The Time Has Come

by Shawn Narancich, CFAExecutive Vice President of Research

Awaiting Lift-Off

Following last week’s solid jobs report, a clear plurality of investors now expect the Federal Reserve to raise short-term interest rates next week. But once the Fed has achieved lift-off, what then? Amid ongoing dollar strength and falling energy prices, corporate profits have stagnated this year and economic growth remains pedestrian, causing concern about more of the same in 2016, but with less monetary accommodation along the way. We expect the path of Fed rate tightening to be gradual because inflation remains nearly non-existent. Even excluding food and fuel prices, so called “core inflation” also remains notably below the Fed’s 2 percent objective.

Mission Partly Accomplished

What we do have, and what is leading to the end of zero interest rate policy, is a state of relatively full employment. Although the labor force participation rate remains near decade low levels, the Fed rightfully sees its full employment mandate as having been achieved. In turn, we have seen stirrings of labor cost inflation, both statistically and anecdotally. The employment cost index is finally nearing 3 percent after having spent a prolonged stretch below that mark. Real life examples include fast food restaurants like McDonald’s and retailers Wal-Mart and TJ Maxx having to boost wage rates to keep employees; the degree to which labor inflation takes hold more broadly will be important to gauge, as this combined with the productivity of labor determine what we believe to be the single most enduring predictor of consumer price inflation – unit labor costs.  Perhaps because of muted levels of capital spending later in the economic cycle, workers’ productivity has proven to be disappointing in recent quarters, increasing upward risk to this key measure. As the Yellen Fed achieves lift-off from zero percent interest rates, it will be closely tracking its labor force dashboard in helping to determine how fast and how high rates ultimately go.

OPEC Laissez-Faire

OPEC finished its latest and much anticipated meeting in Austria last Friday much like we expected, acceding to the current level of the 12-member cartel’s production, but apparently not making any plans to accommodate additional liftings from Iran once UN sanctions are lifted, as expected sometime early next year. While some thought OPEC would cut production, this outcome never seemed likely. Lead producer Saudi Arabia’s strategy has come into focus – keep oil prices low enough, long enough, to accommodate its recapture of market share and stimulate enough additional demand to tighten oil markets naturally. In essence, the cartel has ceased to act as one. By all accounts, the meeting was highly contentious and unusually long, the result of discord that saw members Venezuela, Nigeria and Ecuador argue unsuccessfully for reduced liftings.

Black Gold?

Oil prices fell on the news last Friday and have proceeded to breach late August support levels of $40/barrel. Not helping oil bulls’ cause is news this week that Iraqi production gains have boosted OPEC production to fresh three-year highs in November at the same time the El Nino weather phenomenon has warmed the Northern Hemisphere and squelched early season demand for heating oil, an important seasonal product of crude oil. These headwinds notwithstanding, we maintain our belief that oil markets will tighten as U.S. production continues to roll over, non-OPEC, ex-U.S. production stagnates, and oil demand again grows at a faster than anticipated clip. Barring a market share war within OPEC (one that would be fought with limited means given how little excess production capacity the cartel has), Saudi’s de facto strategy appears destined to succeed. We see modest levels of oversupply morphing into undersupply as 2016 progresses. After all, the following adage holds – the best cure for low oil prices is low oil prices.

Our Takeaways from the Week

• The long awaited Fed lift-off from zero interest rate policy is at hand
• Oil prices have fallen anew in the aftermath of OPEC’s highly anticipated meeting last week

Disclosures

Light at the End of the Tunnel

by Shawn Narancich, CFAExecutive Vice President of Research

Retailing Blues

Earnings season has all but wrapped up for another quarter, but department store retailers are adding a problematic book-end to a quarter that has generally come in ahead of expectations. Flat third quarter earnings were weighed down by widespread losses in energy and dampened again by the stronger dollar, factors that many investors thought would spare U.S. centric retailers. Following Wal-Mart’s surprisingly weak earnings outlook in October, both Macy’s and Nordstrom came to the earnings confessional this week to report weaker than expected sales and substantially reduced profit forecasts. For Macy’s, its red star seems to be falling, as elevated inventories are forecast to weigh on margins for the company’s most important holiday sales quarter. Despite recent evidence of elevated merchandise levels in traditional retail channels, the subsequent 15-20 percent declines in both retailers’ share prices speak to the traffic challenges afflicting both Nordstrom and Macy’s. Investors long retailing stocks will hope for better news from home improvement, off-price, and specialty retailers next week.

