Misled by the Fed?

by Brad Houle, CFA Senior Vice President

In a surprising announcement on Wednesday, Federal Reserve Chairman Ben Bernanke said that the Fed will not be tapering bond purchases this month. He indicated that the $85 billion per month of bond purchases by the Fed in an attempt to stimulate the economy will continue until further notice. Financial markets have been in a tizzy about the tapering of bond purchases since May when the Fed Chairman first suggested that the pace of purchasing would decline. Interest rates climbed following this announcement, which impacted rate sensitive stocks, emerging markets and mortgage refinancing activity.

The Fed was most likely displeased with the increase in interest rates that accompanied the first indication of tapering. To counteract the rise in rates the Fed decided not to taper purchases to drive rates back down. Treasury rates had increased about 1 percent from May to the recent peak. Mortgage rates also climbed a similar amount from 3.5 percent for a 30 year fixed rate mortgage to about 4.5 percent today. This change dramatically slowed mortgage refinancing activity and caused a slowing in the velocity of the housing recovery. As a result of the slowing in refinancing activity, in some cases the banking industry has begun laying off employees involved in mortgage refinancing. Purchase mortgage applications have dropped off dramatically since the initial May announcement.

In actuality, nothing has really changed relative to Fed strategy. Bernanke said, “If the data confirms our basic outlook” for growth and the labor market, “then we could begin later this year.”  There are only two more Fed meetings in 2013, one on October 29^th and one on December 17^th. In all likelihood, the tapering announcement will probably come at the December meeting unless there is a dramatic tick downward in economic data.

It has long been our assertion that the Fed will begin tapering for the right reasons. Looking past the wiggles in monthly economic data, the economy is improving. Employment is making gains, however lumpy the job creation might be. Capacity utilization has rebounded nicely and is moving in the right direction without being inflationary. Also, consumer confidence and auto sales have been strong.

We continue to believe that the economy will be stronger in the second half of this year and the recovery is intact.

Takeaways:

• A rare surprise announcement by the Bernanke Fed is really not a shift in Fed policy
• The brewing debt ceiling battle is shaping up to be contentious and will inject volatility into the markets. This topic will most likely dominate financial news for the next two weeks

Disclosures

Long Strange Trip

by Jason Norris, CFA Senior Vice President of Research

Bucking the normal “sell in September” mantra, stocks have rallied over 3% since the beginning of the month; specifically, the emerging markets. We entered the year bullish on the emerging market economies, thus overweight in our allocation. However, due to increasing inflation and reductions in growth forecasts, the emerging markets were down for the first eight months of the year. We have been seeing some signs of stabilization as economic data remains healthy, specifically in China. Emerging markets will now comprise over 50% of global GDP. This has resulted in a 10% move in the last two weeks. We still remain overweight and believe that the growth dynamics in these markets (both emerging and frontier¹) offer investors a great long-term opportunity.

Come Bite the Apple?

Apple announced their new iPhone earlier this week; however, investors greeted it with little fanfare. The new iPhone 5S will have fingerprint authentication and a distinctly faster processor. The 5C release, which was intended to be a lower-end phone for emerging markets has disappointed, specifically on the price point. At $550, we believe this will be too high to drive market share gains in emerging markets, which is key for Apple revenue growth. It seems that the company would rather sacrifice market share for margins, and we will see if this strategy works. Unfortunately, the wireless handset marketplace can change rapidly. A decade ago, Blackberry owned the enterprise market and Nokia owned the consumer space.

Money for Nothing

The bond market continues to welcome any issuance with yield. Earlier this week Verizon issued just under $50 billion in debt to fund its $130 billion purchase of Vodafone’s share of Verizon Wireless. This eclipses Apple’s $17 billion deal earlier this year. While their cost of debt increased due to the deal, investors ate it up and those spreads (yields above treasuries) have since declined significantly.

From Russia with Love

Earlier this week, Vladimir Putin engineered a “potential” deal with Syria to ward off a U.S. strike. Only time will tell if Syria turns over its chemical weapons to a third party; however, equity markets breathed a sigh of relief. While the humanitarian situation in Syria remains grave, investors continue to be concerned about what the effect of a strike would have on consumer confidence and gasoline prices. This concern looks to have been pushed back for now.

Our Takeaways from the Week:

• Emerging markets still offer a long-term opportunity for equity investors

• We will be deluged in the financial press for months discussing the Twitter IPO filing

¹See our blog posting from August 23, titled “Secular Vs. Cyclical,” for more details on emerging and frontier markets.

 Disclosures

Cole Quoted in Portland Business Journal

September 10, 2013 The Portland Business Journal

By Matthew Kish

Why Nike Being Added to the Dow Matters

Washington County footwear giant Nike is the newest addition to the Dow Jones Industrial Average, the most widely-followed benchmark of the health of the stock market and U.S. economy.

The index includes 30 of the country's biggest blue-chip companies.

"It’s an honor to Nike," said Ralph Cole, senior vice president of research at Portland-based Ferguson Wellman Capital Management.

Goldman Sachs and Visa also will be added. Alcoa, Hewlett-Packard and Bank of America will be dropped.

"There's definitely a prestige factor and a sense that Nike is a large enough, stable enough company that it represents the overall economy and the market," said Sara Hasan, an analyst with McAdams Wright Ragen in Seattle who follows Nike.

As expected, Nike's stock (NYSE: NKE) climbed on the news. Many mutual funds buy the stocks of the companies in the Dow. It was up nearly 2 percent to $66.55 in mid-day trading.

"It generates a little buying power initially as the index needs to rebalance," said Blake Howells, vice president at Portland-based Becker Capital Management Inc. "But longer term the driver of stock prices is fundamentals."

The stock's average trading volume also will likely go up, which could lead to increased volatility.

"(The companies in the Dow) are the vehicles that hedge funds and even retail investors use to get in and out of the market quickly," Cole said.

