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.”
As investors, it’s important to have a view of the world and what you think the economy is going to do in the coming months and years. This informs all investment decisions from which stocks to purchase to which asset classes to over-or-underweight.
After an unusually long spell of low volatility, stocks and bonds sold off in tandem to end a week that was previously on the quiet side following the Labor Day holiday. Coming into Friday, stocks had essentially earned out the high single-digit returns we foresaw for 2016. Low levels of economic growth globally should renew profit growth in future quarters, but neither stocks nor bonds are cheap at this point.
Someone once told me that the secret to a happy life is low expectations. While a melancholy motto, it aptly captures the mood of the current earnings season. The S&P 500 has rallied from the depths of January, and is now positive for the year - this despite earnings estimates dropping rather precipitously
With change at the economic margin beginning to improve (e.g. recent U.S. payrolls, durable goods orders and manufacturing PMI), investors are beginning to see cyclical elements of the equity market improve. Oil prices are now up year-to-date, energy and industrials are all of a sudden outperforming the broader market, and financials, which so far this year have pulled up the rear, are starting to get a bid.
by Ralph Cole, CFA
Executive Vice President of Research
The global economic expansion continues to run at very different speeds around the world. However, the common thread among most all developed economies has been easy money. Today, China joined the party by lowering interest rates for the first time since 2012. The reasons for lower rates has been stubbornly slow growth, and as long as inflation remains low, central banks can feel confident in their choice to stimulate their economies.
Markets were also buoyed this week by dovish comments out of the European Central Bank. With most European economies mired in little to no growth, and the ECB has embarked on its own version of quantitative easing (QE). Mario Draghi hinted in a speech yesterday that their asset-buying program could expand if necessary. The lack of economic growth in Europe can at least be partially explained by Draghi’s habit of speaking about, rather than actually enacting, central bank policy. In Texas, they would call this “all hat and no cattle”.
Thrift Shop
This week just about wrapped up earnings season for retail companies. Earnings were basically strong across the board for retailers from Dollar Tree and Target to Foot Locker and Best Buy. We believe retailers and consumers are starting to feel the benefits of lower prices at the gas pump. Lower gas prices often coincide with higher consumer confidence numbers, which in turn leads to increased consumer spending.
What makes the retail industry so interesting is the plethora of stores from which shoppers have to choose. I don’t think any of us would argue that we aren’t over-retailed in the U.S. This abundance is one reason we don’t see much inflation. Despite a zero percent interest rate policy and a massive expansion of the Fed’s balance sheet, inflation is not yet finding its way onto store shelves. Competition for the consumer’s discretionary dollar remains fierce. Case in point: the phenomenon of Black Friday sales moving earlier into our Thanksgiving holiday week.
Our Takeaways from the Week
by Shawn Narancich, CFA
Executive Vice President of Research
Up, Down & All Around
Hello, Volatility. After having very little of it for nearly two years, stocks and bonds rode a roller coaster this week on trading volumes that exploded to the upside. Investors were forced to come to grips with how much could have really changed in such a short period of time. In our view, not nearly as much as the markets would imply. But whatever your persuasion on the topic, what we witnessed this week is exceptional. Blue chip stock gains for the year evaporated Wednesday on nearly 12 billion shares traded and benchmark 10-year Treasuries surged on decade high volumes, all in a remarkable flight to quality bid driven by concerns about a weaker Europe teetering on the edge of recession, plummeting oil prices, and concerns about Ebola. That markets promptly reversed themselves mid-week and stocks moved back into positive territory for the year is a testament to what we believe are still solid fundamentals for the U.S. economy. Healthy levels of job growth, slowing inflation aided by lower energy prices, and newly diminished interest rates that should help extend gains in housing activity all argue for domestic economic growth of 3 percent or better in the second half of this year.
Black Gold?
Unusual markets sometimes elicit misleading interpretations, and no shortages of would-be pundits have attempted to explain a 25 percent free-fall in oil prices since the summer solstice. The Wall Street Journal, as much as we read and respect this quality newspaper, did readers a disservice by proclaiming on Wednesday’s front page banner: Global Oil Glut Sends Prices Plunging. What we observe is that developed market inventories of the black stuff now stand below five-year average levels and, despite the International Energy Agency’s recent minor 200,000 barrel/day reduction in expected global demand for this year, the world is still using more oil than it ever has.
