tax revenues and government deficits which all improved, along with many other measures of recovery. The latest Department of Labor survey of non-farm employment shows jobs increasing at 196,000 per month on average, year-to-date through April, the highest rate of increase since 2005.2
We are hearing reports of bidding contests between house buyers. The Federal Housing Financing Agency lends credence to the anecdotes with its recent report that the rate of increase in house prices has moved sharply higher from an annual rate of 1.2% last September to 15.6% in March, the latest report.3
Lastly, despite a great deal of anxiety and spilled ink about runaway government spending and the resulting deficit, the federal deficit has been sharply shrinking. As tax revenues have risen along with the economy—recall the New Year’s Day ‘compromise’ that raised taxes and the Sequester’s spending cuts kicking in on March 1—the US government budget has moved to a surplus in April from a post-recession deficit low point in February 2012.4
One would expect tax revenue to pour in during April and the budget to improve each year. What is striking this year is the rising swing from March to April of $219.42 billion versus $198.2 billion last year—another data point attesting to the economy’s recovery. Only the gullible, however, would believe a surplus is sustainable without huge changes to entitlement spending; but the progress is undeniable and gives the Fed and Treasury more time to walk back the massive stimulus when the time arrives.
SO FAR, MARKETS BELIEVE THE FED WILL BE ABLE TO KEEP INFLATION IN CHECK
All this positive and measurable recovery news would not be obtained without the ongoing commitment by the Fed to suppress interest rates in order to promote recovery. Indeed, Chairman Bernanke must have read Emerson, “Don’t be too timid and squeamish about your actions. All life is an experiment. The more experiments you make the better.”5
The great question is, will experiments continue to work? Can the Fed deftly dial back its aggressive quantitative easing initiatives so that a toxic burst of inflation remains only a possibility and avoids rattling expectations so much that a serious economic and market correction occurs? So far, investors vote yes, but they are clearly becoming worried. Fed Governors and Regional Presidents are increasingly and publicly debating the right moment to lighten the foot on the liquidity gas pedal. Sometime later this year is emerging as a likely possibility, at which point the Federal Open Market Committee (FOMC) will have judged the US economy to be strong enough to continue to grow in the face of diminishing Fed support. The debate will likely unsettle many observers, but the decision, when it comes, is bullish.
Productive assets—that is equities—are winning, and will, in our judgment, continue to win the day versus the classic inflation hedges of gold and hard assets, e.g., commodities. Gold has had a humbling -27% correction from the high last October 4. A broad measure of commodities, the Dow Jones UBS Index, is off -26% from its high on April 29, 2011. Only a small fraction of the world’s known gold is put to productive use; the rest is valued by the collective level of fear. Among the useful commodities, copper’s +483% price run-up between September 2002 and the pre-recession peak in June 2008 was not ignored by miners who invested heavily in new mines. More supply means downward pressure on copper prices, and slower-growing Chinese economy has not helped.
EQUITY MARKETS HAVE NOT BEEN DETERRED BY RISING RATES AND EARNINGS DIPS
What is apparent is that for some time the fundamental relationship between equities and bonds is again intact: equity prices and bond yields are moving up together. This is consistent with a recovering economy where rising demand leads to higher prices of things and of money. This has not always been so in the post-2008 period where there was realistic fear that higher interest rates would snuff out recovery and bring a return to recession. The Fed’s success and the economy’s progress beg a critical question: will investors now bid up prices in anticipation of rising profits, or will they focus on higher interest rates as an overwhelming headwind to profit growth? For the past year this anticipation has trumped fear (CHART 3).
This question is important because year-over-year earnings growth has been slowing, animating some to wonder if growth has stalled and renewed recession is at hand. Just reported, S&P 500 companies’ first quarter 2013 earnings grew at +6.1% while sales revenue advanced by +9.2% from the prior year. Estimates for growth in the second quarter 2013 show a slump to +4.8% for earnings and a barely positive +0.96% for sales. Estimates for the third and fourth quarters show strong acceleration and suggest the second quarter will be the low. The economy’s strength suggests the analysts will be right, but the market’s path forward depends on growth returning (CHART 4).