Sales Falling Flat?

Amid increasing concerns about U.S. retailing, news that October retail sales barely budged cast a further shadow on the industry. In our opinion, weakness for select retailers reporting quarterly numbers speaks more to their distribution strategies and product mix than to any deeper concerns about the health of U.S. consumers. Shoppers are buying more of what they want and need online at Amazon.com, disadvantaging traditional bricks-and-mortar retailers that lack the cars, footwear, and food that consumers still want to see and trial firsthand before they buy. Also at work are the weather and the dollar. A mild fall has hurt department store retailers’ apparel sales and the strong dollar has deterred foreign visitors from taking American shopping sprees. Notwithstanding company specific retailing challenges, we continue to believe that a healthy job market, low gas prices, and low interest rates support domestic consumption and will be a tailwind for the U.S. economy.

Oil -- Down but not Out

In addition to the hit that retailers took this week, energy stocks again took it on the chin as oil prices retest August lows. Refineries are going through what’s called the turnaround season, a time of reduced product output that coincides with a change in product emphasis from summer gasoline to winter heating oil. Refinery throughput slows and with it, crude demand. As investors fret about recent US inventory builds, we would observe that seasonal factors are at play that obscure the tightening of oil markets – tightening that coincides with falling U.S. production and flattening OPEC production. We don’t expect OPEC to cut production at its December 4 ministerial meeting, but we do believe it will acknowledge that markets are coming back into balance and accede to the cartel’s current level of output. With fuel demand continuing to grow at healthy levels and global supply flattening, the slack in oil markets is disappearing. We are bullish on oil and look forward to higher prices ahead.

Our Takeaways from the Week

• Retailers are book-ending third quarter earnings season, causing consternation for department store investors

• Oil prices are retesting late summer lows ahead of the upcoming OPEC meeting, amid increasing evidence that supply and demand are rebalancing

Disclosures

Narancich Quoted in Portland Business Journal

Oregon stocks stumble as market plunges

by Matthew Kish 

The stocks of 18 of Oregon's 20 biggest public companies dropped Monday as the stock market tumbled. The S&P 500, Dow Jones industrial average and the Nasdaq Composite each closed down nearly 4 percent.

Northwest Pipe Co. (NASDAQ: NWPX) and Lattice Semiconductor Corp. (NASDAQ: LSCC) were the only large Oregon stocks to post gains. Each ended the day up less than 1 percent.

While there's no consensus on the market stumble, local analysts pointed to weakness in the Chinese economy and uncertainty about central banks and interest rates.

"I would venture to guess it’s more people being skittish about the direction of the Fed right now," said Chris Abbruzzese, chief investment officer for Portland's Rain Capital Management. "The Federal Reserve is going to be less supportive of equities markets going forward.”

They also said the market was due to hit a speed bump.

"The markets had been unusually stable and had come up quite a bit over the past three years," said Kraig Kerr, a senior vice president and financial adviser at D.A. Davidson in Portland. "So most people were expecting a correction at some point and were surprised it hadn’t happened earlier."

Shawn Narancich, executive vice president of equity research and portfolio management at Ferguson Wellman Capital Management, said the firm doesn't see anything "sinister" happening.

"Our mantra continues to be keep calm and carry on," Narancich said.

Ferguson Wellman expects the U.S. economy to continue growing in the second half. The economy is adding jobs and inflation is low. Consumer spending, which accounts for roughly 66 percent of the economy, remains strong.

"Gas prices are going to start dropping," he said. "Unemployment is low. Disposable incomes are up."

Rain Capital’s Abbruzzese said there’s also “quite a bit of evidence” that “we’re due, if not overdue,” for a resurgence in spending on capital projects that would stimulate the economy.

