Full Speed Ahead

by Shawn Narancich, CFA Executive Vice President of Research

 Unexpected Returns

Despite serious turmoil in the Middle East and ongoing conflict in eastern Ukraine, blue-chip stocks have pushed to new record highs amid upbeat quarterly earnings and encouraging economic data. As Wall Street frets about why interest rates are so low, investors are also enjoying what has turned into a nice coupon-plus return environment for bonds this year, one that could continue to confound those expecting higher rates. Indeed, the CPI report out this week provides evidence that a 2.1 percent inflation rate may trend lower over the next few months if commodity prices continue to moderate.

Gasoline prices accounted for two-thirds of the June index increase, and with pump prices now on their way back down, consumers should expect to get a break at the pump and investors a break on headline inflation. Just as important, natural gas prices have fallen precipitously in the past month due to better-than-expected storage refills and grain prices falling under the expectation of record harvests this fall. With wage gains remaining muted and investment-grade bond yields at surprisingly low levels in Europe, bond investors expecting materially higher rates could be surprised by a rate environment that stays lower for longer. We see an environment of muted inflation and accelerating U.S. economic gains creating a profitable backdrop for equity investors.

A Jobs Renaissance?

Supporting the notion of improving economic fundamentals was this week’s jobless claims number, which breached the psychologically important 300,000 level to the downside. U.S. claims trickled in at a rate of just 284,000 in the past week, a level investors haven’t witnessed in over eight years. This bullish claims number and the downward trending four-week moving average lend credence to the strong payroll numbers reported in June, while increasing our confidence that July’s report will be another good one.

Holy Chipotle!

As more people find work, consumption spending should increase, but as the results from McDonalds and its former subsidiary Chipotle Mexican Grill showed this week, where consumers choose to spend their new-found incomes can be as different as, well, burgers and burritos. McDonalds disappointed by reporting falling same-store sales, but Chipotle announced a 17.3 percent surge, the likes of which it hasn’t seen since 2006. Store traffic at the Golden Arches has lagged and McDonald’s contends with a lower income demographic for which pricing is always an issue. In contrast, Chipotle’s higher income constituents are more likely to accept occasional menu price hikes as they did in the second quarter, without chasing away customers. Indeed, Chipotle benefitted from a trifecta of good fortune – higher prices, better mix, and more store traffic that collectively produced 24 percent earnings growth. On much better-than-expected sales and earnings, Chipotle’s stock surged 12 percent while McDonalds’ shares fell 1 percent.

With about half of the S&P 500 having reported second quarter results, approximately 75 percent of companies are delivering better-than-expected earnings, and 65 percent are also besting top-line estimates. As a result, earnings projections for the benchmark index that a month ago predicted 4 percent growth for the quarter now stand at 6 percent.

Our Takeaways from the Week

• Despite stiff geopolitical headwinds, U.S. stocks continue to forge new highs
• A majority of companies reporting so far are delivering better than expected second quarter sales and earnings

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

Ascending to New Heights

by Shawn Narancich, CFA Executive Vice President of Research

Ascending to New Heights

Subsiding geopolitical tensions in Eastern Europe, tentative steps by Chinese policymakers to support slowing growth, and more deal-making domestically combined to send U.S. stock prices to new record highs this week. Investors expecting negative revisions to previously reported first quarter GDP numbers were undeterred by the latest numbers that proved surprisingly poor, buying shares of economically sensitive companies poised to benefit from a rebounding economy. The fact that benchmark U.S. equities are now up four percent for the year is less surprising to us than the observation that bonds have nearly kept pace. Until just recently, key fixed income indices were outperforming stocks, prompting no small amount of ink to be spilled by investment analysts attempting to explain why bonds have done so well at a time when economic growth domestically is accelerating.

Skating to Where the Puck Will Be

While somewhat shocking at first glance, the one percent first quarter GDP contraction reported by the U.S. Commerce Department earlier this week paints an unrealistically dour view of the US economy. By now, almost anyone who didn’t hibernate through the unusually cold and snowy winter knows what the inclement weather did to economic activity. We are encouraged by recent strength in reported payrolls, rising U.S. energy production and the health of key manufacturing indices that point to rising domestic investment. With retail activity picking up, we do not foresee inventory investment continuing to detract from GDP in the second quarter, and surprisingly low interest rates may very well end up providing a nice boost to the recently lackluster housing market. All told, we expect a strong rebound domestically, one that could produce upwards of four percent GDP growth in the second quarter.

Food Fight

We anticipated that a faster rate of economic growth, relatively low interest rates and high levels of cash on corporate balance sheets would stimulate merger and acquisition activity this year, and that is certainly what has transpired. Deal-making in the cable, telecom and drug industries that has dominated M&A headlines so far this year gave way to activity in the food aisle this week, as meat processors Tyson and Pilgrim’s Pride now find themselves in a bidding war for Jimmy Dean sausage and cold cut company Hillshire Brands. What started as an attempt by Hillshire to expand its grocery store presence by acquiring Pinnacle Foods (purveyor of Birds Eye frozen vegetables and Log Cabin syrup) has turned the hunter into prey. Pinnacle Foods, which soared 13 percent earlier this month on the Hillshire bid, has now given back almost all of its recent gains on the heels of Pilgrim’s Pride’s $45/share bid for Hillshire Farms. The presumption is that the poultry producer wouldn’t want Pinnacle in the fold, opting instead to vertically integrate with Brazil’s JBS, the 75 percent owner of Pilgrim’s Pride. Complicating matters, chicken and pork processing competitor Tyson entered the fray by offering a superior bid of $50/share for Hillshire.

How this game of chicken concludes is hard to tell, but what the frenzied deal making in the food business demonstrates is the industry’s slow growth and ultra-competitive dynamics. Key players are being incented to combine and eliminate duplicative cost structures, produce more favorable margins by vertically integrating from the meatpacking floor to the cold-cut aisle and dampen the cyclicality inherent in livestock production.

Our Takeaways from the Week

• Contraction in the US economy early this year should give way to stronger growth in the months to come

• M&A activity continues at a heightened pace as key players jockey for better industry positioning

Disclosures