An Interest in Interest Rates

by Brad Houle, CFA Executive Vice President

At the beginning of the year, we stated our belief that interest rates would gradually rise as three things occurred in 2014: the economy gains strength, unemployment continues to drop and bond market investors anticipate the Fed raising short-term interest rates. Thus far in 2014, the bond market has not been aligned with Ferguson Wellman's interest rate forecast. We continue to look for signs that our thesis was off-the-mark, but the fundamentals that lead us to this conclusion remain. 

After a rough start to the year that was attributed to extreme winter weather, we believe the gross domestic product (GDP) growth can exceed 3 percent without making any heroic assumptions. In 2013, there was significant fiscal drag as government cut spending. This year, the drag of government cuts should roll off and government spending will be additive to GDP growth. Unemployment continues to move downward with the most recent reading being 6.3 percent. In addition, the “wealth effect” of last year's strong stock and real estate returns should add to consumer spending which comprises two-thirds of the economy. With the aforementioned set of economic circumstances, a 10-year Treasury over 3 percent by year-end is not out of the realm of possibilities. 

It is difficult to pinpoint reasons that interest rates have continued to drop this year. Theories include the potential for quantitative easing in Europe, short covering by traders and perceived slowdown in economic growth. Addressing these topics independently, there is thought that the European Central Bank will engage in aggressive quantitative easing similar to what we’ve seen in the U.S. and Japan recently. In other words, the Federal Reserve in the U.S. is buying much of the bond issuance from the U.S. Treasury in an attempt to keep interest rates low. Bonds of developed market countries in the European Union have had strong price performance since the recent debt crisis whereby the yields on Spanish and Italian bonds are not that different than U.S. Treasury bonds. The U.S. has far higher credit quality than these European countries; one can understand investor preference in owing U.S. Treasuries over European country debt.

Short covering is the unwinding of a position by an investor which is designed to gain in value when interest rates climb. Many investors have positions that are bearish “bets” on U.S. interest rates. As rates have declined this year and have not climbed as anticipated these investments lose value. Then as investors unwind these types of trades, it can cause upward pressure on bond prices which correspondingly moves interest rates lower.

Lastly, belief in slower economic data would also potentially cause interest rates to drop because it would signal a slowing economy and a delay in the Fed raising short-term interest rates. Most recently, a disappointing retail sales report for the month of April was cited by some as evidence that the economy is slowing.

We believe that the recent movement in interest rates is mostly a short-term phenomenon. The economic recovery has solid momentum and as a result interest rates should move higher slowly over time. Presently, we are underweight fixed income for our clients and have invested the accounts defensively as a result of our interest rate forecast.

Our Takeaways for the Week

o   We still believe interest rates will move higher throughout the remainder of 2014

o   The U.S. economy is gaining momentum during the second quarter

Disclosures

Motion Simulating Progress

by Ralph Cole, CFA Executive Vice President of Research

Talk, Talk, Talk

It seems that every time you turn around, the Fed is trying to communicate information to the capital markets or to Congress. This week, Janet Yellen made a trip to Congress to speak to the Joint Economic Committee where she gave a very balanced view of the economy and of possible future Fed actions.

Chairwoman Yellen said that the U.S. economy paused in the first quarter, but appeared to be gaining steam in the current quarter. This view dovetails perfectly with our own views at Ferguson Wellman. The questions from Congressional members centered on job growth, unemployment and the labor participation rate. As we watch testimony of this type, it is interesting to observe the new Fed Chair sidestep the clearly partisan questions and get to the heart of what the Fed is tasked to do and what duties are tasked to Congress. This inculcation occurs every time the Fed Chair is invited to give testimony. The Fed has a dual mandate ― maximum employment and stable prices. This slower than usual recovery has placed an increased focus on employment, and what the definition of “full” employment actually is. Congress and the markets want to identify the exact unemployment rate at which the Fed will begin raising rates, which we think is foolhardy. The Fed Chairwoman explained the importance of not reading too much into any one data series, and any one data point. Rather, it will depend on a number of factors.

Here in our office we are turning our focus toward wage-related inflation. Increasing wages are often a precursor to overall inflation for the economy, and just like the Fed, we will be looking for acceleration at the margin for a number of indicators, not any one indicator.

What’s Going On

What has surprised us has been the movement of rates going lower in the face of better growth. Many explanations have been floating around and we suspect it is a combination of slower growth in the first quarter of the year and low rates around the world, making the yield on the 10-Year U.S. Treasury look appealing. We continue to believe that an improving labor market and positive GDP growth will move rates higher in the coming months.

Our Takeaways from the Week

• While Chairwoman Yellen is adept at dealing with Congress, we hope that the Fed can reduce their commentary in the future which we believe will reduce overall volatility in the fixed income markets
• Strong first quarter earnings for the S&P 500 continue to support higher stock prices in the future

Disclosures

Spring is Finally Here

by Shawn Narancich, CFA Executive Vice President of Research

Spring is Finally Here  

True to our outlook for the quarter and in-line with anecdotes from the mass of companies reporting first quarter earnings, the U.S. economy appears to be gaining speed after a weather-induced slowdown earlier in the year. While investors were disappointed to learn that first quarter GDP barely budged in the U.S., their disappointment was short-lived, as the blue-chip Dow Jones Industrial Average traded to new highs this week, with the benchmark S&P 500 not far off its best-ever levels. Merger and acquisition deal flow has picked up markedly, signaling greater confidence in corporate America to deploy near-record levels of idle cash. To our surprise, benchmark 10-year Treasury bonds remain remarkably well bid, with yields that held stable after a bullish jobs report likely reflecting continued geopolitical risk in Eastern Europe.