Ferguson Wellman Capital Management Recognized at Corporate Philanthropy Awards

PORTLAND, Ore. – September 11, 2013 – Ferguson Wellman Capital Management is pleased to announce that the firm has been named by the Portland Business Journal as one of the city’s leaders in corporate philanthropy. Specifically, the Portland Business Journal named Ferguson Wellman Capital Management fifth in the medium sized companies category at their annual Corporate Philanthropy Awards luncheon. The rankings were based upon the total number of dollars donated to nonprofits. Although the Journal did not include the number of hours Ferguson Wellman employees donate every year, the number is an impressive 4,500 hours amongst 39 employees.

“This is an honor and recognition shared by everyone in our firm. It is gratifying to join other like-minded companies that make this city a better place to live and raise a family,” said Jim Rudd, Chief Executive Officer and Principal.

Let's Talk Taper

by Marc Fovinci, CFAPrincipal

 “Ho-Hum” Employment

 All eyes were on the employment report this morning. This morning’s report is the last employment report before the next Federal Reserve meeting on September 17 and 18, and of all the economic statistics, the Fed leans most heavily on the employment report to gauge how well the economy is doing.

Today’s report showed that nonfarm payrolls increased by 169,000 in August and the unemployment rate dropped from 7.4 to 7.3 percent. Although a solid report, it only keeps pace with current “ho-hum” trends. The payrolls report underachieved what the market expected, but the unemployment rate was better than expected. Unfortunately, the good news of unemployment rate was clouded by a lower rate of workforce participation.

The “ho-hum” report does not remove the uncertainty over what the Fed will do at its meeting this month. The report was not conclusively strong enough to make a tapering of Fed stimulus a foregone conclusion. If we were a fly on the meeting room wall, we would certainly expect to witness a vigorous debate over whether to taper or not.

Currently, the Fed is adding $85 billion into the financial system each month through the purchase of securities. In June, Federal Reserve Chairman Ben Bernanke laid out a timetable for reducing the rate of these purchases, leading the market to expect the reductions to start after this September meeting. While a reduction in the size of the purchases is not a tightening of monetary policy, it is a reduction in the rate of stimulus and a new direction for the Fed.

We, along with many investors, expect a “taper-lite” to be announced. A light tapering would be a reduction in monthly purchases by $10 billion, moving from $85 billion to $75 billion per month. With Bernanke’s June timetable and the economy continuing on its trend, it seems appropriate to reduce stimulus by a relatively minor amount.

The markets seem to have already moved in anticipation of a “taper-lite,” so we would expect fairly limited market movement on the announcement: stocks have little reaction and bonds experience a minor sell-off.

The Fed Speaks

On Wednesday, three members of the Ferguson Wellman investment team had the opportunity to hear John Williams, president and chief executive officer of the Federal Reserve Bank of San Francisco, speak in Portland. Fed governor speeches tend to be well-scripted and are usually intended to clarify and explain current Fed policy, not to break new ground on policy and trends. Here are a few of President Williams’ major points regarding the Fed:

• They consider “forward guidance” a very important policy tool. “Forward guidance” is communication of what the Fed thinks policy is likely to be in the future
• They expect to keep the federal funds rate near zero until (1) unemployment drops to 6.5 percent or below, (2) they forecast near-term inflation to 2.5 percent or above, or (3) investor inflation expectations move measurably higher. His expectation was that the Fed would maintain its zero percent interest rate policy into 2015
• They expect to halt their monthly purchases (complete tapering) sometime in the middle half of next year, when they expect the unemployment rate to be about seven percent
• Tapering is not tightening. It is still adding stimulus but at a slower rate
• He emphasized on multiple occasions that Fed actions are very dependent on how well the economy performs in the future. All actions are data dependent

Our Takeaways from the Week

• The economy continues to deliver “ho-hum” performance
• Expect the Fed to announce a “taper-lite” on September 18, reducing monthly purchases by $10 billion
• Having largely discounted the event, markets should not have a large reaction to this announcement

Disclosures

A Change of Tenor

by Shawn Narancich, CFA Senior Vice President of Research

Dog Days of Summer

Change at the margin is key to the direction of stock prices, so with the month of August producing its fair share of downside catalysts, investors are left to ponder whether or not a 4 to 5 percent pullback in blue chip stocks has run its course. Weak earnings reports from benchmark retailers Target, Macy’s, and Wal-Mart, heightened geo-political risks in the Middle East, rising U.S. interest rates, and discouraging economic developments in key emerging market countries serve to remind equity owners that a good bull market is never far from a correction. With the Fed now on the cusp of paring back its program of Quantitative Easing (QE) in a month of September that historically hasn’t been so kind to investors, stock prices could experience some additional downside.

Stagflation

It’s an ugly word for investors, and one that is suddenly being used to describe the economies of several key emerging market countries where inflation is rising and economic growth is slowing. In a world of cause and effect, we see an anticipated slowing of U.S. QE producing weaker emerging market currencies (i.e. Indian rupee down 20 percent since May), which in turn threaten higher levels of inflation, as resource dependent countries like India, South Africa, and Indonesia pay more for oil and other U.S. dollar-denominated imports. Compared to developed market economies like the U.S. and Japan, commodity costs are a bigger portion of consumer spending, and thus put the onus on emerging market central banks to raise rates in an effort to quell inflation.

Investors witnessed this phenomenon again this week, when both Brazil and Indonesia raised their benchmark interest rates by half a percentage point, in continuation of a trend toward tighter monetary policy in emerging markets. The objective here is to contract the money supply and produce higher currency values, while at the same time attracting additional investor capital seeking higher interest rates. While higher interest rates tend to reduce economic activity in the short-term, depressed currency values provide a built-in shock absorber for economies because their exports become more attractive to foreign buyers. In a challenging environment for emerging market economies, the stocks have been notable underperformers year-to-date. That said, we continue to favor emerging market equity exposure for these countries’ faster long-term rates of growth that stem from faster population growth and an ascendant middle class consumer.

