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

Back in Time

by Jason Norris, CFA Executive Vice President of Research

In the last few weeks we have received several questions regarding the headlines coming out of Washington that may have major implications to some sectors of the market (although none of the questions were regarding Israeli Prime Minister Netanyahu’s address to Congress).

The FCC issued a statement that they are going to enact Title II of the 1934 Telecom Act (yes, 1934) to apply to broadband internet. This basically would regulate internet access, as well as any deals companies may make to transmit data (i.e., if Netflix were to strike a deal with Comcast, this would have to be blessed by the FCC). We haven’t seen the specific details of the act since the actual 300 page order has not been released. I had the good fortune of meeting with top managers of Verizon, Comcast and Charter Communications earlier this week and they addressed the topic. While the carriers have not been engaging in practices the FCC is trying to stop, this new regulation will introduce increased uncertainty. Network service providers have essentially had an open playing field as to what to invest in based on market dynamics. This proposed increase in regulation may present a lot of obstacles and conjecture. The consensus view is that new regulation would have a negative impact on innovation and investment longer-term. Also, the issue would be heavily litigated as well. The belief is that net neutrality needs to come through Congress, not the FCC. The DC Court of Appeals has previously overturned the FCC’s attempt to regulate in 2010 and 2014.

The winners of this move will likely be companies that drive a lot of data over the internet, i.e. Netflix and Hulu. Google is a wild card because they drive a lot of data transmission (YouTube) and they are expanding into telecom services (Google Fiber). Thus Google will see both the positive and negative sides of this proposed regulation. Apparently, Google execs had mentioned to President Obama that they are against net neutrality. The potential losers of the act would be the cable and telecom companies and their equipment suppliers if capital spending is slowed. However, the market didn’t bat an eye due to the amount of guesswork remaining before any implementation occurs.

You Keep Me Hangin' On

The Affordable Care Act (ACA) was before the Supreme Court again this week as challengers of the law asked the justices to find the subsidies (tax credits) the IRS is approving unconstitutional. The law states that only customers on a State-run exchange will get a tax credit; however, the IRS has been giving tax credits to all customers on both Federal and State exchanges. The majority of newly insured customers are on Federal exchanges and are receiving credits from the IRS, which would mean their insurance costs could increase meaningfully if this aspect of the ACA is overturned.

After the arguments were made on Wednesday, most legal analysts were unable to get a “read” from the justices on which way were they were leaning. The expectation is that the four “progressive” justices will vote in favor of the government, and the more “conservative” justices, Scalia, Thomas and Alito, will likely vote in favor of the plaintiff. The last challenge to the ACA was in 2012 where Chief Justice Roberts voted in favor of the act, so he could be the swing vote again. However, Justice Kennedy gave the defense a bit of hope due to his questioning of States’ Rights. The essential question is this: if the Federal government mandated the States to set up their exchanges to get its citizens subsidies, would that result in undue “coercion”? Thus maintaining the subsidies for the Federal exchanges may be allowed. It was an interesting line of questioning, and one that moved the HMO and hospital stocks this past week. The HMOs and hospitals will continue to be beneficiaries of the ACA due to the increased number of insured customers, but the HMOs will have less of a benefit since ACA policies dictate a lower profit margin.

Our Takeaways for the Week: 

• Net neutrality will not be solved for some time due to the legal challenges at play
• The current dispute of the ACA presents possible winners and losers in the healthcare sector

Disclosures

Don't Stop Believin'

by Shawn Narancich, CFA Executive Vice President of Research

Don’t Look Back!

As investors question the underlying strength of the U.S. economy, stocks are consolidating gains and bonds are defying Wall Street expectations for yields to rise. Like drivers gawking at a car wreck as they drive past, market participants once again revisited the surprisingly poor economic start to a 2014 that most thought would bring faster economic growth instead of the worst quarterly performance since the depths of the Great Recession. Reasons for the 2.9 percent contraction in first quarter U.S. GDP have been widely discussed, but the cold, inclement weather and late Easter don’t negate the math of such a poor start to the year, and its impact on full year estimates that economists are now scrambling to reduce.

Back on Track

Relatively healthy payroll growth, rising retail sales, and healthy manufacturing indicators bely the wreckage of first quarter GDP, but this week’s surprisingly poor May personal consumption numbers prolong the debate about how strong the economy really is. Few indicators are as simple as they first seem and this number is no exception, being dampened by accounting for the Affordable Care Act that economists first thought would boost healthcare spending. As it turns out, this component of consumer spending actually fell in May, and with the Fed’s preferred inflation measure ratcheting up to 1.8 percent year-over-year, real consumption spending used to compute the GDP number actually dropped sequentially. So what’s an investor to believe?  Notwithstanding the disappointing May number, we expect Q2 consumption spending to increase at a faster pace and look for better capital spending and housing investment to produce GDP growth somewhere in the 3-4 percent range. If achieved, this level of growth will be the best in a couple years and should go a ways toward allaying concerns about the pace of economic expansion. In this environment, we expect bond yields to rise.

Clear as Condensate?

The U.S. energy industry was jolted this week by surprise news that the Commerce Department has granted approval for two energy companies to begin exporting very light crude oil known as condensate. The U.S. energy renaissance has boosted domestic oil production by over 70 percent since the lows of 2008 and, owing to the nature of unconventional development, an increasing amount of the liftings are of the clear variety. The challenge for U.S. refiners has been to revamp their capital intensive facilities to accommodate this light production after years of gearing up for heavier Mexican and South American imports. The reaction on Wall Street was dramatic, as stocks of oil producers rallied and refining stocks tanked. If the first government approvals this week turn out to be a harbinger of additional exports to come, benchmark WTI oil prices should increase relative to the global benchmark Brent. Accordingly, the producers would realize higher prices at the expense of the refiners, which have benefited greatly from the discount at which they buy U.S. light crude. Only time will tell whether additional export approvals are granted, but the risk for refining investors is not only that their feedstock costs increase, but that investments made in recent years to process lighter grade crudes fail to pay off.

Our Takeaways from the Week

• Q2 comes to a close, with stocks hovering near all-time highs as investors assimilate disappointing headline economic news into full year estimates
• Energy stocks are in focus following initial government approval for light crude oil exports

Disclosures