Market Letter First Quarter 2015

Please click here to find our Market Letter First Quarter 2015. We hope you find our economic insights interesting and informative.  

Negative Interest Rates: What Color is the Dress?

by Brad Houle, CFA Executive Vice President

In Europe there are now more than $4 trillion in bonds that have a negative yield, a number which is about 15 percent of the global bond market. The countries of Germany, Switzerland, Sweden, Finland and the Netherlands are all unfortunate members of this club for at least part of their respective yield curves. What this means is investors are paying a government such as Germany for the privilege of loaning them money. This is contrary to the concept of compound interest or the time value of money. In the investment profession we do not use the word "guarantee" as it can cause trouble with our chief compliance officer or possibly the SEC. However, with negative yielding bonds you are all but guaranteed to lose money except in the circumstance where the yield on the bond goes more negative. In this instance you can then sell the bond for more than you paid for it earning a small profit. This is a flimsy investment thesis at best.

Bond yields in Europe are negative for fear of falling inflation and the fact that the European Central Bank is purchasing large quantities of sovereign debt in an effort to hopefully stimulate the economy. All of this begs the question: who is buying these bonds with negative interest rates and why? Some bond managers are forced to buy negative yielding bonds due to flows of funds into the mutual funds they manage. For example, if the bond manager is managing an index fund that replicates the debt markets of countries experiencing negative yields and receives cash deposited in the fund, the manager is forced to invest in bonds in markets that are outlined in the prospectus of the fund. In addition, many investors are restricted to investing in very narrow slices of the bond market. Owning sovereign debt is important to banks due to regulatory capital requirements. This means that banks need to own high quality assets as part of their capital in order to makes loans to customers. For instance, it’s likely that a bank in Germany will need to own negative yielding German government bonds as capital.

The long-term implications of negative yields are unknown. This phenomenon has been exceedingly rare in history and has never been this widespread. We have received questions from clients as to the chances of this happening in the United States. Short-term treasury bills did go negative for a time during the financial crisis in 2008; however, we do not believe that we will see negative interest rates in the United States anytime soon. While it is possible, the U.S. has inflation of 1.6 percent, as measured by the Consumer Price Index last month, and the U.S. also has GDP growth of 2.2 percent. These facts would suggest higher interest rates as opposed to negative interest rates.

 Our Takeaways for the Week:

• Risks of negative interest rates in the United States are low. Our economy is growing as evidenced by consumer spending in the United States. Household consumption grew by 4.2 percent year-over-year in the fourth quarter of 2014. Consumer spending, which comprises 70 percent of the economy, has been robust due to a strong labor market and falling gas prices

Disclosures

Liquid Courage

by Jason Norris, CFA Executive Vice President of Research

Volatility increased this past week in most asset classes with oil being in focus. In the last two weeks, crude oil is up roughly 20 percent, its best two-week move in 17 years. While the demand picture has not changed, we have seen U.S. oil and gas companies announce major employment cuts and capital expenditure reductions for 2015. We believe that there has been some “short covering” in the market which has led to recent strength. Our belief is that by year-end, oil prices will be between to $60-$70/barrel, due to reduced supply in the U.S. In the face of this, we do believe we see some opportunity in energy stocks. While earnings continue to come down, we think we can find value in select names with strong balance sheets.

All Over the Road

As mentioned earlier, the energy complex was not the only asset class exhibiting volatility. In the first five weeks of 2015, the S&P 500 has been either up or down more than 1 percent 11 times, which is 44 percent of the trading days. To put it in perspective, last year the S&P 500 moved this much only 15 percent of the time. The chart below highlights the last five years.

Days the S&P 500 Was Up or Down More Than 1 Percent

	2011	2012	2013	2014	2015
Number of Days	96	50	38	38	11
Percent of total trading days	38%	20%	15%	15%	44%

Source: FactSet

This year is setting up to be similar to 2011, a year that  saw a lot of uncertainty due to surprisingly poor U.S. GDP growth, a U.S. debt downgrade and the European crisis coming to the forefront. All this uncertainty resulted in a flat market for 2011, but it was a rollercoaster ride. We believe the fundamentals of the U.S. economy and the recent actions of the European Central Bank leave the foundation of the global economy a little firmer. We don’t think the volatility mitigates itself; however, we do believe that equity returns will be better than 2011.

