George Hosfield, CFA, discusses Ferguson Wellman's quarterly strategy titled, "Inflation's Flame Flickers," which addresses the narrow market leadership, the impact of higher interest rates on inflation and how assets are priced at this stage of the economic cycle.
George Hosfield, CFA, discusses the firm's quarterly strategy titled "Stalemate," which highlights the Fed's ongoing battle to tame inflation along with our views on the health of the banking industry and capital market expectations for the balance of the year.
Director and Chief Investment Officer George Hosfield, CFA, discusses the Fed raising interest rates, peaking inflation and our view on equities and volatility across all asset classes in our Investment Strategy titled, “Balancing Act.”
In October 2022, the S&P 500 hit a low of 3,577, which was 25% lower than at the start of the year. The Federal Reserve had just started an aggressive interest rate hiking cycle and 100% of Wall Street economists were calling for a recession by 2023. We believed otherwise.
Over the last week, investors and market watchers were introduced to a relatively unknown economic indicator, the Sahm Rule. As highlighted by Google search data, interest in the indicator spiked last week.
On Friday, stock and bond investors wrestled with conflicting conclusions from jobs reports. Two surveys report jobs data: the payroll survey and the household survey. The payroll survey showed a gain of 272,000 new jobs. However, the household survey showed a loss of jobs and an uptick in the unemployment rate to 4.0%.
With today’s jobs number showing a monthly gain of 151,000, it didn’t tip the scales much regarding a Federal Reserve rate hike this year. This number was below expectations of 180,000; however, it was still viewed as solid growth. Wage growth remained a steady 2.4 percent, slightly below last month. The August jobs report number regularly gets revised higher.
With the opening ceremonies of the Rio Olympics set to begin tonight and on the heels of a strong number in the month of July in which the U.S. added 255K jobs, stocks ended the week with a bang. This was meaningfully ahead of
When we met with clients in January of this year we highlighted our thesis that while 2015’s equity returns were anemic and there were concerns at the outset of 2016, we maintained that the equity bull market was not over. This
There are only a handful of retailers left to report their earnings this quarter and thus far, it appears that companies’ results reflect a tough year in 2015. Profit growth declined just over 1 percent from 2014 as weak commodity prices and a strong dollar were major headwinds. This resulted in earnings per share (EPS) for the S&P 500 of $116. There were pockets of strength
Speaking before a packed Portland Business Alliance audience, economist John Mitchell predicted that the region’s economy will continue to expand at an annual rate of about two percent through 2016.
by Jason Norris, CFAExecutive Vice President of Research
Back in Business Again
It has been a volatile year for equities and as we head into the holiday season, that doesn’t look to dissipate. After the 12 percent sell-off investors went through over the past few months (Fed rate hike concerns, China market crash, Greek debt issues and the constant geo-political flare-ups), the S&P 500 has rallied back, culminating with its best week of the year. While 2014 proved to be a narrow market, 2015 is even more so. When you look at the 10 largest U.S. companies (see table below), you notice the majority of them, have enjoyed significantly greater returns than the 3 percent for the S&P 500.
Source: FactSet data through Nov 20, 2015
What is even more dramatic is that three stocks were responsible for all of this return: Amazon, Alphabet/Google and Facebook.
There have been prior periods of large cap driven markets, coupled with a handful of names driving that performance. But what we have experienced this year is less than a handful of mega cap names delivering all the index returns.
One thing to note on this narrow focus is the emphasis on “growth.” The sell-off we experienced this summer was a classic “growth” scare. Investors believed that due to the strong dollar and the slowdown in China would cause global economic growth to slow. While we’ve seen some stabilization in the equity market, there is still concern over global economic growth. As such, investors have been willing to “pay up” for growth companies and avoid cheaper names that are tied to the face of economic growth. For instance, the three stocks mentioned earlier trade at substantial premiums to the overall market.
Source: FactSet data through Nov 20, 2015
Investors are paying a lot more for a dollar of earnings for a select few names due to the concern over growth. This has resulted in growth stocks returning roughly 7 percent this year, while value stocks are down 2 percent.