SIGNS OF ONGOING MARKET STRENGTH CONTINUE
Another positive marker is the shift by investors from defensive to cyclical companies. This change suggests to us that investors are less fearful, agree with the analysts and see economic growth and earnings accelerating into next year (CHART 5).
Lastly, the negative real interest rates (yield minus inflation) are a powerful influence to invest idle cash. This observable fact has no doubt been a factor supporting the equity market’s rise (CHART 6).
WE BELIEVE THERE IS FURTHER UPSIDE TO GO, BUT EXPECT INEVITABLE PULLBACKS ALONG THE WAY
The core lesson of the past five years, after Lehman, is not to fight a committed Fed. Indeed, central banks across the globe, most recently joined by the Bank of Japan, are committed to sustaining stimulus until economies can withstand tightening. Only Eurozone governments are still toying with austerity. We can allow our imagination to locate the inevitable dangers created by the Fed’s ‘experiments’ hitting markets in the immediate future, but doing so today has and will, we believe, come with a hefty opportunity cost. The accumulated evidence of real growth, low inflation and committed central bank support tells us the +141% has further to go.
We are today just at the threshold of a period when sustainable economic recovery is coming into view. As such, we are maintaining full exposures to equities and among them emphasizing US companies. As the evidence of global recovery keeps increasing, we expect to expand allocations to smaller companies and emerging markets in coming months. Our optimism, however, does not ignore the many risks and threats to investors’ growing confidence. We are not naïve to think the pathway ahead will be smooth, and the evidence is the meaningful corrections in each of the past three years. No one can predict what event will shake confidence, but we believe the ever-present ‘known unknown’ should not divert attention from the evidence and the potential for further market gains. The risk posed by the obvious challenges—for example, the threat of sharply higher oil prices from Mideast turmoil— appears worth taking when arrayed against the increasing confirmation that a sustainable global recovery is underway.
1. Bloomberg, US Real GDP, quarterly data, USD.
2. Source: US Department of Labor.
3. Bloomberg; Federal Housing Financing Agency, Monthly House Price Index, Monthly Change, Purchase Only.
4. Bloomberg; US Government monthly surplus/deficit.
5. Ralph Waldo Emerson; Section: The Conduct of Life (1860).
STRATEGIC ASSET ALLOCATION
WE BELIEVE THE ECONOMIC PICTURE SUPPORTS CONTINUED GAINS IN EQUITIES
We have increased our equity allocation to an overweight recommendation reflecting positive macroeconomic trends and the lack of attractive investment alternatives in today’s environment.
- While stock valuations have increased, they still appear reasonable in our view.
- Our bias remains toward US firms as the US continues to appear to be the best house on the global block.
- We expect to expand allocations into small-cap and emerging markets as global economic strength continues to build.
We are maintaining an underweight fixed income allocation due to our expectation of relatively low income and return potential for the asset class in the near-term.
- We continue to favor both the municipal tax-exempt and corporate sectors relative to Treasuries and mortgage-backed sectors.
- Although we believe gradually rising rates will cap the return profile relative to historical experience, the asset class still possesses diversification, low risk, and negative correlations relative to most risk assets.
We are recommending that portfolios be fully invested, with cash allocated at no more than 5%.
FIDUCIARY TRUST FORUM
Interview with Ronald Sanchez
Executive Vice President and Director of Fixed Income Strategies
THE GREAT ROTATION?
An unprecedented demand for bonds from central banks and investors has defined the fixed income markets since the credit crisis. Today, with the S&P 500 making new highs, our Fiduciary Trust Forum examines whether a “great rotation” in investor demand away from bonds and toward stocks is underway.
Q. Do you believe investors are beginning to abandon bonds in favor of stocks?
RON: Much has been written this year regarding a “great rotation” whereby investors reduce elevated fixed income allocations in favor of equities as the heightened post-credit crisis conservatism further subsides. While in the long- and even medium-term we subscribe to this point of view, we see little to persuade us that this dynamic is happening at present or will happen in the near-term. Instead, data shows investors funding the flows into stocks largely from cash reserves, with bond investments also remaining robust.