Yes, Chinese demand growth has slowed, the U.S. energy boom has added new production to a global oil market, and OPEC member Libya’s exports have risen by about 500,000 barrels/day recently, but all the hub-bub about swing producers Saudi Arabia, Iran, and Iraq (combined export volumes = 15.5 million barrels/day) cutting official selling prices is nothing more than these countries acceding to recently lower prices on stable sales volume. Although oil demand is unquestionably tied to economic growth, which recent developments have called into question, we still see growing demand for oil tied to what we believe will be record levels of economic output globally. The lack of any smoking gun supply surge and evidence that hedge funds have been exceptionally active in trading oil contracts leads us to conclude that the downside in oil has been more about speculation than physical supply and demand. As seasonal refinery maintenance concludes and crude demand rises into winter, we expect oil prices to climb out of their hole in the low $80’s.
And They’re Off. . .!
Third quarter earnings season has begun and results from the 50 or so companies that have reported to date have been relatively encouraging. Banks like JP Morgan and Citigroup are beginning to benefit from rising loan volumes and higher trading volumes in fixed income, currencies, and commodities, while benchmark industrials like GE and Honeywell are demonstrating the ability to navigate a stronger dollar environment without reporting excessive hits to the bottom line. In part because of the industrials’ foreign currency exposure, investor expectations for earnings in this group were muted into earnings season, so decent results are being met with enthusiasm. Next week the floodgates will open wide, as hundreds of additional companies across industries come to the earnings confessional.
Our Takeaways from the Week
by Jason Norris, CFA
Executive Vice President of Research
Seasons
The more things change, the more they stay the same. Five months ago, we rebuked the old Wall Street adage of “sell in May and go away” which, through the end of August, was a good call. From May 1st to Aug 31st, the S&P 500 was up just over 7 percent. However, just like clockwork, the month of September looks to be producing the same results it historically has. Since 1928, September is the only month out of the twelve that has an average negative return. With only a couple of trading days left, it looks like that trend will not be “bucked” this year. Even though there is still time to pull even, the end of the month is usually the weakest (see below).
Source: Renaissance Macro Research
Send for the Man
While this has been a bad week for stocks, it was also not a good week for healthcare mergers and acquisitions. On Monday afternoon, U.S. Treasury Secretary Jack Lew issued some administrative rules making it harder for U.S. companies to start inversion mergers. This type of merger allows a U.S. company to buy a smaller foreign company and relocate offshore to lower tax jurisdictions (see an earlier post for details). Most of these deals are centered in the healthcare space and while these changes will not stop potential inversions, they are designed to make them more difficult. For example, Medtronic is currently in talks to purchase Covidian (based in Ireland) and would use a meaningful amount of offshore cash to finance the deal. With these new rules, Medtronic would not have access to that cash without paying U.S. taxes. Therefore, they will have to look for other financing means, most likely debt, thus slightly increasing the cost. We still believe the deal will be completed, but it does show that the U.S. Treasury is adamant about changing this part of the U.S. tax code. AbbVie and Shire may also be affected; however, the tax benefits are not as meaningful and the gains from the Shire pipeline are significant enough to proceed.
Lesson Learned
Last week was not a good week for Apple. After announcing a record weekend of sales for the iPhone6 and iPhone6+ with over 10 million handsets sold (and this without shipping any to China), any good financial news was eclipsed by issues with the iPhone6+ bending and a botched iOS update. Investors didn’t have patience for the stock during the last few days. We believe that despite these hiccups, this iPhone launch will net over 60 million units this month, and based on pricing and component costs, should be accretive to gross margins.