Kerr said D.A. Davidson's advice for clients depends on circumstances.

"Clients that are going to need cash in the near term may want to consider locking in gains," he said. "For the most part if a client has a well balanced portfolio we're not doing anything."

Abbruzzese said Monday's market volatility highlights the need for investment strategies that minimize risk.

“This is the type of market where we really thrive,” he said. “The approach thrives because we are more mindful of risk factors in portfolio construction.”

Here's a look at how Oregon's biggest stocks fared:

Nike Inc. (NYSE: NKE) — down 2.81 percent to $103.87

Precision Castparts Corp. (NYSE: PCP) — down 1.95 percent to $228.85

Lithia Motors Inc. (NYSE: LAD) — down 2.82 percent to $101.89

StanCorp Financial Group Inc. (NYSE: SFG) — down 0.85 percent to $112.59

Schnitzel Steel Industries Inc. (NASDAQ: SCHN) — down 2.66 percent to $16.10.

Keep Calm and Carry On

by Shawn Narancich, CFAExecutive Vice President of Research

Feeling Violated

Worries about competitive currency devaluations emanating from China’s small haircut to the yuan last week were supplanted this week by manufacturing related fears that the world’s second largest economy could be experiencing a hard landing. The result was a tough week for equity investors, as European stocks entered correction territory and U.S. stocks fell five percent.

Timing is Everything

As the sell-off accelerated into today’s close, we couldn’t help but wonder what market soothing policy moves the Chinese might institute next, nor could we ignore the palpable sense that the Fed’s lift-off from zero interest rate policy just got delayed again. Volatility in stocks will register with Yellen & Co. as they attempt to time this cycle’s first interest rate hike. However, more impactful will be the continued deflation in commodities that threatens to leave the price level far from the Fed’s stated goal of two percent inflation. As oil seeks out new cyclical lows and Treasuries benefit from a flight-to-quality bid, the trade-weighted dollar actually declined today. At a time of increased economic and market turmoil overseas, this hints of US monetary policy remaining easier for longer.

Reasons For Optimism

Low fuel prices and an increasingly healthy job market are combining to boost the collective spending power of U.S. consumers, helping drive the economy to what we believe will be a stronger second half of the year. Notwithstanding this week’s pullback in stocks, we look forward to a better second half of the year for corporate America, which should benefit from easier foreign currency comparisons and a turnaround in oil prices, two key factors that have helped keep earnings flat so far this year. As profit visibility improves, we expect stocks to make forward progress.

Ringin’ the Till

With all but a small number of companies having now reported, the sun is setting on a second quarter earnings season characterized again by companies under promising and over delivering. Retailers book-ended Q2 numbers this week by reporting a decidedly mixed bag of results. While America’s largest retailer struggles to grow, Wal-Mart’s rival Target came through with earnings just strong enough to make investors believe that this beleaguered retailer has put the worst of its merchandising and credit breech struggles behind it. Standing out to the upside was Home Depot, which reported another impressive quarter of sales driven by higher house prices and rising home improvement spending. While closing down for the week amidst market turmoil, Home Depot’s stock outperformed the broader market as management once again raised its profit forecast for the year.

Our Takeaways from the Week

• A sell-off in global equities pierced the veil of U.S. market tranquility

• Retailers concluded second quarter earnings season by reporting mixed results

Disclosures

Narancich Quoted in Reuters

Investors eye gaming stocks beaten-down by China headwinds

by Ross Kerber 

Shares of U.S. gaming companies operating in Macau have tumbled on worries over China but some investors now see them as a buying opportunity, despite a slowing Chinese economy and volatile stock market.

Shares in Wynn Resorts Ltd have lost over half their value since last year and those of Las Vegas Sands Corp are down nearly 40 percent from their 2014 high. Beijing's currency devaluations have put further pressure on these companies which run gaming resorts on the Macau Peninsula across the Pearl River delta from Hong Kong.

Still, some influential investors think the stocks may be oversold.

"There are some beaten-down sectors in China now. I would go so far as to say that Macau gaming is an undervalued asset," said Mark Kiesel, chief investment officer for global credit for Pimco.

