Second Quarter 2014 PerspectiveJune 2014
Sell and Go Away—We Think Not
Since we last wrote in early March, US markets, as well as equities around the world, continued to rise. Even emerging markets no longer lagged their developed market cousins, and frontier markets bested the pack. US small-cap stocks were one of the few asset classes to fall, but this decline was a minor setback in context of the overall +299% increase since the post-recession market recovery began on March 9, 2009. Similarly, Japan slipped slightly, following a +96% rally from mid-2012 when investors sensed that Shinzo Abe would become Prime Minister and initiate policies to revive Japan from its two-decade slumber (CHART 1).
INVESTORS PULLED BACK FROM RISK
Since the beginning of this year, investors moved back toward income and perceived safety. This is not surprising given the softer economic data, which undoubtedly rested on the harsh winter weather and a smaller degree to the political and military situations in Ukraine, Russia and Syria. Investors favored large-cap value stocks, those that often offer higher dividend yields and lower valuations, over their growth counterparts, which was reflected in the respective +4.3% versus +1.7% performance of these equity categories. The stronger performance among more defensive sectors, such as telecom and energy, also echoed investors’ bias toward what are perceived as lower-risk areas of the stock market (CHART 2).
INTEREST RATES FELL ALONG WITH INVESTORS’ LOWER APPETITE FOR RISK
Reflecting investors’ relative caution, the yield on the 10-year Treasury bond declined from 2.65% at the end of February to 2.48% in May, a -18.9% drop.1 Despite responding to investors’ sentiment and the lurch toward deflation in Europe, the lower Treasury yield triggered home mortgage rates to drop by -11.1% to an average rate for a 30-year fixed loan of 4.15%.2 This lower consumer cost, coupled with a relatively stable price for gasoline, which has barely budged over the past four years, add support to our sanguine outlook.
THE FUNDAMENTALS SUPPORT A CONTINUED BULL MARKET FOR EQUITIES
A long-time observer of the market scene commented recently, there’s “nothing to fear, but nothing to fear.”3 There are, of course, lots of micro and macro things that might derail the worldwide bull move in financial assets—most are daily on the front pages. Our view is that the fundamentals—the forces that influence investors to have the confidence to take on risk—are supportive of a continued bull market, particularly across equities.
Most important are the expectations for company earnings over the coming several years. Forecasts are just that, but it is the year-to-year direction—up, flat or down—that alters confidence and drives prices. Note the accelerating growth of earnings and sales across the US, Europe, Asia and among the emerging markets (CHARTS 3 & 4).
ARE EQUITY MARKETS OVERVALUED?
The next question, which we wrote of last time, is the value of this growth. How much are investors willing to pay for it? There are many measures, and none are conclusive, but the ratio of price-to-earnings as it relates to anticipated interest rates and inflation continues to be a useful thermometer.
Today, interest rates are indeed low, and the expectations for inflation are, at best, modest for the next two years or more. Some note that current valuations are at long-term levels, suggesting markets are ‘fully’ valued. But, the accelerating earnings growth forecast—particularly for US companies—challenges the overvalued argument. Forecast price-to-earnings multiples suggest equities are not trading at excessive valuations (CHART 5).
SOLID EVIDENCE SUPPORTS AN ONGOING US EXPANSION
The earnings forecasts and valuation numbers rest on reasonably solid evidence of ongoing US expansion. For one, the counterintuitive impact on growth from Bush-era tax cuts and congressionally-imposed delays in spending—‘sequestration’—have passed as these initiatives expired. What had equaled a drag on US GDP growth of 1.9% last year has now shrunk to 0.5%. Federal outlays, which are important stimulants to economic growth, are no longer declining and the stable outlook for government spending is now underpinning recovery (CHART 6).
While total US GDP advanced 2% in the first quarter of this year, the private economy grew 2.8% and has averaged 3.2% for the past three years.4 Strong growth in bank loans over the past several months, especially those made by smaller US banks, is evidence of the likely sustained growth ahead. It is small banks who finance small businesses which are the engine of employment. Indeed, total payroll employment is expected to surpass the 2007 peak of 138.4 million job holders when the May Labor Department report appears later this month.
WE ARE STAYING THE COURSE WITH A SUBSTANTIAL COMMITMENT TO US EQUITIES
What do these numbers mean? For one, they support our staying the course with a substantial commitment to equities across accounts, and with an emphasis on the US. We are, however, sensitive to the long-term ebb and flow of returns across equity asset classes, in this case between US and non-US developed markets.
US equities have sharply outperformed in the recovery that began in March 2009, +193% versus +137% compared to non-US developed markets; however, non-US equities bested the US by 114% in the pre-recession rally that ended in October 2007, a year before Lehman.1
The lesson is that today’s US leadership will likely fade and that attractive international investment opportunities should appear. It should not surprise that we are today evaluating how attractive these opportunities are.