Taper Light

Anecdotal evidence of weaker retail sales, slower order rates for interest-sensitive capital goods, and below-target levels of inflation serve as the backdrop for next week’s payroll report, the last one before the Fed’s next meeting on September 17^th. Consensus believes the Fed will announce a $10 to 20 billion per month reduction in its $85 billion per month QE program, but with housing activity starting to slow because of higher mortgage rates and consumer spending threatened by the tax of higher oil prices, we believe the Fed’s error of action is to taper less rather than more.

Our Takeaways from the Week

• The near-term tenor of equity markets has deteriorated amid higher interest rates, Middle East turmoil, and emerging market turbulence; nevertheless, we continue to favor equities for their longer-term growth potential

• Ahead of Labor Day, we wish our clients and friends a safe and enjoyable holiday

Disclosures

Secular Vs. Cyclical

by Ralph Cole, CFA Senior Vice President of Research

Our days in the investment management world are spent balancing the benefits of short-term risks, against what we believe to be long-term themes or opportunities. In other words, very favorable long-term (“secular”) investment paradigms are interrupted by transitory (“cyclical”) factors. For example, we believe that over the long-term, stocks will outperform bonds, but there are times when stocks are over-priced and/or the economy lapses into a recession. During these instances, we want to own comparatively more bonds because they would most certainly outperform equities during the inevitable correction.

Those same forces are occurring in the international markets today. While in the near-term we are seeing a rebound in Europe and possibly Japan, the emerging markets continue to lag. Though they face cyclical headwinds in the near-term, we continue to believe that emerging markets offer better growth opportunities over the long-term for equity investors.

India is a perfect example of an emerging market that is facing cyclical headwinds versus positive secular demographics. India is currently experiencing high inflation, a tumbling currency, and a slowing economy. However, over the next 25 years, the working age population in India is set to grow by over 245 million, more than the current working age population in the U.S.* As such, we believe India represents a compelling long-term investment opportunity.

What Is the Difference Between Emerging Markets and Frontier Markets?

For investment purposes, the emerging markets universe is dominated by the “BRIC” countries. Specifically, Brazil, Russia, India and China are large, growing countries that still do not have deep enough capital markets, or refined enough judicial and regulatory systems, to be considered developed. MSCI specifies 17 additional countries with that designation. You can find the complete list by clicking here.

Frontier markets are smaller countries, with even less developed capital markets. Countries such as Argentina, Croatia, Kenya, Saudi Arabia and Vietnam are examples of frontier markets. The complete list can be found by clicking here.

As of late, there has been a dramatic contrast in the fortunes of these two categories as year-to-date, frontier markets are up some 19 percent, while emerging markets are down 10 percent. For investors interested in accessing frontier markets, we advise utilizing a pooled vehicle (mutual fund or ETF), rather than attempting to purchase individual stocks in these countries.

Takeaways for the Week:

• Though facing some cyclical head winds, we continue to favor both emerging markets and frontier markets over the long-term in client portfolios

• While not mentioned above, we think the back-up in rates has gotten ahead of itself and bond yields as defined by the 10-year treasury should remain in a 2.50 percent to 3.00 percent trading range in the coming months   

* Source: Merrill Lynch

Disclosures

Summertime Blues

by Jason Norris, CFA
Senior Vice President of Research

As we move into the dog days of August, both equity and bond markets have experienced some seasonal weakness due to Fed taper fears and some weaker-than-expected earnings reports. Historically, August and September are relatively poor months for equities and with concerns about the Fed taking its foot off of the liquidity gas, equities may take a breather. That said, we believe there is a 50/50 chance the Fed will begin to taper their bond buying at the September meeting, but this will be contingent on economic data for the next month.

Superunknown

Retailers delivered mixed results this week with disappointing reports from Macys and Wal-Mart. In both instances the retailers were able to maintain pricing, but volumes were weak. In short, consumers are going to the stores, but they are being more selective in their purchases.  Macy’s did state that August back-to-school shopping showed a nice pick up. We have seen some positive recent data with weekly jobless claims continuing to make post-recession lows and consumer confidence has been in an upward trend since mid-April. While these data points are positive, we realize that they are modest and may stagnate. Though the U.S. economy is improving and we are seeing improvements in northern Europe; however, as Cisco CEO John Chambers stated earlier this week, the recovery is “inconsistent.”

Highway Star

With consumers purchasing less, we are seeing a deleveraging of their personal balance sheets. Mortgage debt declined meaningfully as consumers refinanced at lower rates. Credit card debt remained stable, but auto loans saw a nice increase. While mortgage and credit card debt are meaningfully below their pre-recession peaks, auto loan is back to peak levels. We believe that with relatively low interest rates and an aged auto fleet, consumers will continue to upgrade their auto purchases. The average car in the U.S. is now 11.2 years old while in 1995 it was 8.4 years old. For the time being, rising interest rates won’t have a negative effect on auto loans since these loans are based on Prime, and until the Fed begins to raise the funds rate, prime will remain low.

Schools Out

Unfortunately, the deleveraging theme is not occurring for young college graduates as student loan debt reached the $1.0 trillion mark and shows no signs of declining. While one can debate if the loans are “worth it,” the load of debt post-graduation will impair spending. We are already seeing red flags in this market with delinquency rates meaningfully above historic levels. Over 30 percent of student loan borrowers are at least 90-days delinquent compared to 10 years ago when less than 20 percent were. There are now concerns that recent graduates may be less likely to start a small business due to their debt burden. Unlike the mortgage and credit crises of 2007 and 2008 which had a devastating effect on the banking sector, the Federal government (or U.S. taxpayer) back the student loans.

