Stuck With You

by Ralph Cole, CFA Executive Vice President of Research

Stuck With You

We all know too much of a good thing is no longer a good thing: that has been the case with interest rates in recent years. Coming out of the financial crisis, banks needed lower interest rates so they could repair their battered balance sheets. Short-term rates came down even faster than long-term rates and allowed banks to pay virtually nothing on deposits and make loans at a substantial profit. As long-term rates have come down, banks have had to lower what they charge for loans, thus reducing their profit margins (otherwise known as net interest margins). For the last couple of years, banks have been hoping for higher rates. Thus far this quarter they have received their wish and we can see that regional bank stock prices have responded well.

Source: FactSet

The correlation between U.S. 10-year Treasury yields and the regional bank index has been remarkable. The theory is that as long-term rates rise banks will be able to charge more for the loans than they make. They will also get higher returns on bond investments that they offer. These improved profit margins will help bank earnings. Much like the relationship between oil and gasoline prices at the pump, banks will be slow to raise interest on deposits and much quicker to increase what they charge on loans. We expect rates to continue to move higher throughout the rest of the year.

Every Little Thing Is Going to be Alright

In a year when the Fed is expected to raise interest rates every piece of economic data is parsed and picked apart. This week it was retail sales and consumer comfort. Retail sales were strong, whereas consumer comfort came in weaker than expected … So let’s just step back for a moment.

Employment gains have resumed their 200,000+ trajectory from 2014. Wage growth is finally starting to flow through the economy. Consumers and corporations continue to benefit from generationally low interest rates. We believe the consumer and the economy are on solid footing and that bodes well for whenever the Fed starts raising rates - be it June, September or December. We caution all not to worry too much about the daily economic numbers or the daily movements in the stock market.

 Takeaways for the week:

• Banks are a beneficiary of higher long-term interest rates
• "Main Street" is finally feeling the positive effects of this economic expansion

Disclosures

Here Comes Santa Claus

by Ralph Cole, CFA Executive Vice President of Research

The Federal Reserve delivered some early Christmas cheer with a new policy statement on Wednesday, and by Thursday afternoon the Dow average had advanced 700 points. Please excuse us for being frustrated by the constant attention to the Fed and the parsing of every statement they utter. This tends to happen during any Fed tightening cycle. The chart below shows the average S&P 500 performance around the last five Fed tightening cycles. As you can see, about six months before the Fed starts raising rates the market goes through a correction of 5–7 percent and volatility rises.

The U.S. economy continues to hum along, and there is no lack of positive economic indicators. We believe that the Fed will be raising short-term interest rates in the middle of next year and they are doing their best to signal that move to the markets well in advance. The most recent examples last week were jobless claims, which dropped to a six-week low, consumer comfort climbing to a seven-year high, leading economic indicators rising an additional .6 percent and retail sales increasing by the most they have in eight months. In short, there is plenty of good economic news to go around, and enough momentum for the Fed to justify raising rates next year.

Wind of Change

While oil prices fell modestly this week, energy stocks began to rally. Since the peak in oil prices in June, the S&P energy sector fell 25 percent. This week oil prices are down another 2 percent, but oil stocks in the S&P were up 7 percent. We can’t say that we are surprised. Whenever you get such a dramatic drop in prices, it tends to produce bargains. Financial buyers aren’t necessarily brave enough to step into these situations, but strategic buyers are. This week Repsol, a Spanish oil company, made an offer to buy Talisman Energy for $12.9 billion. Talisman’s share price was as low as $3.96 on December 8, and now trades for just over $9.00 per share. We made the case last week that the sell-off in oil was overdone, and it appears others are coming to the same conclusion.

Our Takeaways from the Week

• The stock market will continue to experience increased volatility in the coming months as the Fed communicates its tightening plans
• The sell-off in oil stocks is overdone, and there is value in the sector
• Our warmest wishes for a happy holiday season!

Disclosures

The Talking Heads

by Shawn Narancich, CFA Executive Vice President of Research

A good indicator of financial markets adjusting to a slower rate of news flow is the frequency with which the same stories are replayed and debated in the financial press and on television. With retailers now wrapping up second quarter earnings season, Wall Street strategists and commentators have resorted to debating ad nauseum what will happen to short-term interest rates once the Fed ends its program of quantitative easing. Minutes of the latest Fed meeting this week revealed that the Fed will remain data dependent, letting incoming economic reports and anecdotal Beige Book reports tell the story of progress for the economy in general and for the labor markets and inflation in particular.