FUNDAMENTALS IN EMERGING MARKETS ONCE AGAIN TRULY MATTER
The emerging markets have offered attractive money-making opportunities over the past decade. Central bank initiatives to blunt the impact of essentially disappearing credit and liquidity after Lehman collapsed hugely benefitted daring emerging market investors. From the start of the worldwide equity rally on March 9, 2009 emerging markets leapt ahead of developed markets by a wide margin until April 2011 when it became accepted that fundamental economic recovery was indeed taking hold.
Since then, developed markets have steadily marched upward at twice the rate of the emerging markets. The current and significantly lower price-to-earnings ratio among the emerging markets suggests they offer value. We are intrigued, but also cautious. Investing in the emerging markets is no longer assuredly underwritten by the Fed making massive cheap credit available to all comers. If anything, the Fed is gradually stepping back, although it is still many months away from actually raising interest rates.
Fundamentals within the emerging markets once again truly matter, and the wide dispersion of country circumstances is fascinating and challenging. Brazil will highly likely descend into recession, as will likely Russia, largely because of poor self-inflicted policies. India appears resurgent. China is struggling to sustain growth, although its influence on world markets continues to expand.
CHINA’S GROWTH IS EXPECTED TO BE MATERIALLY SLOWER
A material part of our work is probing to understand the impact that China’s ambitious reengineering of its economy toward consumption and away from exports and investment will have on its domestic growth, as well as on the rest of the world. The country is managing a difficult set of opposing issues: maintaining enough growth to satisfy its peoples’ rising expectations, while deflating a credit bubble created to sustain the economy in the immediate aftermath of the recession. If these are not enough, the new leadership is also trying to root out endemic corruption and clean up massive pollution that are not only headwinds to growth but also undermine the Party’s legitimacy to govern.
The result could be slower growth, and probably materially less than the official 7% target. Indeed, The Wall Street Journal reported that Premier Xi Jinping suggested this target would be missed, preparing the way for a weaker report later this year.5 The fact that rail freight traffic is now shrinking at a 3.3% annual rate, a big change from the average 4.3% annual growth over the past five years, adds credence to the leader’s lament. One global impact may be continued weakness among industrial commodities bolstering the benign outlook for inflation. The import price for iron ore arriving in China, for instance, is off -35% from its August 2013 high
WE DO NOT THINK THAT IT IS TIME TO SELL
After so much market and fundamental progress, should we just sell and go away? We think not. The fundamentals are sound and improving. US auto sales as of May 14 are at a post-recession 16.7 million unit high, bolstered by GM’s +12.6% sales increase over last year. We do anticipate more volatility in the coming months and shaky, uncertain moments when confidence is challenged. The “Sell in May” fable may at times seem true, although the long-term record shows it is not.
What worries us more is the complacency and accepted consensus that central bankers will always do ‘whatever it takes’ to underpin markets whenever trouble appears. Gillian Tett reminds us in a May 30 Financial Times comment, “Market tranquility tends to sow the seeds of its own demise, and the longer the calm, the worse the eventual whiplash.”6
STRATEGIC ASSET ALLOCATION
WE CONTINUE TO FAVOR US EQUITIES
- We continue to overweight equities, favoring developed over developing markets.
- US equities are no longer inexpensive; however, they continue to be supported by strong economic fundamentals and earnings.
- Our exposure to developed markets outside of the US remains slightly underweight; however, several key markets appear to be improving.
- We remain underweight emerging markets. Attractive valuations do not exclusively present a compelling case as earnings growth remains weak and we believe political and other uncertainties will impact the asset class in the near term.
- Our fixed income allocation remains underweight due to diminished return potential; however, we continue to view fixed income as necessary within a multi-asset class portfolio to help mitigate volatility.
- While overall municipal bond valuations are high, we are carefully selecting issues that appear attractive in context of the higher tax environment.
- We are recommending that portfolios remain fully invested, with cash positions no more than 5%.
2. Bankrate.com US Home Mortgage 30-Year Fixed Average 2/28/14-5/30/14.
3. Ed Yardeni, 6/3/14.
4. Cornerstone Macro, Global Economic Outlook.
5. The Wall Street Journal, 4/11/14.
6. Gillian Tett, Financial Times, 5/30/14.
Fiduciary Trust Company International and subsidiaries (doing business as Fiduciary Trust International), and Fiduciary Trust Company of Canada are part of the Franklin Templeton Investments family of companies.
This communication is intended solely to provide general information. The information and opinions stated are as of June 1, 2014, 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 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
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