Our Takeaways from the Week:

• Though equities are in the midst of a pullback, we believe stocks will be higher by year-end
• Economic data continues to show improvement, but the pace remains tepid

 Disclosures

Ferguson Wellman Honored by Willamette Falls Hospital

PORTLAND, Ore. – August 15, 2013– Ferguson Wellman Capital Management was recognized by the Dr. John McLoughlin Heritage Society of the Providence Willamette Falls Hospital Foundation for years of philanthropic giving. 

Ferguson Wellman was given the award at the annual “Friends of Dr. John” reception where they thanked their largest donors. Ferguson Wellman has supported the mission of Dr. John and the Willamette Falls Hospital Foundation by acting as sponsors of the event for over four years. The foundation raises funds to benefit the health and wellbeing of the community and is located in Oregon City.

Founded in 1975, Ferguson Wellman Capital Management is a privately owned investment advisory firm, established in the Pacific Northwest. With more than 600 clients, the firm manages $3.4 billion in assets that comprise union and corporate retirement plans; endowments and foundations; and individuals. Minimum account size: $2 million. (as of 6/30/13) 

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Ferguson Wellman Capital Management Makes Forbes Magazine's Top 50 Wealth Managers List

Ferguson Wellman Capital Management is pleased to announce that the firm has been named by Forbes Magazine as a top investment company. Specifically, Forbes named Ferguson Wellman Capital Management 40th in the “RIA Giants” category of the Top Fifty Wealth Managers list. The data for the rankings is provided by RIA Database and is based on the total discretionary assets under management.

“While it is always gratifying to be ranked highly among your peers – what is most meaningful to us is earning the trust and confidence of our clients.  We work hard at doing that every day,” said Jim Rudd, chief executive officer.

Methodology RIA Database compiled the Top Advisor lists using data as reported March 31, 2013. The Top Advisor list ranked RIAs (registered investment advisors) based on total assets under management. The Growth list ranked RIAs (registered investment advisors) based on their growth in total assets under management as reported March 31, 2011 through March 31, 2013.  The Emerging Advisors list ranked RIAs (registered investment advisors) under $500 million in total assets under management based on growth in total assets under management as reported March 31, 2011 through March 31, 2013. Advisors qualified based on quantitative and qualitative factors. RIAs (registered investment advisors) qualified for the list if at least 50% of their clients include high net worth and/or non-high net worth individuals and conduct wealth management services including portfolio management services, asset allocation, manager selection and/or financial planning services.  Firms that were dually registered with FINRA as a broker/dealer and firms where their primary business includes managing hedge funds or mutual funds were excluded. Firms affiliated with banks or broker/dealers were included. Firms with no or unreported assets under management as of March 31, 2011 were excluded from the lists.

Motor City Meltdown

by Brad Houle, CFA Senior Vice President

On June 6, the city of Detroit declared Chapter 9 bankruptcy, which is the largest municipal bankruptcy in U.S. history. Detroit has an estimated $18 to $20 billion in debt and over 100,000 creditors. The city has suffered a long, slow decline over the past few decades as the U.S. auto industry has withered. According to the U.S. Census 2010 findings, the population base in Detroit has declined 60 percent from 1960 to 2010. Moody’s Corporation has reported that Detroit’s general fund revenues have declined 25 percent since 2007  As the population has declined the city has struggled to provide city services due to their shrinking tax base.

Municipal bond investors are among the creditors who have effectively loaned money to the city of Detroit for operating expenses as well as capital improvements. How bondholders are treated in this bankruptcy is being carefully monitored by municipal bond investors. Part of Detroit’s debt is general obligation municipal bonds that are theoretically backed by the city’s taxing authority. In question is the value to be recovered by these bondholders who theoretically bought bonds with the assumption that they were backed by the city’s full taxing authority. In addition to debt holders, there are pension recipients that are also in the mix of creditors. Detroit also has an unfunded pension liability that is between $3 and $3.5 billion, depending upon the assumptions used in the calculations.

Unfortunately, it looks as if the bankruptcy process is going to pit the bondholders against the pension recipients and the taxpayers to see who will bear the burden. How the remaining value is going to be divided is an open question at this point. Federal bankruptcy law treats each creditor equally while Michigan has strong protections in place for public employee pensions in the event of a bankruptcy.

Detroit is an extreme example of a municipality in financial distress. While there are other cities that are facing financial challenges, such as Chicago, the probability of default is fairly low. Chicago still has a dynamic economy, a recovering real estate market and a more stable population. Detroit had no other options other than bankruptcy due to an extraordinary drop in population impacted by a revolutionary change in the auto industry. This population decline coupled with corresponding erosion in the economic base created a downward spiral that Detroit could not reverse, which may impact bondholder’s recovery potential.

While the Detroit bankruptcy has made headlines and has caused bond investors to reconsider how cities with similar problems are evaluated; historically, municipal bonds have been a safe investment. According to Moody’s, the default rate on rated bonds has been .012 percent for the 40-plus years of data available. Looking at it differently, of the greater than 1 million municipal bond issues outstanding, only 71 have defaulted since 1970.

Moody's Rated Municipal Issuer   Defaults 1970-2011
Type of Bond		Defaults	Percentage
Housing		29	40.80%
Hospitals		22	31.00%
Education		3	4.20%
Infrastructure		4	5.60%
Utilities		2	2.80%
Cities		2	2.80%
Counties		1	1.40%
Special Districts		1	1.40%
Water & Sewer		1	1.40%
State Governments		1	1.40%
Non-General Obligation		66	93.00%
General Obligation		5	7.00%
Total		71

Our Takeaways from the Week:

• The situation in Detroit is an extreme example of a city in financial distress.
• Municipal bonds historically had very low default rates and are an important component of many investors’ portfolios.