Working for the Weekend

Heading into a wet weekend on the west coast, the monthly jobs report this morning was very strong with the U.S. economy adding 257,000 jobs in January. The unemployment rate ticked up to 5.7 percent due to an increase in people looking for jobs, which is a positive for the economy. This is only a small part of the story. Job gains for December and November were revised higher by 147,000. The third leg of the stool of the January jobs report was an uptick in wages. Wages bounced back after a disappointing December, rising 0.5 percent month-over-month. With a strong labor market and unemployment close to the Fed’s target, we believe this wage growth will persist throughout 2015. This further reinforces our view that 2015 will be a good year for “Main Street.”

Our Takeaways for the Week: 

• Main Street will fare better than Wall Street in 2015
• Adding to high quality energy names at this time could pay dividends in 2015

Disclosures

Friends in Low Places

by Ralph Cole, CFA Executive Vice President of Research

In a much anticipated move, the ECB joined the rest of the developed world by announcing a comprehensive quantitative easing package this week. Investors were worried that maybe the plan would not be big enough or long enough to satisfy global capital markets. Bond yields and equity indices gyrated as the official announcement was released but eventually stocks moved higher and European bond yields moved lower. Yields on 10-year bonds around the world remain shockingly low, and it appears they may remain low for some time. Here is a list of global 10-year yields:

U.S.	1.88%
UK	1.51%
Canada	1.42%
France	0.61%
Germany	0.38%
Italy	1.54%
Spain	1.41%
Switzerland	-0.20%

Source: Factset

The goal of quantitative easing is to lower longer-term borrowing costs in an attempt to incentivize businesses and individuals to borrow money and invest. Some of the excess liquidity in the system can also flow to equity markets, and drive prices higher. This acts to boost confidence and hopefully trigger investment and spending. This recipe worked well in the U.S. during QE3, and Europe is hoping to follow the same path.

Golden Years

Golden months may be a better term. Somewhat under the radar, gold has turned up in a strong performance in the last three months. It appears that a race to the bottom in currencies is finally starting to resonate with global investors. Gold is up 15 percent from recent lows to nearly $1,300 per ounce. Gold is viewed as a hard currency that can't be debased like fiat currencies. When we held gold in client portfolios several years ago it was for this very reason.

Takeaways for the week

• Despite a well telegraphed move, the QE announcement by Mario Draghi was celebrated by markets around the world
• Many developed economies are attempting to deflate their currencies in an effort to boost growth. This has led some investors to purchase gold as a store of value

Disclosures

Easy Money

by Ralph Cole, CFA Executive Vice President of Research

The global economic expansion continues to run at very different speeds around the world. However, the common thread among most all developed economies has been easy money. Today, China joined the party by lowering interest rates for the first time since 2012. The reasons for lower rates has been stubbornly slow growth, and as long as inflation remains low, central banks can feel confident in their choice to stimulate their economies.

Markets were also buoyed this week by dovish comments out of the European Central Bank. With most European economies mired in little to no growth, and the ECB has embarked on its own version of quantitative easing (QE). Mario Draghi hinted in a speech yesterday that their asset-buying program could expand if necessary. The lack of economic growth in Europe can at least be partially explained by Draghi’s habit of speaking about, rather than actually enacting, central bank policy. In Texas, they would call this “all hat and no cattle”.

Thrift Shop

This week just about wrapped up earnings season for retail companies. Earnings were basically strong across the board for retailers from Dollar Tree and Target to Foot Locker and Best Buy. We believe retailers and consumers are starting to feel the benefits of lower prices at the gas pump. Lower gas prices often coincide with higher consumer confidence numbers, which in turn leads to increased consumer spending.