It owns debt in the sector, and Kiesel said he expects new infrastructure will bring more people to the resorts.

Also enthusiastic are the managers of Longleaf Partners Small-Cap Fund, advised by Southeastern Asset Management. In their most recent commentary the managers wrote that "Weakness in the Macau (China) gaming market provided the opportunity to purchase Wynn Resorts at a substantial discount to our appraisal." Southeastern is now the sixth-largest holder of Wynn.

Representatives for Wynn and Sands did not return messages. Wynn shares closed at $94.62 on Thursday, down from their high above $246 last year. Sands shares closed at $53.12 on Thursday, down from their high above $87 last year.

Skeptics still seem to outnumber the value-driven investors putting money into the stocks.

Shawn Narancich, executive vice president of equity research and portfolio management at Ferguson Wellman Capital Management, said his firm sold about 360,000 shares of Las Vegas Sands last year as they fell in value.

With several new resorts about to open in Macau he worries supply may outstrip demand, especially amid other headwinds like a Chinese anti-corruption campaign that has hurt gaming revenue in Macau, down 35 percent in July.

"It's hard for me as a money manager to make the case to return to the stock," Narancich said.

In commentary posted on July 27, managers of Wintergreen Fund wrote how they sold their holdings of Wynn Macau - majority owned by Wynn Resorts - in the first quarter of this year, citing weakening economics.

"Without a firm or improving business environment for gaming companies, it is very difficult for casino stocks to perform well," they wrote.

Supreme Summer

by Shawn Narancich, CFAExecutive Vice President of Research

While Chinese stocks endured more losses in a week that now puts the A-Shares Index into correction territory, U.S. investors continue to preside over a range-bound market domestically. With U.S. equity indices near record levels and late quarter news flow reduced to a trickle, all eyes were focused on the U.S. Supreme Court decision this week regarding the legality of federal tax subsidies for states not running their own insurance exchanges. A high court ruling upholding a key tenet of the Affordable Care Act (ACA) was greeted with a sigh of relief by investors who own hospital stocks, while sending speculators short names such as HCA Holdings running for cover. While minor tweaks to the ACA are still possible, such as the repeal of the medical device tax, this week’s key ruling all but assures that the key structure of the national healthcare law will remain intact at least until the Obama administration leaves office.

Gathering Pace

As healthcare stocks reacted to the Supreme Court drama, investors with more cyclical leanings received the latest confirmation that moribund first quarter consumption and weak retail sales were transitory. U.S. consumption spending in May rose at the fastest month-to-month rate in nearly six years, and the 0.9 percent surge easily outpaced a smaller increase in consumer income. Indeed, the U.S. consumer has not forgotten how to spend! Coupled with a strong job market confirmed by a surge in May hiring and an upbeat retail sales reported for the same month, we are left to conclude that the U.S. economy has picked up considerable pace from the slight contraction it experienced during the first quarter. Our best guess is that the Federal Reserve will exit zero interest rate policy sometime later this year, and it will most likely be in September.

Greece Ad Nauseum

The melodrama of Greece failed to find a resolution this week, but European stocks seem to have found their footing nonetheless. Regardless of whether ongoing talks with Greece are successful in retaining the country as a solvent member of the Eurozone economy, the European Central Bank (ECB) has demonstrated its commitment to do, as chief Mario Draghi famously observed several year ago, “whatever it takes,” to keep the Eurozone and its currency viable. Exhibit A of this commitment is the ECB’s ongoing program to enhance the European monetary base by purchasing $60 billion of European bonds every month until at least the fall of next year. Exhibit B, key in the latest Greek crisis, is the central bank’s commitment to fund Greek banks with loans to accommodate ongoing deposit flight from these institutions. Our main observation here is that if no acceptable resolution is reached and Greece ends up leaving the common currency, then Europe and its central bank will do what is necessary to keep the region’s banking system and economies liquid, thus preventing any lasting type of contagion from Greece’s exit.