Green Shoots

Investors were encouraged to see that the U.S. jobs market kicked into a higher gear, producing substantially better than expected growth of 288,000 net new jobs in April. Previously reported jobs numbers were revised higher and the unemployment rate fell to a 5-and-one-half-year low of 6.3 percent. Bears will argue that a drop in the labor force participation rate to 36-year lows was responsible for the falling jobless rate, as discouraged workers gave up the hunt for jobs. We would argue that an accelerating economy will produce more job opportunities for disaffected workers, pulling them off the sidelines and tempering the decrease in unemployment. Average hourly earnings remain subdued, rising at the slowest pace of the year, and likely heartening the Fed, which earlier in the week left its QE3 tapering on course for conclusion by year-end. In addition to healthier labor markets, equities are responding favorably to further strengthening of the U.S. Purchasing Managers Index, a benchmark gauge of manufacturing health; it rose for the fourth consecutive month in April and dovetails with the rising levels of manufacturing and construction employment seen in the payroll report. U.S. auto production in March rising at the fastest pace since 2007 is another data point confirming for us the renaissance in domestic manufacturing. Finally, we were encouraged to see March consumption spending increase by nearly 1 percent sequentially, indicating that shoppers are beginning to spend at healthier rates following a brutal winter.

The Urge to Merge

All of a sudden, deal-making abounds: the planned combination of orthopedic device makers Zimmer and Biomet, Comcast’s proposed acquisition of Time Warner Cable, GE’s bid for Europe’s Alstom, Exelon’s planned acquisition of fellow utility Pepco Holdings, and Pfizer’s $106 billion bid for British drug maker AstraZeneca. This sample of proposed combinations highlights companies attempting to grow their bottom lines through sales and cost synergies at a point later in the economic cycle, when organic growth is harder to come by.

Only time will tell whether these deals actually get consummated as antitrust issues and nationalistic sentiment could foil at least a couple of them. For investors, the bidding activity shines a positive light on the economy and corporate valuations that we believe will continue to expand.

Late Innings of Earnings Season

Nearly 75 percent of the S&P 500 Index has now reported first quarter earnings. With forecasts that initially called for a decline in earnings now morphing into the reality of low single-digit growth, we observe that corporate America is once again proving its ability to under-promise and over-deliver.

Our Takeaways from the Week

•  Evidence of an accelerating economy continues to mount as weather-induced weakness fades
•  Heightened deal activity and better-than-expected corporate earnings leave stocks well bid, trading at near-record highs

Disclosures

Will Unemployment Be the Rat in My Kitchen?

by Brad Houle, CFA Executive Vice President

The British reggae band, UB40, was formed in 1978 and, according to Wikipedia, went on to have more than 50 singles on the UK Singles Chart and achieved considerable international success, selling over 70 million records. During the late 1970s and early 1980s, the economy in the UK was depressed with high unemployment and the band's name reflected the economic environment of the time. UB40 is a reference to a document to obtain unemployment benefits from the UK government. The designation UB40 stood for Unemployment Benefit, Form 40. As investors, we have been very focused on unemployment in this country, which is measured by two different measures, U-3 and U-6.

The most widely quoted measure of unemployment is collected by the Bureau of Labor Statics and is called U-3. This gauge of joblessness simply assesses the percentage of the labor force not employed. Total labor force is defined as the number of employed plus unemployed. Presently, the U-3 is 6.7 percent and has been as high as 10 percent following the Great Recession.

U-6 is a measure of underemployment that is presently 12.7 percent and was as high as 17 percent in the time following the financial crisis. U-6 determines the unemployed as well as those that are working part-time but desire full-time work. It includes workers that are overqualified for their current position based on education or experience level as well as those that are considered to be marginally attached to the workforce. Marginally attached workers are persons that have not looked for work in the past 12 months yet indicate that they are open to being employed.

Currently, full employment, as based upon the U-3 number, is considered to be between 4 and 5 percent. Full employment is an evaluation of unemployment whereby the vast majority of employable people are employed. Unemployment never drops to zero because there is a segment of the population that is unemployable.

Despite the continued slack in the labor market, we view the economy as still growing. The unemployment rate as measured by U-6 or U-3 continues to go down, just at a rate that is slower than most investors would like to see.  We continue to expect stronger economic growth for the rest of the year as we get past the weather impacted data from the winter months.

Takeaways for the Week:

• Companies are in the midst of reporting first quarter earnings. Of the S&P 500 companies that have already reported their earnings, more than half the companies beat sales expectations and 75 percent have beat earnings expectations
• Apple had stronger than expected earnings and raised the dividend and increased their share repurchase

Disclosures