What makes the retail industry so interesting is the plethora of stores from which shoppers have to choose. I don’t think any of us would argue that we aren’t over-retailed in the U.S. This abundance is one reason we don’t see much inflation. Despite a zero percent interest rate policy and a massive expansion of the Fed’s balance sheet, inflation is not yet finding its way onto store shelves. Competition for the consumer’s discretionary dollar remains fierce. Case in point: the phenomenon of Black Friday sales moving earlier into our Thanksgiving holiday week.

Our Takeaways from the Week

• Global markets continue to respond positively to easy money policies around the world
• Lower gas prices should lead to positive sales for retailers this Holiday season
• Have a Happy Thanksgiving and travel safely

Disclosures

Putting It All Behind Us

by Brad Houle, CFA Executive Vice President

More than anything, the financial markets dislike uncertainty and the most recent source of angst was the election. With the mid-term elections behind us, the market participants are free to focus on economic data and not political minutia. One of our research partners, Cornerstone Macro, published a great summary of likely legislative change and probable market impact from the change in control of the U.S. Senate.

The European Central Bank (ECB) met this week and the takeaway from their meeting is the ECB is still poised to take extraordinary measures to keep the Eurozone economy from lapsing into a recession and possible deflation. Mario Draghi, the ECB president, reiterated the ECB's commitment to do whatever it takes to keep Europe's economy staggering forward. He did not go so far as to announce quantitative easing which just ended in the United States. The ECB has been doing some bond buying on a smaller scale and keeping the possibility of a large scale quantitative easing program on the back burner in the event the European economy goes from bad to worse.

The employment data for the month of October was released today. The unemployment rate declined to 5.8 percent and nonfarm payrolls increased 214,000 jobs. In addition, there was a 31,000 revision to the September employment report. While the absolute number of jobs was a bit behind the consensus number, this is a very solid report and continues to demonstrate that the labor market is healing.

Takeaway for the Week

• The equity markets traded around all-time highs this week as the labor markets continue to improve and the uncertainty of the election is behind us

Disclosures

Somebody’s Watching Me

by Jason Norris, CFA Executive Vice President of Research

There were two high profile data breaches this week which highlighted the importance of cyber security, as well as “implied privacy.” Home Depot announced that they had a breach where credit and debit cards used at its stores may have been compromised. Initial speculation was that this may have just happened within the last few weeks; however, some reports indicate the breach may extend back to April of 2014. There were also reports from Goodwill, Dairy Queen and Supervalu that some of their locations may have experienced a data breach. What this shines a light on is the importance of corporate security, as well as vigilant consumers. One potential solution to this problem would be the implementation of “chip and pin” debit/credit cards. Most of the world has already implemented this means of transaction, but the U.S. has not. The main difference between “chip and pin” cards and standard debit cards is, when using a chip card, there is no magnetic strip to swipe. The card is put in a Point of Sale (POS) terminal, the chip is read, and the consumer has to input a PIN number. The security for these transactions is much more reliable. The chip cannot be copied like a magnetic strip can (as we saw in the Target case, and it looks like the Home Depot breach as well.) Visa and MasterCard are big proponents of this technology; however, it has been very slow to roll out in the U.S. The Netherlands company NXP Semiconductor is a key player in the technology for these cards.

The distribution of several celebrities’ nude pictures this week has also highlighted the importance of personal cyber security. Over the weekend, more than 100 personal iCloud accounts were hacked and private photos were leaked to the media, with several prominent actresses being victimized. Apparently, this was a case of hackers easily decoding individuals’ passwords. While this action is not condoned, individuals have to remember that any material that is stored in the cloud runs the risk of being compromised.

Less Than Zero

The European Central Bank continued to take rates lower this week by reducing its deposit rate to -0.2 percent from -0.1 percent. You are reading that correctly, that is a negative number. This seems to be more symbolic, rather than having much of an impact on the market. The market impact decision came in the same announcement that the ECB will increase its purchase of ABS (Asset-Backed Securities). This is very similar to what the U.S. Fed had been doing with its purchase of mortgage-backed securities. The key item missing is that the ECB did not announce a plan to purchase sovereign debt. The ECB is hoping banks will sell their ABS to them and in its place, make loans. Europe continues to sputter out of recession with expectations of GDP growth and inflation below 1 percent. This move by the ECB showed the market that it is willing to support European economies, although one has to wonder if they have enough power to do so.