Takeaways for the Week:
Our Takeaways for the Week
by Jason Norris, CFAExecutive Vice President of Research
A Light in the Black
What a week! With concerns about growth in China, continued deterioration of the Chinese equity market and U.S. investors rushed to the sidelines by redeeming over $17 billion in equity mutual funds and ETFs. This, coupled with concern over when the Fed will raise rates, led U.S. equities to experience a 12 percent correction from recent highs on Tuesday (see last week’s blog for more detail). This was long overdue as it had been almost four years since the S&P 500 had corrected by at least 10 percent, which was the third longest period in history. However, after six consecutive days of selling, on Wednesday the near-term bottom was reached on the S&P at 1867, down from its all-time high of 2130 which was reached on May 21, 2015.
Understandably, rapid downward moves in equities can be disconcerting. We don’t know if we’ve seen the bottom; however, we believe there is a light at the end of this tunnel in the form of domestic market fundamentals. For example, U.S. GDP was revised higher on Thursday from 2.3 percent q/q annualized to 3.7 percent. This was driven by several factors - primarily capital spending and consumer spending. Earlier this month we also saw retail sales numbers revised higher. When this data was originally reported, we did view it with some skepticism since our bottoms-up analysis did show better strength than the broad government reports.
After analysis of the earnings reports for the companies we own, it revealed annual growth in earnings of 2 percent; however, excluding Energy, growth was close to 13 percent. Even when looking at the broad market, earnings growth (excluding Energy) was around 5 percent. This growth was driven by the U.S. consumer and healthcare. These fundamentals signal to us that the U.S. economy is healthy and improving.
Earnings Growth for the 10 Economic Sectors of the S&P 500
| Q2 y-o-y growth | 2015e | |
| Consumer Discretionary | 9.2% | 11.3% |
| Consumer Staples | 2.5% | 1.7% |
| Financials | 6.8% | 15.9% |
| Healthcare | 14.4% | 12.7% |
| Industrials | -4.5% | -1.0% |
| Info Tech | 4.5% | 4.9% |
| Basic Materials | 6.0% | -1.0% |
| Telecom | 8.5% | 8.3% |
| Utilities | 6.5% | 1.6% |
| Total (ex. Energy) | 5.3% | 7.0% |
| Energy | -55.7% | -56.3% |
| Total | -0.7% | 1.0% |
Source: FactSet
The table above highlights the underlying sectors of the U.S. market, showing both the actual growth rate for the second quarter and an estimate for 2015. The key to focus on is that commodity prices are bringing down Energy and Basic Materials, and the strong U.S. dollar and China is hurting Industrials. However, when you lift up the hood of the market, corporate America is still exhibiting solid growth.
Our Takeaways for the Week
by Jason Norris, CFAExecutive Vice President of Research
Good News First
The jobs market continues to chug along adding 215,000 jobs in the month of July with upward revisions to June and May of 14,000. While this is a solid pace of gains, it hasn’t been strong enough to push wages higher.
Equity markets, on the other hand, have struggled the last several sessions, despite favorable earnings reports. We have seen the major declines in profits in the energy sector; however, the rest of the economy seems to doing well. With just under 90 percent of companies in the S&P 500 reporting second quarter earnings, year-over-year profit growth could very well be negative 1 percent. While nothing to write home about, the main culprit has been the energy sector. Energy earnings are going to be down close to 60 percent year-over-year. If you back out the energy sector, earnings for the rest of the market will be up 5 percent year-over-year. Healthcare, consumer discretionary and financials have led the way higher. We recommend that investors don’t get caught up in the headline numbers, especially now that one sector is having such a major impact on the overall number.
The price of oil won’t necessarily be helping out the energy sector in the third quarter. With WTI at $44, it is close to its March lows. We moved to an overweight in the energy sector six months ago with the belief that as prices fell, demand would increase and supply would decline. What surprised us was the supply side. While rig count has declined by 60 percent domestically, U.S. supply has been somewhat slow to respond to reduced drilling activity. Nevertheless, U.S. supply has peaked and should decline into the second half of the year. We contrast the ex-growth situation domestically with OPEC, where key producers Saudi Arabia and Iraq have combined to boost cartel volumes by 6 percent so far this year. Aside from flattened production domestically and OPEC’s production growth this year, the key to our call for higher oil prices is stronger than commonly perceived demand growth and production from non-U.S., non-OPEC regions around the world. Despite oil prices that reached $140/barrel in 2008, this key source of global supply has failed to deliver any additional production over the past eight years. Our bet is that if additional volumes weren’t forthcoming in more propitious times, this key source of approximately 54 million barrels/day of supply is likely declining at currently depressed prices. Therefore, it will increasingly help to balance the market. We still believe oil will be closer to $70 then $40 at year-end and are focusing on companies with strong balance sheets to weather this near-term storm.