Our Takeaways from the Week

• The U.S. economy is perking up after a slow start to the year
• Global capital markets are unlikely to suffer any lasting repercussions from Greece, regardless of how the melodrama concludes

You're Hired!

by Shawn Narancich, CFAExecutive Vice President of Research

Green Shoots

 A week chocked full of economic insight concluded with a bang, as a strong jobs report for the month of May provided more assurance to investors that a contraction in first quarter GDP is likely to be transitory. The U.S. economy created a net 280,000 nonfarm jobs last month, nearly a third better than what Wall Street was expecting. Good news on the jobs front was widespread among various industries and accompanied by more evidence that wage gains are firming. After being hamstrung by the West Coast ports strike, an exceedingly strong dollar and another harsh conclusion to winter, the U.S. economy now appears to be gathering speed.

In its attempt to determine the right time to begin raising interest rates, the Fed will triangulate today’s bullish job report with additional evidence of gathering momentum in manufacturing released earlier this week, that coming in the form of an ISM report showing that activity has picked up for the first time since last fall. As well, construction spending perked up in April and previous months’ activity was revised upward. Finally, Yellen & Co. would observe that U.S. light vehicle sales posted another strong number in May, rising to a seasonally adjusted annual rate of 17.8 million vehicles sold, a 10-year high. The plurality of this week’s data reveals an economy no longer in need of unconventional monetary policy and leads us to believe that the Fed will achieve lift-off from zero interest rate policy this fall, most likely in September.

Raise Rates in 2015 … Mais Non?

As investors were digesting the good news domestically, the International Monetary Fund was busy revising down its estimate of how fast the U.S. economy will grow this year. In an unusual move, Managing Director Christine Lagarde urged the Fed to hold off on raising rates this year, arguing that doing so would lead to an even stronger dollar and threaten the rate of expansion globally. The French may be opinionated, but even her admonition is likely to fall on deaf ears. We have said repeatedly that when the Fed raises rates, it will be for the right reasons, and the data we are beginning to see affirm for us that the U.S. economy is rebounding in the second quarter. Like last year, we see a second quarter reversal carrying through with strength into the second half of 2015.

Markets on the Move

Although the IMF might not be convinced, bond investors have responded in dramatic fashion, selling longer dated issues in mass and sending benchmark U.S. rates to their highest levels of the year. Equities in the financial sector are doing the opposite, rallying in anticipating of higher rates boosting banks’ net interest margins. In anticipation of rising rates, we recently increased our weighting to financials, while further trimming our exposure to a consumer discretionary sector that appears closer to full value.

Our Takeaways from the Week

•  The U.S. economy appears to be perking up, solidifying expectations for Fed action later this year
•  The bond market is responding, with rates rising to their highest levels of the year

Disclosures

Belaboring Labor

by Shawn Narancich, CFAExecutive Vice President of Research

Working for a Living

Investors unnerved by disappointing economic data of late breathed a sigh of relief with the April jobs report, which showed that nonfarm payrolls rebounded to a monthly rate of 223,000 last month. Unemployment dropped again and now stands at 5.4 percent, a rate not too far from the Fed’s definition of the full employment rate of unemployment (somewhere just north of 5 percent.) A “goldilocks” report of sorts that’s neither too hot nor too cold, the April payroll release supports the notion that the Yellen & Co. will likely begin the rate tightening process this fall. As policymakers and investors debate how tight labor markets actually are against a backdrop where the labor force participation rate hovers near its lowest level since the late 1970s, we are increasingly attuned to reported wage rates and the broader employment cost index (ECI). While wage gains remain muted at 2.2 percent in April, the ECI of 2.6 percent released last week demonstrated a notable uptick. When juxtaposed against anecdotal evidence of wage gains at fast food restaurants and retailers, our best guess is that the worm has turned with regard to employment costs this cycle. Because labor accounts for the predominant cost of doing business, the near-zero inflation rates we’ve seen of late appear likely to begin rising. When combined with the recent rebound in oil prices, headline inflation probably rises closer to the Fed’s 2 percent target by year-end.