Why Worry

The employment report this morning was a disappointment with the U.S. only adding 142,000 jobs in the month of August; expectations were for over 200,000.  Ferguson Wellman believes this data will eventually be revised upward.  The economic data the last few months has been very robust and is not consistent with this weak jobs number.  Therefore, we aren’t concerned about the number unless other economic data starts to signal a slowdown.

Gameday

With the Seattle Seahawks opening game win Thursday, it reminds us of the Super Bowl stock market prediction. Some may recall when we highlighted the belief that if the Seattle Seahawks won the Super Bowl this year it would foretell a positive year to the market. So far so good with a 9 percent+ gain in the S&P 500 to date. Even with this strong run, we believe that earnings growth and low inflation will continue to be tailwinds for equities, pushing them higher to year-end.

Our Takeaways for the Week

• Internet security will become more of a focus for companies and individuals
• Global central banks are supporting economies - coupled with strong earnings, this is a positive for stocks

Disclosures

The Last Days of Summer

by Ralph Cole, CFA Executive Vice President of Research

Stronger The U.S. economy was indeed stronger than first reported in the second quarter as estimates were revised higher this week when the commerce department reported that the U.S. economy grew 4.2 percent during the quarter. This pace fits with our narrative that the U.S. economy is truly getting healthier, particularly in the aftermath of a very harsh winter.

In fact, there was a lot to like about most of the economic reports this week. For example, durable goods orders grew 22 percent, led by airplanes; unemployment claims came in again under the 300,000 mark - yet another example of vitality in the labor markets; auto sales for the month of July were robust at over a 16 million annual rate of sales. In summary, current economic statistics suggest a sustainable expansion with moderate inflation.

Witchcraft Black magic may be the only explanation for ultra-low interest rates in the face of sound economic numbers. Our industry heuristic states that strong economic growth ultimately must translate into higher interest rates. Not so fast my friend. While the U.S. economy is growing quite nicely, Europe is suffering from falling growth rates, and plunging inflation which has contributed to record lows in interest rates throughout the Eurozone. For example, Germany’s 10-year bund fell to a .88 percent yield while 10-year debt yields touched 1.24 percent in France and hit a 2.22 percent in Italy. With European Central Bank chief Mario Draghi’s most recent speech in Jackson Hole last week, he essentially took perceived credit risk off the table for the Eurozone. With a compelling endorsement of U.S. style quantitative easing on the horizon, investors clearly are (for the time being) comfortable holding European debt.

Lower rates throughout the Eurozone have effectively put a bid under U.S. bonds. In the global market for debt, savers view U.S. debt as a good deal at these levels and continue to buy. Studies estimate that the downward pressure on U.S. rates from lower European rates is anywhere from 20–30 basis points. As you can see from the chart below, U.S. 10-year yields are at their outer-bounds relative to the yield on the 10-year German bund.

Our Takeaways for the Week

• The U.S. economic expansion has taken hold, and looks to be sustainable throughout the second half of 2014
• Lower interest rates around the world and continued quantitative easing by the Fed has kept a lid on interest rates … for now
• The end of summer brings the anticipation of football season, and the end to QE infinity

Disclosures

Sovereign Debt Risk in Europe Takes a Holiday

by Brad Houle, CFA Executive Vice President

We have illustrated below the details of the convergence of government bond yields between the stronger credits of Germany and the United States versus the weaker credits of Italy and Spain. Germany and the United States are arguably two of the strongest sovereign bond insurers in the world. While not perfect, both Germany and the United States have dynamic economies with reasonable levels of inflation versus economic growth. Also, both countries have excellent ability to pay their debts and are viewed as "safe haven" credits by bond investors.