Only a Matter of Time
Recent economic data has not been conducive to a September Fed rate hike. While the unemployment rate at 5.3 percent is a positive sign, coupled with weekly jobless claims at historic lows, there is still a lot of slack in the labor market. There are currently over 5 million jobs that are available, which is an all-time high. While this data signals a tight labor market, the unemployment rate figure does not. Also, wages aren’t increasing at a rate that is a threat to inflation. Earlier this week, the Employment Cost Index showed only a 2 percent increase in labor costs, which comprised 2.1 percent in wages and 1.8 percent in benefits. Today’s jobs report confirmed this with hourly wages rising only 2.1 percent.
We believe a Fed rate hike will happen before the end of the year. Given current data trends, whether it is September or December is a toss-up. We have seen and read about indications that the Fed wants to start the process; however, we believe the data is still signaling uncertainty.
Our Takeaways for the Week
by Jason Norris, CFAExecutive Vice President of Research
Volatility in the second quarter reigned in both equity and bond markets. Interest rates rose close to half-of-a–percent, resulting in negative returns for bonds. While U.S. equities were volatile, they ended the quarter relatively flat. International markets were roiled in June with China equities moving into bear market territory following a parabolic run and as for Greece…
In the face of this uncertainty, we are still constructive on equities for the back half of 2015. The U.S. economy is slowly improving. Excluding energy, corporate profits should still exhibit high single-digit growth and equities are still relatively inexpensive. Therefore, with the Fed set to raise interest rates later this year, bonds will continue to face a headwind, thus equities warrant an overweight versus fixed income.
While headlines reported a healthy increase of 223,000 new jobs in the month of June, analyst expectations were a bit higher. Also, previous reports were revised lower and the labor participation rate declined, which resulted in a lower unemployment rate of 5.3 percent, which is a seven year low.
One of the major disconnects in the job market is that there are close to 5.4 million job openings currently in the U.S. This is the highest level we’ve seen since January of 2001. We believe this will provide a tailwind throughout 2015 in the labor market.
There are a lot of mixed data in Thursday’s report that can help us assess if it’s too hot, too cold, or just right. Therefore we do believe that our call that the Fed will raise rates later this year has not changed.
Grexit, Greferendum, Grapituation and Gratigue
Frankie Valli sang it best in 1978, “Grease is the word.” After missing a payment to the IMF on June 30, Greece headlines have rattled markets in the last few weeks and that volatility are here to stay with the possibility of a pending referendum on July 5 and a debt payment due to the ECB July 20. The key issue we are focusing on include whether or not the Greek contagion will affect other nations in southern Europe. Whether we have yet to see if the Germans will let the Greeks leave the Eurozone or if they will be “hopelessly devoted.” What has changed since 2010 is that Greek debt is now held by government agencies, such as the IMF and ECB, not banks. In 2010, 140 billion euros of Greek debt was held by global banks, with over 100 billion of that amount being held by European banks. The amount held by banks has dropped by over 100 billion with the European banks, on the hook for less than 20 billion.*
We don’t want to handicap the pending referendum (on whether vote for or against austerity) by the Greek people and current polls show a dead heat. What we do believe is that volatility will continue in July, fueled by Greece and earnings season; however, by year-end this Greek drama will be in the rear-view mirror.
Our Takeaways for the Week
*Euro to US Dollar exchange rate was +0.13367 percent at time of publication.
by Jason Norris, CFAExecutive Vice President of Research
For technology junkies, the Re/code conference in Southern California is one of the highlights of the year. It is a broad mix of public and private companies speaking on innovation today and what the future holds -- from automobiles and wireless to media and culture.
One of the most popular segments of the conference is Mary Meeker’s annual presentation of internet trends. Meeker is a partner at venture firm Kleiner Perkins; however, her thrust into the spotlight came about 20 years ago when she was an internet analyst for Morgan Stanley. The key point to her 190+ page slide deck was that the internet is still in its very early stages and mobile is becoming more of a dominant aspect of the web. While the consumer and businesses have been pushing the internet, there are several other areas of the economy where opportunities are still great. Government, education and healthcare are just a few examples of sectors that have not yet fully leveraged the internet.
As users, traffic, and transactions increase online – security becomes more of a focus. What has been a common news event of late, there are breaches at various institutions that can put both individuals and those entities at risk. The IRS unfortunately is the most recent institution to be significantly impacted. As more people connect to mobile devices, security and encryption are even more essentials. The chart below highlights time spent with digital media on different devices.