What we know
by Jason Norris, CFA
Executive Vice President of Research
There were two high profile data breaches this week which highlighted the importance of cyber security, as well as “implied privacy.” Home Depot announced that they had a breach where credit and debit cards used at its stores may have been compromised. Initial speculation was that this may have just happened within the last few weeks; however, some reports indicate the breach may extend back to April of 2014. There were also reports from Goodwill, Dairy Queen and Supervalu that some of their locations may have experienced a data breach. What this shines a light on is the importance of corporate security, as well as vigilant consumers. One potential solution to this problem would be the implementation of “chip and pin” debit/credit cards. Most of the world has already implemented this means of transaction, but the U.S. has not. The main difference between “chip and pin” cards and standard debit cards is, when using a chip card, there is no magnetic strip to swipe. The card is put in a Point of Sale (POS) terminal, the chip is read, and the consumer has to input a PIN number. The security for these transactions is much more reliable. The chip cannot be copied like a magnetic strip can (as we saw in the Target case, and it looks like the Home Depot breach as well.) Visa and MasterCard are big proponents of this technology; however, it has been very slow to roll out in the U.S. The Netherlands company NXP Semiconductor is a key player in the technology for these cards.
The distribution of several celebrities’ nude pictures this week has also highlighted the importance of personal cyber security. Over the weekend, more than 100 personal iCloud accounts were hacked and private photos were leaked to the media, with several prominent actresses being victimized. Apparently, this was a case of hackers easily decoding individuals’ passwords. While this action is not condoned, individuals have to remember that any material that is stored in the cloud runs the risk of being compromised.
Less Than Zero
The European Central Bank continued to take rates lower this week by reducing its deposit rate to -0.2 percent from -0.1 percent. You are reading that correctly, that is a negative number. This seems to be more symbolic, rather than having much of an impact on the market. The market impact decision came in the same announcement that the ECB will increase its purchase of ABS (Asset-Backed Securities). This is very similar to what the U.S. Fed had been doing with its purchase of mortgage-backed securities. The key item missing is that the ECB did not announce a plan to purchase sovereign debt. The ECB is hoping banks will sell their ABS to them and in its place, make loans. Europe continues to sputter out of recession with expectations of GDP growth and inflation below 1 percent. This move by the ECB showed the market that it is willing to support European economies, although one has to wonder if they have enough power to do so.
Why Worry
The employment report this morning was a disappointment with the U.S. only adding 142,000 jobs in the month of August; expectations were for over 200,000. Ferguson Wellman believes this data will eventually be revised upward. The economic data the last few months has been very robust and is not consistent with this weak jobs number. Therefore, we aren’t concerned about the number unless other economic data starts to signal a slowdown.
Gameday
With the Seattle Seahawks opening game win Thursday, it reminds us of the Super Bowl stock market prediction. Some may recall when we highlighted the belief that if the Seattle Seahawks won the Super Bowl this year it would foretell a positive year to the market. So far so good with a 9 percent+ gain in the S&P 500 to date. Even with this strong run, we believe that earnings growth and low inflation will continue to be tailwinds for equities, pushing them higher to year-end.
Our Takeaways for the Week
by Ralph Cole, CFA
Executive Vice President of Research
Stronger The U.S. economy was indeed stronger than first reported in the second quarter as estimates were revised higher this week when the commerce department reported that the U.S. economy grew 4.2 percent during the quarter. This pace fits with our narrative that the U.S. economy is truly getting healthier, particularly in the aftermath of a very harsh winter.
In fact, there was a lot to like about most of the economic reports this week. For example, durable goods orders grew 22 percent, led by airplanes; unemployment claims came in again under the 300,000 mark - yet another example of vitality in the labor markets; auto sales for the month of July were robust at over a 16 million annual rate of sales. In summary, current economic statistics suggest a sustainable expansion with moderate inflation.
Witchcraft Black magic may be the only explanation for ultra-low interest rates in the face of sound economic numbers. Our industry heuristic states that strong economic growth ultimately must translate into higher interest rates. Not so fast my friend. While the U.S. economy is growing quite nicely, Europe is suffering from falling growth rates, and plunging inflation which has contributed to record lows in interest rates throughout the Eurozone. For example, Germany’s 10-year bund fell to a .88 percent yield while 10-year debt yields touched 1.24 percent in France and hit a 2.22 percent in Italy. With European Central Bank chief Mario Draghi’s most recent speech in Jackson Hole last week, he essentially took perceived credit risk off the table for the Eurozone. With a compelling endorsement of U.S. style quantitative easing on the horizon, investors clearly are (for the time being) comfortable holding European debt.