Q. Are investors’ perspectives changing in regard to risk and return?
RON: When looking at the performance of the US equity market, it would appear to us that over the past few quarters investors have undergone a reassessment of risk and return. The S&P 500 has been one of the best performing global equity markets year-to- date. It bested just about all developed markets ex-Japan. It has also outperformed bond market performance as measured by the Barclays U.S. Aggregate Index. The US stock market outperformance is even more pronounced when compared with emerging markets, where broad emerging market indices have had negative absolute performance during 2013.
Q. How has the S&P 500 run-up affected valuation?
RON: The valuation gap between stocks and bonds has narrowed as equity risk premiums have compressed and equity prices rose. Reflecting this, the price-to-earnings ratio on the S&P 500 began 2012 at 13.2 times and has expanded to 15.9 times today.
We believe that US risk assets have been repriced presumably on the basis of changing investor assumptions and perspectives. We believe these may include the perception of lower global systemic risk at the sovereign and banking level, extraordinary global liquidity, and perhaps crisis fatigue. This changing dynamic has contributed to the normalization of risk tolerance and investor focus slowly shifting back to a pursuit of return. This perspective is potentially supported by the drawdown in cash reserves and the recent price action in the gold markets throughout the quarter.
Q. How have interest rates been affected by the strong market performance?
RON: Despite the strong relative outperformance of the S&P 500 versus the broader US bond market year-to-date—+15.4% versus -0.9%—the general level of interest rates seems to be constrained on the upside. During the course of the first quarter, 10-year Treasury rates struggled to break out of their 2% range even as impressive data, particularly on housing and employment, buoyed equity markets.
During the second quarter interest rates have risen quite quickly during the month of May as the 10-year Treasury rose above the 2% threshold. During the first half of the year we have seen the long end of the Treasury market exhibit increased volatility relative to the second half of 2012 where Treasury yields were remarkably stable. We most likely are entering a period whereby the 10-year Treasury note hovers above the 2% level as opposed to below this range, which has been the case so far this year.
Q. How are investors bridging the income gap?
RON: With risk-free assets being absorbed by central bank buying and depressing the general level of interest rates globally, the desire for yield appears to remain in vogue. Exemplifying the unusual relationship between the valuation of bonds and stocks, some bond fund managers are including dividend-oriented equities in dedicated bond funds in an effort to capture better yield and return opportunities in the marketplace.
As investors look for opportunities within the broader equity market, there is a clear preference for dividend-oriented stocks as investors use these sectors as income substitutes given the lack of income in the traditional bond market. Stable companies with solid balance sheets and strong cash flow in defensive sectors have been the beneficiary during this period of strong equity market rally and are now trading at a premium to more growth-oriented sectors of the broader equity market.
That being said, it appears the same valuation gap between debt and equity markets is presently being capitalized upon by borrowers. For instance, Apple, one of the largest and most cash-rich companies in the world, raised $17 billion by accessing debt markets for the first time since before even the first iPod. The company capitalized on the valuation gap to raise capital which will not be dedicated to investment, but rather to increase both the dividend distribution level and the share repurchases, while sparing the company a multibillion dollar tax bill had repatriated overseas cash been used for those same purposes.
Q. Do you expect rates to increase as the economy continues to improve?
RON: With respect to fixed income markets, our view remains that we are presently at or near the bottom for rates. However, we see the move to a higher interest rate environment as a multi-year phenomenon. Our expectation for the balance of the year is that any rise in interest rates will occur on the longer end of the yield curve—10 years and longer—and will be relatively muted as risks to rates remain asynchronous as long as unprecedented central bank activism remains largely in place for the balance of the year.
This communication is intended solely to provide general information. The information and opinions stated are as of June 1, 2013, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.
Vice Chairman and
Chief Investment Officer
Executive Vice President and
Director of Fixed Income Strategies
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