Accessing digital media continues to grow at a double-digit rates and the growth is primary coming from mobile. This growth in connectivity globally continues to benefit companies such as Apple, Samsung and Avago.
Increased transactions as well as a growth in private information shared digitally, specifically wirelessly, does increase the need for better security, as well as the opportunity for companies to analyze consumer behavior and offer personalized deals. These trends have resulted in chief information officers (CIOs) to forecast security and analytics spending to continue to increase as a percentage of information technology (IT) spending. Morgan Stanley released a survey earlier this week highlighting a 210 bps increase in the growth of network security spending in 2015 (12.8 percent up from 10.7 percent). To put in perspective, overall IT spending usually grows in the low-to-mid-single digits. Some beneficiaries of this trend would be Cisco, Checkpoint and Palo Alto Networks.
Watch What You Do
As consumer utilize more wireless devices and with the most recent launch of the Apple Watch, some legal issues become a bit fuzzy. In several states, it is against the law to use your wireless handset while driving. What if you are using your watch? This was the case in Quebec earlier this month where a watch owner was fined $120 for operating his watch while driving. As devices become more integrated, especially in cars, safety regulators are going to have a tough time keeping up.
Our Takeaways for the Week
by Jason Norris, CFAExecutive Vice President of Research
Apple reported earnings earlier this week. Due to recent strength in the stock, investors took profits. Specifically, sales grew 27 percent year-over-year, driven by 55 percent growth in iPhone revenues. This resulted in profit growth of 40 percent. These growth rates are very rare for companies with annual revenues over $200 billion and a market capitalizations (the share price multiplied by total number of shares outstanding) in excess of $700 billion. Therefore, sustainability does frequently come up.
On a similar note, with Apple’s market capitalization of $725 billion, it is now considered the highest valued company in the world. With that value, it is now 4 percent of the S&P 500, the most common equity benchmark. When active investors attempt to beat their benchmark, knowing some of the major constituents is critical for investment managers. In the case of Apple, if an investor believes that Apple is going to perform better than the S&P 500, they now have to allocate more than 4 percent of their portfolio to that stock. If they do not and Apple were to perform better than the S&P 500, investment managers will not keep up.
From a diversification standpoint, most investment managers are hesitant to hold positions greater than 4 percent, thus would now be underweight Apple. Since Apple is a very large component of the large-cap equity benchmarks, we recently reviewed the 10 largest actively managed core and growth mutual funds. For core managers trying to beat the S&P 500 when Apple is a 4 percent position, eight of 10 are underweight, and the other two are equal. When looking at growth managers when Apple is 7 percent of the benchmark (i.e., Russell 1000 Growth), nine managers are underweight and only one is equal. This data revealed that Apple is extremely underowned among the world’s largest mutual funds. If those funds were to move to an equal weight position relative to the benchmark, we would see over $29 billion worth of buying, which is roughly 235 million shares. Since we have a positive view on Apple, we believe this data is also positive.
Just like clockwork, this time of year the financial press will be prognosticating about the old adage, “sell in May and go away.” This comes to the forefront since equity markets often experience lackluster performance in the spring and summer months. However, it does not necessarily mean that investors lose money. Since 1978, from May to September, stocks median return was 3 percent, lagging the performance of equities from September to May. This has resulted in a median performance of 11 percent. We believe this doesn’t signal “a sell” since there are still positive returns to be had, just more potential volatility. The negative returns captured in the chart below are the result of two poor months, July and September.
Source: FactSet
Our Takeaways from the Week
o Apple continues to be an "underowned" stock which may provide outside buying power adding support to the name
o While summer is often a results in lackluster equity period for performance, we don’t think investors should trade based on the calendar
by Jason Norris, CFA
Executive Vice President of Research
The official start of earnings season kicks off next week and it looks like earnings for the broad market are going to be negative five percent. There are two main culprits for this. First, the recent strength in the U.S. dollar took large multinational companies by surprise, which resulted in major revenue and earnings revisions lower in 2015. The S&P 500, a standard large cap equity benchmark, has approximately 35-40 percent of its constituent’s revenues outside the United States. Therefore, a major strengthening of the U.S. dollar (see the below chart) results in U.S. goods being more expensive.