Spring Forward

In contrast to the encouraging labor report, investors were greeted by a report showing that productivity of the U.S. labor force declined for the second consecutive quarter. While somewhat obscure, the statistic shines a light on the U.S. economy’s weak start to the year. By marrying employment and output statistics, the report tells us that the U.S. economy produced less per each hour worked in the first quarter. The reason productivity is such an important statistic is because when it’s combined with employment costs, it generates what we call unit labor costs. As alluded to above, sustained increases in the cost of labor are a key signpost for inflation, particularly when they translate into rising costs of production on a per unit basis. Just as importantly, unit labor costs determine how profitable companies are and the overall standard of living enjoyed by workers. Another tough winter combined with disruptions from the west coast ports strike put a damper on the U.S. economy in the first quarter, but we believe that an improving labor market, rising disposable incomes, and higher capital spending will engender a rebound of sorts in the second quarter. Commensurately, we would expect productivity to return to positive territory.

Exceeding Expectations

First quarter earnings season is just about finished and, once again, U.S. companies have done a remarkable job of under promising and over delivering.  Compared with expectations of a low single-digit decline in first quarter profits, corporate America is instead delivering earnings that should end up being marginally above levels of a year ago. In particular, while dramatically lower oil prices caused red ink to flow on the income statements of many energy companies, the damage was ameliorated by better downstream refining and marketing results and the quick pace with which oil and gas producers have right-sized their cost structure.

Our Takeaways from the Week

• A solid April employment report bodes well for better economic times ahead
• Another encouraging earnings season is just about finished

Mastering Expectations

by Shawn Narancich, CFAExecutive Vice President of Research

 A Tradition Unlike Any Other

 As another Masters golf tourney gets underway in Augusta, Georgia this week, investors are beginning to process the first reports of a dawning earnings season; as well, they have been jolted by a strong dose of deal news this week totaling well over $100 billion in announced acquisitions. Whether this flurry of activity heralds meaningfully more late-cycle deal making remains to be seen, but low interest rates as well as low oil prices support the rationale for energy deals like Royal Dutch’s $70 billion purchase of British energy company BG Group. Speculation is rife that rivals Exxon and Chevron could be compelled to do the same. Although buying another European producer might make more sense now in light of the strong dollar, we view neither of these integrated oil producers as likely to attempt a large deal for a major peer. More likely are deals for smaller independent U.S. producers with quality acreage in key Texas shale plays like the Permian Basin and the Eagle Ford.

Ready, Fire, Aim

As Royal Dutch jockeys for position in Big Oil, energy investors attempting to divine the low in prices for this cycle were forced to confront the not-so-shocking news out of Iran that that their “supreme leader” Khamenei is calling for the immediate lifting of economic sanctions in return for concessions limiting the country’s nuclear program. As well, he apparently disdains the idea of nuclear inspections that would confirm the country’s compliance with key provisions of the agreement reached in Switzerland last week. All of which leads us to conclude that predictions about a wave of new Iranian oil buffeting the markets any time soon is premature. From our perspective, the likelihood of reaching a final nuclear agreement with Iran looks increasingly unlikely.

Skating to Where the Puck Will Be

Geopolitics aside, we believe oil prices have bottomed and that markets will tighten meaningfully in the second half of this year, pushing prices closer to the marginal cost of production estimated to be somewhere between $75 and $100/barrel. From an investment perspective, we are overweight the energy sector and favor upstream producers and the service companies that enable their production as the two groups most likely to benefit from rising oil prices.

And They’re Off!

Alcoa marked the unofficial beginning of first quarter reporting season by announcing better-than-expected earnings on healthy growth in aluminum demand from both the aerospace sector as well as the emerging market in autos. Unfortunately for shareholders, the results met with a thud by investors who drove the stock down 3 percent on fears that aluminum prices will succumb to excess supply from China, the world’s largest producer. Next week will mark the first full week of earnings, with the money center banks and a few select industrial and healthcare companies on tap to deliver their numbers. In contrast to depressed energy results amid low oil prices, we expect earnings growth from sectors like healthcare and technology.

Our Takeaways from the Week

• Deal making is being stimulated by low oil prices, low interest rates and a strong dollar
• Investors are beginning to turn their attention to first quarter earnings