Source: Moody's Corporation

Disclosures

Amid Dry Holes, Positive Change at the Margin

by Shawn Narancich, CFA Senior Vice President of Research

Revisionist History

Amid hundreds of quarterly earnings reports daily, investors were challenged to stay on top of a slew of important economic data hitting the tape this week. While always old data by the time the report sees daylight, GDP for the U.S. economy remains an important benchmark for investors and the Fed, and the 1.7 percent growth rate came in substantially above where we thought it would for Q2. Underlying detail reveals that consumer spending continues to support growth, with housing construction and a reduced drag from government spending also helping boost numbers. That U.S. businesses had sufficient confidence to build inventories in the quarter (thus also adding to reported GDP growth) is a good sign. Comprehensive revisions from the Commerce Department, dating back to 1929, showed that GDP growth was better than expected last year at 2.8 percent, with the Great Recession also being less severe than previously advertised.

Bullish confirmation came from another number that isn’t subject to ex post facto revisions – the survey of U.S. purchasing managers. That number skyrocketed to 55.4 in July, meaningfully above the growth/contraction dividing line of 50, and the strongest reading for U.S. manufacturing in nearly two years. Coupled with better than expected manufacturing indicators in China, the news helped to confirm stocks’ recent gains and was a catalyst to push both the Dow Industrials and benchmark S&P 500 Index above the 1700 level. With blue chip U.S. stocks up about 20 percent for the year, the question now is whether the economy can attain the higher rate of growth investors increasingly expect in the back half of 2013.

Help Wanted?

Friday’s monthly payroll report completed the week’s troika of important economic indicators, and the fact that a net jobs gain of 162,000 disappointed expectations met with a yawn by investors. After all, what’s sustaining the Fed’s quantitative easing program and well contained labor costs is a jobs market that remains slow to expand, keeping pressure off employers to raise wages and pushing corporate profit margins to record levels. Second quarter earnings reports have confirmed the bottom line benefits which, when combined with share buybacks and acquisitions, promise to deliver 6-8 percent profit gains for the full year.

Dry Holes

This week, it was Big Oil’s turn at the earnings confessional, and unfortunately for them, the congregation of investors was in no mood for penance. One after the next – first British Petroleum, then Royal Dutch Shell and Exxon Mobil, and finally Chevron – delivered what we judge to be Big Oil’s worst collective set of numbers in recent memory. In Royal Dutch’s case, this Netherlands-based integrated oil company continues to be confounded by pipeline sabotage in Nigeria, a production mix weighted toward natural gas, and failure to gain traction in the booming U.S. shale plays. The stock rightfully got hammered, off almost 6 percent on the discouraging report. Aside from company-specific issues with Royal Dutch, the common denominator for the four Super-Majors was poor refining results. Contraction in refining margins was most pronounced domestically, where the rising cost of benchmark West Texas Intermediate (WTI) crude pinched margins relative to the price of gasoline, diesel, and jet fuel production. As takeaway capacity has increased from key producing basins in North Dakota, West Texas, and Canada, the anomalous discount of WTI to Brent has disappeared, and with it, the outsized profits that mid-continent refiners once enjoyed. Remarkably, all four companies missed consensus earnings forecasts and all four experienced downdrafts in their stock prices afterward.

Our Takeaways from the Week

• An important week of economic news flow was encouraging overall, and stocks responded by trading to new highs
• Big Oil was an exception to what has generally been a decent second quarter earnings season

Disclosures

Ayotte Promoted to Senior Vice President

Ferguson Wellman Capital Management is pleased to announce that Nathan Ayotte, CFP® , has accepted an invitation from the board of directors to purchase additional shares in the firm. In this process, he was also promoted to Senior Vice President.

“When Nathan joined us, he brought experience in business management, as well as proven skills in wealth management and client service,” says Steve Holwerda, CFA, principal and chief operating officer. “Both our clients and our firm have benefitted from his contributions over the past five years.”

Ayotte joined the firm in 2008 and is a member of the investment team and wealth management committee. He has helped develop wealth management resources for clients and has been involved with the creation of Ferguson Wellman’s new division, West Bearing Investments. Ayotte is also the firm’s first Certified Financial Planner^®.

Ayotte is a member of both the Chartered Financial Analysts Society and the Financial Planning Association of Portland. He currently serves as a board member of Doernbecher Children's Hospital Foundation at Oregon Health & Science University and as a board member of the Ainsworth Foundation.

It's Earnings Season: Industrials and Tech Gain Traction

by Shawn Narancich, CFA Senior Vice President of Research

Earnings Central

Economic news was light this week, and what there was took a back seat to earnings. As we approach the midway point of second quarter earnings season, investors who were late to the equity party and were looking for cheaper admission remain confounded by a market characterized by a strong underlying bid. On balance, second quarter earnings have been positive so far, with most companies avoiding disastrous misses and again eking out profit gains through good cost control, share buybacks and modest underlying growth. That the U.S. stock market has become a consensus favorite despite sub-2 percent economic growth for the past three quarters is a testament to highly accommodative monetary policy and themes like the renaissance of U.S. energy production and the rebound in housing, both of which promise to deliver better GDP numbers in the second half of this year.

Shock and Awe

What strikes us most about the numbers so far are the trends by sector. While about two-thirds of companies are delivering earnings above estimates and half of those are generating better than expected revenue, the industrial and technology sectors are reporting the best numbers relative to expectations. That blue chips industrials like General Electric, Honeywell and United Technology are clearing the earnings bar is less surprising than the numbers delivered by defense companies, which Wall Street had widely expected to be weakened by the early innings of federally sequestered spending cuts. Much to our surprise, defense primes Lockheed Martin, Northrop Grumman, and Raytheon reported clean sweeps, exceeding top and bottom line expectations for the second quarter while also raising guidance. Multiple factors explain this paradox, including the fact that Pentagon cutbacks are still in their early days. More notably, the defense contractors represent “Exhibit A” in the manual on how to manufacture earnings growth—cut costs, repurchase shares and, if you are an old-line industrial with roots in the defined benefit pension era, recognize the earnings benefit that rising interest rates have on projected benefit obligations. Remarkably, the stocks of all three of these companies have outperformed the S&P 500 year-to-date.