For example, if $1.00 = 0.80 Euro, then if a U.S. manufacturer were selling a $100 item in Europe, customers there would be spending 80 Euros. With the recent strengthening, $1.00 is now the equivalent of 0.95 Euros, thus that same $100 item would cost 95 Euros. This is a major price increase and headwind for U.S. exporters. We saw this instance with companies like Microsoft, Caterpillar, and more. On the other hand, the weakening Euro makes those products cheaper in the U.S. Thus, we believe European exporters should stand to benefit from this, and will be a catalyst to stimulating growth in Europe. As such, we recently increased our exposure to the International markets.
Down In a Hole
The other culprit for the major negative revisions for earnings is the reduction in the price of oil. In the past six months, the price of oil has been cut in half which is having a dramatic effect on the earnings in the oil patch. The year-over-year change in energy earnings in the first quarter is a negative 65 percent. Excluding this area of the market, earnings are forecasted to grow by three percent.
Outshined
These two attributes are setting up for a tough year for headline growth numbers. Earnings growth estimates have declined from seven to two percent for 2015. However, if you exclude Energy, earnings growth should come in closer to nine percent. Our belief is the overall economy is improving and the consumer will be the main beneficiary. While recent consumer spending data has been mixed, we are seeing an improving trend, particularly in consumer confidence. Therefore, continued low interest rates and energy prices throughout 2015 are a tax cut for consumers, and with a tightening labor market, we expect to see an increase in wages. This is all setting up to be a good year for “Main Street.”
Our Takeaways for the Week:
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:
by Jason Norris, CFA
Executive Vice President of Research
Headline sales numbers from Black Friday looked disappointing with revenues falling 11 percent in 2014, which follows a negative year in 2013 as well. However, when we dig into the data, we see that sales have spread out over the entire week. Many stores have been starting their promotions earlier in the Thanksgiving week, meaning Black Friday is not the seminal event it once was. Coupled with an increasing amount of shoppers going online, the post-holiday shopathon is not the signal to the markets it once was.
Data from the entire weekend looked fine with sales rising approximately four percent, with a 15 percent clip coming from online sales. In forecasting the entire holiday season, industry analysts still expect low to mid-single digit growth. In light of gasoline prices down 35 percent from last year, we are comfortable with that growth forecast. In fact, this led us to increase our allocation to the consumer discretionary sector recently.
Quantitative Speaking
With the Fed wrapping up its quantitative easing last month, the European Central Bank has upped their rhetoric. This week, ECB president Mario Drahgi was more adamant that the ECB will be in the markets buying bonds. This put a small bid on the Euro; however, we are still waiting for the ECB to actually make meaningful purchases. Since 2012 when Drahgi stated the bank would do "whatever it takes" to prop up the Euro economy, there has been a lot of speaking, with little actual easing.
The economic data points coming out of Europe have been neutral at best. While the old adage of "don't fight the Fed" may be appropriate for the ECB and European equities, we would rather focus on large cap U.S. stocks due to a strong economy, falling commodity prices and low interest rates. One potential headwind for multinationals is going to be the strength of the U.S. dollar. The dollar has rallied 10 percent the past few months and this will start effecting overseas results this quarter. Due to this, recent portfolio additions have focused on the domestic economy, rather than the global economy.
Our Takeaways for the Week:
by Jason Norris, CFA
Executive Vice President of Research
The first couple weeks of trading in October have been volatile, primarily on the downside. While the U.S. economy continues to print positive data points, most other regions around the globe seem to be experiencing some headwinds. We continue to see deteriorating economic data coming out of the Eurozone. Germany had been stronger; however, recent data is pointing to the country possibly entering into recession. Industrial production and manufacturing orders came in weak, and this concern has pushed the yield on the 10-year German Bund to 0.84 percent.
China is a wildcard as well. Growth has been slowing moderately; however, Thursday evening technology investors were greeted with bad news from a key component supplier. Microchip Semiconductor, a supplier of chips that go into a broad array of consumer, household and industrial products, issued a warning citing weakness in China. The company believes this is a short-term issue, but demand just three months ago was strong. This resulted in a drubbing of the Philadelphia Semiconductor index and caused the industry to be down over 5 percent on Friday. Even though there may be some general hiccups in demand, we continue to play the semiconductor space through specific technologies and applications, primarily in the wireless space.
We don’t anticipate a slowdown here in the states. The U.S. economy should continue to exhibit solid growth and decouple itself from the rest of the globe. The most recent positive development has been the decline in energy prices over the last couple weeks, which will result in a nice increase of discretionary income for U.S. consumers.