Italy and Spain are a different matter. While we do believe that these countries are starting to recover from the European debt crisis, there are still many structural economic issues that need to be addressed. For example, Italy has a 12 percent unemployment compared to the six percent unemployment in the United States. However, Italy's unemployment looks very favorable compared to the 25 percent unemployment currently in Spain. In addition, both of these countries have severe demographic issues with aging populations and strict labor market regulations that make the labor force less flexible.

What changed to cause interest rates to drop from around the seven percent for a 10-year bond for Spain and Italy in 2021 to the less than three percent rate of interest they now pay were the actions by the European Central Bank or ECB. Essentially, the ECB, which is akin to the Federal Reserve for Europe, announced they would do whatever it takes to backstop these countries. These words gave bond investors the confidence that Italy and Spain will have the ability to honor their debt obligations. Financial markets run on confidence, and this was enough to cut the borrowing costs of these countries by half.

Countries compete for capital from investors. Investors strive to get the best return for the risk that they are taking. Given this set of facts, buying United States treasury bonds versus European country debt seems like a much better investment from a risk versus reward standpoint. While the words of the ECB do merit more investor confidence, there is still underlying credit risk that does not seem to be properly priced into European government debt.

This week there was an event in Portugal that highlighted this risk. During the European debt crisis, Portugal was in a similar position to Italy and Spain. Portugal had a heavily indebted economy with structural economic issues and a high cost of borrowing based on perceived credit risk. Portugal fell under the ECB umbrella and their borrowing costs have declined in a similar fashion to Spain and Italy. However, this week Portugal's Banco Espirito Santo announced that they were having issues meeting debt payments on some short-term borrowing the bank had done to fund operations. This news was enough to cause a one day .30 percent increase in the yield of the Portuguese 10-year bond and a broader decline in European stock markets. While relatively minor, this incident demonstrates the market confidence in European sovereign debt markets is on the razor's edge and credit risk is probably not properly reflected in the possible risk of this debt.

Our Takeaways for the Week

• U.S. Treasury debt is more attractive than European sovereign debt

• While we do believe interest rates will rise in the U.S. as economic growth continues, there is a cap on how high interest rates will climb. Investors will favor U.S. Treasury bonds over European bonds which will help keep rising rates in check

Disclosures

A Little Less Conversation, a Little More Action

by Ralph Cole, CFA Executive Vice President of Research

A Little Less Conversation, a Little More Action

The European Central Bank (ECB) finally stopped jawboning the markets this week and put into place additional policies to get the European economy moving forward. Slow growth and disinflation continue to loom over the EU and spurred the ECB to take aggressive actions.

Specifically, the ECB announced the following policy actions¹; they are:

1)      Lowering the Eurosystem refinancing rate to .15 percent 2)      Lowering the interest rate on the marginal lending facility to .40 percent 3)      Lowering the deposit facility rate to negative 10 basis points (you have to pay the ECB 10 basis points to hold your money if you are a bank) 4)      They have outlined a new $400 billion long-term refinancing operation (LTRO) to aid bank lending

The ECB stopped short of QE but did not rule out the idea in the future. The central bank is hoping to stimulate bank lending which in turn should promote growth throughout the region. The EU is anticipating that some of this growth comes from a weakening Euro. A weaker currency would encourage tourism and make EU products cheaper abroad.

Working for the Weekend

We would be remiss if we didn’t at least mention the monthly jobs report that comes out the first Friday of the month. We have pointed out to readers that it is probably the most important report for understanding the durability of the recovery and the mood of the American consumer.

At this point in the cycle, we are also starting to look at the monthly jobs report for an additional source of insight about inflation. Wage inflation is a precursor to overall inflation in the economy. Wages in the U.S. have started to rise, albeit slowly. For the month of May average hourly earnings increased 2.4 percent year-over-year. While that is not a level that we would deem inflationary, wages in certain sectors are accelerating.

Takeaways for the Week

• Equity markets around the world responded positively to the new round of policies announced by the ECB this week
• Job growth of 217,000 was not enough to trigger sharp wage inflation in the month of May

¹Source: Barron’s

Disclosures