On the latter topic, policy makers received reassurance this week that inflation is not presently a problem, as headline CPI numbers came in spot-on with the Fed’s 2.0 percent target. Tame inflation indicates that labor markets, absent select areas in energy and manufacturing, still contain the sufficient slack necessary to boost output without spurring a wage spiral. As the old saw says, time will tell. In the meantime, investors seem to be tuning out the chatter as they bid equities to new record highs.

Like Sands Through the Hour Glass. . .

Believe it or not, we’re now halfway through the third quarter and, once again, the error of estimates appears to be on the downside with regard to economic growth forecasts. While this week’s housing statistics were encouraging, with July new housing starts up 16 percent sequentially, a key fly in the ointment was last week’s retail sales report, which came in flat with June numbers and continued a disappointing trend of sequentially slowing retail sales since May. At a time when international headwinds are increasing thanks to Europe teetering just above stall speed and China continuing to undergo a growth-slowing transition away from excessive investment, our forecast for 3 percent GDP growth domestically is starting to feel just a bit optimistic.

Ka-Ching!

As tempting as it might have been to write-off last week’s poor retail sales report as a statistical anomaly when juxtaposed against increasingly positive employment numbers, considerable anecdotal evidence from retailers reporting fiscal second quarter numbers affirms the data. Two key bellwethers of American retailing – Wal-Mart and Target – both reported earnings declines on moribund U.S. sales, and investors have consistently overestimated the companies’ earnings power over the past six months. In addition, Macy’s surprised investors by uncharacteristically missing numbers and lowering sales guidance. Alas, this week brought some better news on the retailing front, with Home Depot reporting strong sales and earnings coupled with a boost to their full year earnings forecast. In contrast to the drubbing that Macy’s took, stock of the home improvement leader broke out to new all-time highs. Similarly, off-price merchandisers T.J. Maxx and Ross Stores both outperformed Wall Street expectations and were accordingly rewarded by investors. With retail earnings reports nearly wrapped up for the quarter, we observe that results are hit and miss, and that investors are best served to take a rifle shot approach to owning specific names advantaged by key trends in retail.

Our Takeaways from the Week

• Stock prices remain resilient despite mixed economic data and geopolitical turmoil globally
• Retailers are book-ending another quarter of better-than-expected earnings in general, though one with more cross-currents below the surface

Disclosures

Should I Stay or Should I Go?

by Jason Norris, CFA Executive Vice President of Research

Should I Stay or Should I Go

This question seems to more prevalent these days as equity markets muddle along and bonds continue to rally. The yield on the 10-year Treasury fell below 2.5 percent this week as investors attempted to seek safety and income. Economic data hasn’t been great, but it hasn’t been bad and we still believe that the “Spring Thaw” will come to fruition and stocks will outperform bonds in 2014.

Best of Both Worlds

As investors increase their exposure to bonds, driving the yield on the 10-year Treasury below 2.5 percent, it leaves us curious as to what is driving this behavior. One culprit may be that U.S. yields are relatively high on a global basis. Global fixed income investors have a lot of markets to consider, but it seems the U.S. continues to be very attractive. Yields in Germany on 10-year government debt are as low as 1.3 percent, where France isn’t much higher at 1.8 percent. There is relatively no income in Japan, with yields under 0.6 percent. Therefore, the U.S. is competing more with Norway (2.6 percent) and even Spain and Italy (both around 3 percent). It is no wonder with global rates so low, that investors are flocking to the U.S. to boost their coupon.

Gettin’ Better?

We received mixed data on the consumer this week. Retail sales came in with a disappointing 0.1 percent monthly gain, with autos being a drag. Walmart disappointed investors as higher gas prices and lower government assistance programs were a drag on spending. Nordstrom, however, exhibited strong growth in their market segments. Jobless claims hit a seven year low on Thursday with initial applications for benefits dropping 24,000 last week to 297,000 this week. Meanwhile, small business sentiment hit a six year high. We believe the U.S. economy is improving after a poor first quarter, primarily due to weather, and we remain bullish on increasing domestic growth. Cisco Systems reiterated this view on their most recent earnings call citing a “very good month [of April]” with the U.S. leading the way in growth.

A New High in Lows

Global hedge fund data was released and for the first time on record (data inception 2003), hedge funds have lost money for three consecutive months while equity markets rose. It seems that a lot of hedge funds have been long on small cap growth and as we’ve seen that trade unwind (rather quickly), they have been slow to follow. Time will tell if this is a short term phenomenon, or a longer term trend. There have been parts of that market that moved into “bubble” territory. Our small cap exposure tilts toward quality and we still believe this area of the market is attractive due to its exposure to the U.S. economy.

Our Takeaways from the Week:

• Investors remain skittish and are seeking safety over risk, but this will be a short-term occurrence
• We believe the U.S. economy will continue to grind higher and will be a stand out for the developed world

 Disclosures