Hall Pass Anyone?

In technology, it’s hard to emphasize the upside without highlighting Facebook, which blew away expectations for both revenues and earnings. Revenue growth accelerated to 53 percent in the quarter, defying skeptics who claimed that they would be unable to monetize an avowed shift to mobile advertising. As investors took notice of a remarkable 75 percent sequential surge in mobile ad sales, bears ran for cover and prompted a huge short squeeze in the stock. Facebook’s stock was an overnight success, surging 30 percent on immense trading volume that brought shares to within shouting distance of the company’s ill-priced IPO. While Facebook profits surged, Amazon.com disappointed investors by reporting a quarterly loss on slightly lower than expected revenue growth.  Nevertheless, Wall Street again looked the other way, seeing eventual riches behind the bounty of sales this web giant continues to amass. Despite management telling investors to expect another loss in the third quarter on lower than expected sales, shares rose 3 percent.

Green Shoots

Earnings remain front and center, but we would be remiss not to mention the change at the margin that we perceive in Europe. While the Continent has been plagued by recession for two years now, increasingly easy monetary policy and reduced emphasis on fiscal austerity appear to be germinating some green shoots. A broad mid-month survey of manufacturing activity there rose above 50 this week (the dividing line between contraction and growth), consumer confidence is up, and a handful of companies are reporting that their European business isn’t quite as bad as it was. In a world of 12 percent unemployment and weak export markets, it wouldn’t take much of a spark to move Europe’s GDP needle back into positive territory.

More Where That Came From

Next week brings another huge wave of corporate earnings reports, including bellwether reports from ExxonMobil and Chevron in the energy sector. In addition, the economics calendar ramps up, with the July employment report Friday preceded by what will be investors’ first look at second quarter GDP here in the U.S. on Wednesday. Finally, investors will scour reports from the Fed, which will meet again on Tuesday and Wednesday to review monetary policy and perhaps give additional clues about its plan to reduce the size of QE.

Our Takeaways from the Week

• Equities finished a busy week of earnings largely flat, with industrials and tech companies providing the most encouraging results
•  Europe’s recession appears to be waning

 Disclosures

A Dovish Bernanke Soothes the Market

by Shawn Narancich, CFA Senior Vice President of Research

Bend it Like Bernanke

Concerned about the steep rise in 10 year U.S. Treasury interest rates that help set the price of mortgages, our fearless Fed Chairman went before Congress to give his semi-annual testimony to Congress this week. While he disclosed little to lawmakers that was new, one key takeaway was his emphasis on the idea that tapering the Fed’s program of buying U.S. mortgage backed securities (QE) has no pre-set schedule. Stocks, bonds, gold, and the dollar responded predictably (rally, rally, rally, decline) to the notion that the Fed will be slower to pull back the punchbowl of stimulus than traders first thought when it fired its first volley of commentary about “tapering" last month. At a time when the Fed’s forecast for 3-4 percent economic growth next year appears increasingly optimistic when juxtaposed against sub-2 percent GDP growth currently, investors are left to hope that a good old fashioned earnings season can sustain and perhaps enhance the heady returns US stocks have delivered so far this year.

Earnings Season Shifts into High Gear

On this topic, investors have now parsed their first full week of Q2 numbers. With over 15 percent of the S&P 500 having now reported, two-thirds of companies are beating earnings expectations, but only about 40 percent are exceeding the top-line forecasts promulgated by Wall Street. In broad brushstrokes then, not much has changed since last quarter, but as always, what makes this business so interesting is the detail beneath the averages.

Money in the Bank

Delving into sectors, we observe that banks have generally reported encouraging numbers, helped by higher levels of capital markets activity (IPO’s driving growth in investment banking, rising fees on managed assets, better trading revenues, etc) that have boosted earnings at the likes of Goldman Sachs, Morgan Stanley, and JP Morgan. Also at work for the financials is better credit quality, which has allowed key regional lenders like Wells Fargo and PNC to reduce their credit provisioning for bad loans. Looking ahead, higher levels of interest rates, if sustained, should help banks increase core earnings power on both their portfolios of marketable debt securities (maturities reinvesting at higher rates) and, more importantly, on new loans benchmarked to market rates. Anecdotally, several management teams have noted stabilization of net interest margins and the potential for rising net interest income if rate gains hold.

Like Falling off a Log

In tech land, no one can be too surprised by the weak numbers out of Intel and Microsoft, given the continued double-digit losses in sales of the PC, still their core market. And while Yahoo’s earnings beat expectations, this aging Internet player once again missed on the top line as its display ad business declined at double-digit rates despite the fact that the Internet continues to take ad share overall. Notwithstanding erosion in Yahoo’s core business under the leadership of new CEO Marissa Mayer, earnings expectations post-quarter actually increased because of Alibaba. This Chinese e-commerce giant reported 71 percent revenue growth and margin expansion as well, resulting in an earnings boost for Yahoo because of its 24 percent ownership interest. So as Wall Street begins to assess the effectiveness of Ms. Mayer’s leadership one year in, she has Alibaba to thank for a stock price that rocketed 10 percent higher post-earnings and now stands at nearly twice the level it was when she arrived last summer.

Next week, investors can look forward to an even heavier slate of second quarter earnings, with more consumer, industrial and energy names entering the fray.

Our Takeaways from the Week

• Stocks, bonds, and gold melted up this week against the backdrop of further dovish jawboning by the Fed

• Earnings season is off to the races, with puts and takes

Disclosures

Somebody’s Watching Me

by Ralph Cole, CFA Senior Vice President of Research

“Fed-watching” is a time-honored tradition among industry insiders who parse every word that the Fed Chairman and his committee utter. While it is entertaining for many, it is also the cause of unnecessary volatility in the bond and stock markets. In his efforts to be as communicative as possible, Fed Chair Ben Bernanke has probably come to realize that people are going to interpret things he says differently, or ways that he might not intend … despite every attempt to be as clear as possible!