When Doves Cry
The Fed released its meeting minutes earlier this week and the capital markets were pleasantly surprised. There had been some concern that the Fed may become more hawkish and looking to tighten. However, contents of the minutes showed the Fed to be focused on the data. They highlighted benign inflation, a strengthening U.S. dollar (which is positive for low inflation) as well as increased risks of a global slowdown due to Europe’s stalling growth. We still believe that the Fed will be looking to raise the funds rate in the second quarter of 2015. Even though inflation remains low, U.S. economic growth will support the beginning of a rate hike cycle.
European Central Bank President Mario Draghi also signaled his dovish intentions for the ECB earlier this week. At a speaking engagement in Washington D.C., he stated that the bank was willing and able to alter its current bond buying program which may eventually move from just asset-backed securities to actual sovereign debt. We believe the ECB will be active in the market and will attempt to push growth higher to fight any possibility of deflation.
Our Takeaways for the Week:
by Jason Norris, CFA
Executive Vice President of Research
Recent weakness in the S&P 500 has led to a lot of chatter regarding the inevitable pullback in equities. While the last few weeks have exhibited some weakness, stocks are still up close to 5 percent, year-to-date. While the United States continues to show improving growth, as seen in recent jobless claims and the Purchasing Managers Index (PMI), global political affairs have wound the markets tight. Russia continues to make noise in the Ukraine while the Middle East is demonstrating that nothing has (nor will) changed for decades. This uncertainty coupled with growth concerns in both China and Europe has led to a rally in bonds as well as a minor sell-off in equities.
The 10-year Treasury now yields just above 2.4 percent, which is the lowest in over a year, as global investors flock to the U.S. dollar and park cash in “risk free” assets. This flow of funds has resulted in weakness in equities. U.S. equities are down close to 4 percent from recent highs which have led to some talking heads focusing on an impending sell-off. However, these 2 to 5 percent pullbacks are normal in bull markets. For instance, over the last 30 months, we have seen nine 2+ percent pullbacks, but the S&P 500 is up over 60 percent in that period. What we continue to watch is improvement in the U.S. economy, growing corporate revenues and reasonable valuation. The current environment is favorable for all of those.
Messin’ with a Hurricane
This week brought the first hurricane to the Hawaiian Islands in 22 years, as well as a “storm of headlines” regarding U.S. companies relocating offshore. The equity market was not too happy with Walgreens’ decision earlier this week not to seek a “tax inversion” with its pending acquisition of Alliance Boots in Switzerland. While domiciling in Switzerland would have saved Walgreens billions of dollars in tax expenses, the company decided stay committed to the state of Illinois. There is speculation that the Obama administration’s use of the bully pulpit was a key factor in management’s decision to continue to pay higher taxes. We believe that an inversion would be more difficult for Walgreens to pull off since most of their revenues are generated in the U.S., thus no offshore cash to repatriate. On the other hand, companies like Abbvie and Medtronic have meaningful amounts of international business, thus their “inversion” acquisitions (Shire and Covidian, respectively) would be easier to justify.
What this recent trend highlights is the need to restructure the U.S. tax code so companies can be more competitive globally. While many of these deals may still be pursued, the tax savings is a key attribute in the overall structure. What can’t get lost in the noise is that although U.S. companies may change their mailing address, they will still bring their offshore cash back to the U.S. and reinvest domestically. With a mid-term election this year, major tax reform may not happen at least until 2015, and possibly not until after the 2016 presidential election.
Too High to Fly
A few weeks ago, the state of Washington started selling recreational marijuana which coincided with the cracking of the high-yield bubble. High-yield bonds have been a strong performer over the last several years; however, like stocks, the month of July hasn’t been friendly to the high-yield market. Spreads have started to increase in the face of lower Treasury yields. This culminated with over $7 billion exiting high-yield funds last week. We don’t believe this is a “canary in the coal mine” with respect to corporate America; however, we are watching it closely. High-yield bonds are trading at historically tight levels, just over 3 percent above Treasury yields, as investors seek income. The long-term average spread has been close to 6 percent higher than Treasuries. Therefore, we would not be surprised if that market continues to show poor performance as we revert back to the mean. While, there are times we may venture into lower rated bonds, we believe that the market as a whole is a bit rich and would wait for spreads to widen further before we allocate additional capital.
Our Takeaways for the Week