Lower rates throughout the Eurozone have effectively put a bid under U.S. bonds. In the global market for debt, savers view U.S. debt as a good deal at these levels and continue to buy. Studies estimate that the downward pressure on U.S. rates from lower European rates is anywhere from 20–30 basis points. As you can see from the chart below, U.S. 10-year yields are at their outer-bounds relative to the yield on the 10-year German bund.
Our Takeaways for the Week
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
by Ralph Cole, CFA
Executive Vice President of Research
Although this time of year is often described as the summer doldrums, that certainly was not the case this week. Earnings, the Fed and economic data dominated the tape … and made for interesting market activity.
All Along the Watchtower
Fed-watching during a time of taper is an essential part of managing money these days. The Federal Open Market Committee (FOMC) announced on Wednesday that they would continue to taper their purchases of Treasuries and mortgage-backed securities by an additional $5 billion each this month. The Fed continues on pace to stop all security purchases by October. While they made mention that there is still slack in the labor market, the Fed must be comforted by the consistency of job growth in 2014. The U.S. has added an average of 230,000 jobs per month this year versus 194,000 per month in 2013. Commentary after their two-day meeting continues to signal that they are on pace to begin raising rates in the middle of 2015.
Too Hot?
The Bureau of Economic Analysis reported that U.S. GDP grew 4 percent during the second quarter. This robust growth and some of the comments by the Fed may have spooked investors this week into thinking that the Fed will raise rates sooner than expected. We believe this was more of an excuse for a sell off rather than a good reason for selling stocks. There will be volatility in the stock market as we move into next year and the Fed communicates their outlook. In the end, we believe that they will be raising rates for the right reasons … the economy is getting better and extraordinary stimulus is no longer needed.
Upside Down
Earnings season is always one of the more volatile times of the quarter. While earnings have come in very strong (7.7 percent growth up to this point), seemingly minor misses are punished unmercilessly. The healthcare sector has provided the biggest positive surprise for the quarter. Thus far, healthcare companies have reported 14.8 percent growth. On the other end of the spectrum, consumer discretionary companies have only reported 2.9 percent earnings growth.
Our Takeaways for the Week
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
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
by Ralph Cole, CFA
Executive Vice President of Research
A Little Less Conversation, a Little More Action
The European Central Bank (ECB) finally stopped jawboning the markets this week and put into place additional policies to get the European economy moving forward. Slow growth and disinflation continue to loom over the EU and spurred the ECB to take aggressive actions.
Specifically, the ECB announced the following policy actions1; they are:
1) Lowering the Eurosystem refinancing rate to .15 percent 2) Lowering the interest rate on the marginal lending facility to .40 percent 3) Lowering the deposit facility rate to negative 10 basis points (you have to pay the ECB 10 basis points to hold your money if you are a bank) 4) They have outlined a new $400 billion long-term refinancing operation (LTRO) to aid bank lending
The ECB stopped short of QE but did not rule out the idea in the future. The central bank is hoping to stimulate bank lending which in turn should promote growth throughout the region. The EU is anticipating that some of this growth comes from a weakening Euro. A weaker currency would encourage tourism and make EU products cheaper abroad.
Working for the Weekend
We would be remiss if we didn’t at least mention the monthly jobs report that comes out the first Friday of the month. We have pointed out to readers that it is probably the most important report for understanding the durability of the recovery and the mood of the American consumer.
At this point in the cycle, we are also starting to look at the monthly jobs report for an additional source of insight about inflation. Wage inflation is a precursor to overall inflation in the economy. Wages in the U.S. have started to rise, albeit slowly. For the month of May average hourly earnings increased 2.4 percent year-over-year. While that is not a level that we would deem inflationary, wages in certain sectors are accelerating.
Takeaways for the Week
1Source: Barron’s
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
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