Although market action that has been to the contrary, we think the Fed chairman has been very clear in his messaging, which simply has been: If the economy continues to improve, the Fed will likely begin tapering in September. If the economy fails to improve in the coming months, the Fed will continue with QE3. The chairman has bent over backwards to make it clear that he is more afraid of deflation than inflation, and the Fed stands ready to support the economy.

What indicators are we watching? Late last year, the Fed indicated that it was monitoring the unemployment rate and by this measure, 6.5 percent would be the level by which the economy would be considered on sound footing. Currently the unemployment rates stands at 7.6 percent, a good deal away from Bernanke’s threshold.

Where Do We Go from Here?

Our attention turns in the coming weeks to second quarter earnings reports. Estimates are for 4 percent profit growth from the S&P 500. More important than reported earnings, the key to earnings season will likely be company guidance for future quarters.

In particular, we will be listening to companies’ insight on growth in Europe (is it bottoming?), growth in China (is it falling off a cliff?), and U.S. (does the second half look better than the first?). Company projections will go a long way in determining if the S&P 500 can hold recent gains and extend to new all-time highs.

Takeaways for the Week

• Don’t overanalyze Fed commentary; rather, watch employment numbers the first Friday of every month
• Fed commentary has led the market to new highs. It is now up to corporate earnings to take the market to another level

Disclosures

The Sport of Protesting for Brazil

by Brad Houle, CFA Senior Vice President

The Sport of Protesting for Brazil

Brazil has been in the news recently with images of large protests filling public squares that have turned violent in some instances. There is no one issue that is sparking the protests other than what can be described as a general dissatisfaction by the public. Issues from a rise in bus fares, lowering of fuel taxes and a call for improved government services have caused the citizens to take to the streets.

Until recently, Brazil has been considered a model emerging market economy with its burgeoning middle class and abundant natural resources. Also, next year is Brazil’s big “debutante ball” to the world as it is hosting the 2014 FIFA World Cup and the 2016 Summer Olympics. Despite spending on infrastructure as well as the government’s efforts to stimulate the economy, Brazil is struggling. The Brazilian stock market is down over 20 percent this year and the Real, Brazil’s currency, has depreciated versus the dollar. There are broader structural economic issues which are causing the slowdown in the economy and have filtered down to create social unrest.

Brazil is a large exporter of commodities with exports accounting for 14 percent of GDP, compared to 6 percent of GDP in the 1990s. Brazil exports agricultural products and metals, with China being a large trading partner of Brazil. With the Chinese slowdown and a general slump in commodity prices, pressure has been placed on Brazilian incomes. According to the World Bank, the per capita GDP is around $12,000, which has grown nicely in the last few years. However, this number also suggests that despite recent progress of income gains and standard of living, much of the population still lives in abject poverty.

Also hampering the Brazilian economy is an explosion of debt that accompanied the strong economic growth that was fueled by the commodity boom. With the private sector saddled with debt, the ability to invest and grow businesses is hampered by high current debt service requirements. As we have recently witnessed in developed economies, deleveraging is a long and painful process that crushes growth opportunities.

Despite the efforts to “dress up” Brazil for the World Cup and Olympics, there are global economic headwinds which are making it difficult for the country to pull out of the current economic malaise. Brazil is a reminder that conditions can change rapidly and dramatically in emerging markets. It also reinforces the growing interdependence of economies around the globe.

Disclosures

Fovinci Quoted in Bloomberg News

July 2, 2013 Bloomberg News

By Wes Goodman and Lucy Meakin

U.S. 10- to 30-Year Yield Gap Shrinks as Inflation Seen in Check

The difference between 10- and 30- year Treasury yields approached the narrowest in 17 months on speculation inflation will stay in check as the Federal Reserve scales back efforts to spur economic growth.

The spread was 1 percentage point today, down from this year’s high of 1.26 percentage points on April 1, data compiled by Bloomberg show. Longer maturities are more influenced by the outlook for prices. While U.S. government securities have handed investors a loss of 2.5 percent this year, Treasury Inflation Protected Securities tumbled 7.9 percent, Bank of America Merrill Lynch indexes show. Economists say reports today will show factory orders and vehicle sales rose.

“The economy is not growing fast enough to bring on an inflation acceleration,” said Marc Fovinci, head of fixed income in Portland, Oregon, at Ferguson Wellman Capital Management Inc., which has $3.5 billion in assets. “I certainly wouldn’t be a holder of TIPS.”

The benchmark 10-year yield fell two basis points, or 0.02 percentage point, to 2.46 percent at 8:44 a.m. London time, according to Bloomberg Bond Trader prices. The 1.75 percent note due in May 2023 rose 5/32, or $1.56 per $1,000 face amount, to 93 26/32. Even after climbing from the record low of 1.38 percent set almost a year ago, the yield is still less than the average of 3.56 percent for the past decade.

The spread between 10- and 30-year yields contracted to 97 basis points on June 24, the least since Jan. 3, 2012, data compiled by Bloomberg show.

Favoring Corporates

Ferguson Wellman favors corporate bonds for their higher yields versus Treasuries, Fovinci said. The company’s recent purchases include Yum! Brands Inc., Intel Corp., Emerson Electric Co. and Wells Fargo & Co., he said.

Investors should avoid the longest maturities because yields have been too low, said Kathy Jones, a New York-based fixed income strategist at Charles Schwab & Co., which has $2.11 trillion in client assets.

“You should be in shorter- to intermediate-term bonds,”Jones said yesterday on Bloomberg Radio’s “The Hays Advantage”with Kathleen Hays and Vonnie Quinn. “They’ll be a lot less volatile. Then as the rate environment changes and those bonds mature, you’ll have some money to reinvest at higher rates.”

Ten-year yields may rise to about 3 percent by the first quarter of next year, Jones said.

The difference between yields on 10-year notes and similar- maturity TIPS, a gauge of expectations for consumer prices over the life of the debt, was little changed at 2.03 percentage points. The average over the past decade is 2.21.

Volume Declines

Treasury trading volume at ICAP Plc, the largest inter- dealer broker of U.S. government debt, fell 44 percent yesterday to $250.9 billion, the least since May 7. June’s average was

$446.2 billion.

Volatility in Treasuries as measured by the Merrill Lynch Option Volatility Estimate MOVE Index was 101.32 yesterday. It climbed to 110.98 on June 24, the highest since November 2011.

The Fed is buying $85 billion of Treasuries and mortgage- backed securities each month to support the economy by putting downward pressure on borrowing costs. Chairman Ben S. Bernanke said on June 19 that policy makers may begin slowing bond purchases this year if the economy achieves the sustainable growth the central bank has sought since the last recession ended in 2009.

To read more, visit our News Worth Noting section on our blog, To Coin a Phrase.

First Half 2013 . . . A Tale of Two Asset Classes

by Shawn Narancich, CFA Senior Vice President of Research

Ready, Fire, Aim

The fact that financial markets are closing the first half of 2013 on such a volatile note is not so surprising given the concern investors have about the timing of the Federal Reserve’s contemplated exit from quantitative easing. The Fed has been instrumental in manufacturing a rebound in housing that is adding not only to the investment accounts of the GDP equation, but also indirectly to consumer spending through the wealth effect of higher home prices and 401(k) values. Against this backdrop, several Fed governors and regional bank presidents hit the lecture circuit this week to clarify for investors that the Fed is not imminently planning to reduce monetary accommodation. Stocks responded in predictable fashion, and are now set to post the best first half gains since 1999, with returns of about 14 percent. We continue to believe that the Fed will remain accommodative for some time to come, helping support further expansion in a U.S. economy that many Americans still think is in recession.

 Bonds . . . Et Tu Brute?

In the bond market, it’s another story entirely. Although benchmark 10-year Treasuries stabilized this week, bond indices are littered with small losses for the first half of the year. The good news is that bond investors who put money to work today are realizing real rates of return for the first time since early 2011. For example, a benchmark Treasury purchased today yields a nominal 2.5 percent which, when a 1.4 percent rate of inflation is subtracted, results in a real rate of return equaling 1.1 percent.

Bonds 101

With the recent spike in interest rates, we encourage clients to recognize the power of time and reinvestment to heal bond market wounds. In addition, we would note that recent bond market “losses” will only be realized if investors sell their paper below par. To that end, we plan to continue owning our clients’ bonds into maturity and look forward to reinvesting those funds at higher rates of interest. Furthermore, fixed income investors can reduce interest rate risk by structuring bond portfolios with shorter term maturities, thus reducing the duration of their investments and hastening the maturity of lower coupon bonds. On the other hand, investors in bond funds confront a harsher reality. In a rising interest rate environment, the net asset value of these funds drops with bond prices, but unlike a portfolio of individual bonds, there is no assurance that their initial purchase price will be recouped because they share ownership of that fund with other investors. Indeed, what we are beginning to see now is an accelerated rate of bond fund redemptions by investors who don’t want to wait for bonds to mature. In this case, losses may be realized by fund managers forced to sell, with proceeds used to redeem the bond fund shares being liquidated.

As the second quarter of 2013 comes to a close, we wish our Ferguson Wellman friends and clients a happy and safe Fourth of July holiday. Investors should rest up, because second quarter earnings reports are right around the corner!

Our Takeaway from the Week

• Stock and bond markets stabilized following reassuring comments from Fed officials and generally upbeat economic data

Disclosures

Taper Tantrum

by Brad Houle, CFA Senior Vice President

The sell-off in virtually all financial markets and asset classes preceding and following the Federal Reserve meeting and press conference this week has been dubbed the “Taper Tantrum” in the press. Investors and the media parsed and analyzed every syllable uttered by Federal Reserve Chairman Ben Bernanke during Wednesday’s meeting.

While nothing really changed in the message that the Federal Reserve Chairman delivered … the markets took it as an opportunity to overreact. The passing of time has merely brought us closer to the Federal Reserve’s previously announced subtle change in strategy as the economy has improved. The good news about “The Taper” is that it is clearly and acknowledgement that the economy is actually recovering. We do not believe that conditions exist for interest rates to move up sharply. Both the current rate of inflation and the projected future rate of inflation remains contained. Further, the tepid current economic growth does not seem poised to increase so rapidly that would cause the Federal Reserve to be forced to raise rates.

Fear of sharply rising interest rates and a bear market in bonds seem overblown. Interest rates are artificially low based upon the Fed’s bond purchase, however; if the purchases are curtailed, rates should seek a higher equilibrium but are unlikely to explode higher. If rates move slowly higher over the next two-to-three years, investors will have disappointing bond returns. The silver lining is the opportunity to reinvest at higher rates. Time is a bond investor’s friend in a rising rate environment. Also, it is advantageous for investors to own individual bonds and use active management in this type of environment. Many investors will welcome the end of the “tax on savers” that has been a consequence of zero interest rate policy. 

Equities that are viewed as interest rate sensitive have sold off the most during this correction. REITs and utilities have been notable underperformers. It is important to remember that most equity indexes are up nearly 12 percent for 2013. The equity markets probably got a bit ahead of themselves and were due for a normal correction. We still view the economy as being stronger in the second half of 2013 and equity markets should find a firmer footing when this myopic view of the “The Taper” has passed.

Our Takeaways for the Week

• Nothing has really changed relative to the Federal Reserve announcement this week and the financial markets seem to be overreacting to the situation

Disclosures