US equity markets have seen what we would describe as mild volatility over the last few weeks, mostly attributed to geopolitical tensions emanating from the Ukraine-Russia belligerence. For the first quarter, the S&P 500 rose 1.30%, while the Dow Jones Industrial Average and the NASDAQ composite were both down slightly.
This lack of any meaningful gain from the major indices is just fine with us, frankly. As we pointed out in our previous Outlooks, US stocks have been approaching a “fair value” given the run-up we saw in 2013. Fair value in this context refers not to an intrinsic measure, but to current versus historical P/E valuations. As the chart to the left indicates through March 31, 2014, while the S&P 500 itself is just shy of its 29 year average P/E level, many other equity sub-divisions within US markets are trading at or slightly above their historical averages. “Growth” stocks may look cheap on a relative basis here, but we attribute this historical discount more to the “outlier” years of soaring technology valuations in the late ‘90s which has inflated their long-term average P/Es.
The US first quarter GDP growth rate of 0.1% was just released—a fairly dismal figure that came in even below reduced consensus expectations of 0.11%. This slow-down has been attributed almost entirely to our bout with the “polar vortex” weather challenge which consumers, businesses and home-builders faced this past winter. Yet, as corporate earnings pour in for Q1, we expect no downward revisions to the consensus 3% full year GDP estimate. Rising earnings with a pause in stock price appreciation will eventually work to lower P/E levels, providing more attractive entry-points for US stock investing. We ultimately believe the fiscal drag caused by the “sequester” last year, estimated to have shaved ~1.3% from GDP in 2013 will become a much lighter headwind this year and next, offsetting the effects the “polar vortex” may have on the full year GDP.
The new Fed Chair, Janet Yellen, could be said to have had a rocky debut in March with her somewhat confusing comments regarding the timing, or economic mile markers for a projected increase in the Fed Funds rate. While Fed guidance has always been more rhetorical acrobatics than substantive insight, stirring confusion (along with disavowing previous “rules”—like the 6.50% unemployment target) risks devaluing their credibility in the financial markets, in our view.
We’ve given further thought to this muddled message after listening to PIMCO’s Saumil Parikh’s self-described out-of-consensus views on an increase in inflation, possibly this year.
The Great Recession of 2008 left millions of Americans unemployed, and today, nearly six years later, the unemployment rate stands at 6.3%, having dropped sharply from 6.7% last month. In our discussions with clients over these years, we find that by now nearly everyone is aware that the more shocking statistic lies in the actual employment rate—or the ratio of employed civilians to the working-age population. This rate stands at just 58.9% according to the US Bureau of Labor Statistics through March of this year. This is a level on par with the dismal economic conditions that existed in the recessionary 1970’s and early 1980’s. Add to this the ranks of under-employed, and the US employment picture would seem to paint a picture of economic contraction, rather than the steady (if tepid) growth we’ve experienced. We would summarize Saumil Parikh’s thesis on inflation as having its origins in possible wage inflation.
To flesh this out further consider the staggering number of US citizens who were forced out of the work-force in 2007-2009, and who, six years later, remain unemployed (and increasingly unemployable). This number contrasts with the more transitory rate of “normal” unemployment, which, as depicted in the chart above, is actually back to pre-recessionary levels. The long-term unemployed may simply remain unemployed, and/or officially “retire”. This would actually represent a structural shift in US employment rather than simply a prolonged cyclical issue (indeed, it could make the US look much more like Europe from a labor perspective). The thesis is that under these conditions, we may not
have the deep pool of “available” labor many attribute to our population, increasing the competition among employers for employable workers and thereby ratcheting up wage inflation, which would eventually find its way into consumer prices. Its notable then, that even as the most recent unemployment rate dropped sharply, the employment rate hasn’t budged.
We haven’t spent much time musing on the topic of inflation since our 2009 Outlook discussed it as an inevitability once the economy returned to growth with a 0% Fed Funds rate. We were of course wrong—but we at least have plenty of company. While we expect the Fed to continue to reduce bond-buying to zero by the end of this year, and we continue to expect an “orderly” reaction in the bond markets (in contrast to last year), we see the inflation issue as an interesting thought to ponder as GDP and labor statistics conflict. Surprises are what really move markets, and we think a notable pick-up in inflation this year or next could be that catalyst, precisely because consensus disagrees.
CCR Wealth Management’s US equity models remain unchanged in our balanced weighting between growth and value investment styles. Quarters like Q1 make us appreciate dividends all the more. We continue to have a small cap equity weighting in our portfolios of approximately 10%.
While we discussed inflation as a possible surprise, and we discussed equity valuations as a function of P/E, we do not know what short-term shocks may come into play for US equity markets. We think it’s a good idea to remind our clients that true corrections, defined as a significant draw-down of equity values within an otherwise upward trending market, are both commonplace, and perhaps healthy to a longer-term bull market.
Over the past 34 years, the average intra-year (calendar year) down-draft in US Equity markets has been approximately 10%. As the S&P 500 rose over 13% in 2012, and over 30% last year, it’s notable that we haven’t seen a stock market correction of 10% since 2012.
CCR Wealth Management continues to view non-US developed markets and particularly European markets as attractively valued relative to the US. Additional dovish comments by ECB President Mario Draghi in early April opened the door to possible “extraordinary” stimulus measures akin to those adopted by the Fed several years ago, and those currently being pursued by the Bank of Japan and in the UK. Given the lower P/Es of global European companies (which are drawing from the same revenue sources as global US companies), we continue believe a European equity market surge is possible within the next 12 to 18 months. In some ways it’s hard to believe how far Europe has come considering less than three years ago many in the financial community thought we were witnessing the unraveling of the European Monetary Union itself as Greece, and then Cyprus became virtually “failed” states, along with strong and continual support needed for financial institutions within Spain and Italy.
The fact is, there has been a remarkable turn-around in confidence both within Europe and across the broader global financial universe. Consensus views for Euro-zone GDP growth this year are 1.0%-1.5%. While this seems an unremarkable number, it’s coming off a level of -0.5% a year ago, and represents a significant jump relative to US GDP expectations vs. a year ago.
The European investment “theme” is not without challenges and potential pitfalls ahead. Mario Draghi’s comments were made in-part to address the issue of the rising value of the Euro relative to their major trading partners. The Euro has risen as a result of the aforementioned increase in investor confidence. As money floods in to buy stocks and bonds, it needs to be converted to Euros, increasing demand, and therefore increasing the price of Euros.
Exports are the only real way to continue to grow out of recession, but with the Chinese devaluing the Yuan, the Japanese in their second year of aggressive quantitative easing, and the US continuing an asset-purchase policy—though at a tapering pace—growing exports with a rising currency is a daunting task.
An asset-purchasing strategy like that being pursued in the US, UK and Japan is not a simple prospect in Europe, which has 18 different geopolitical components to contend with. We expect to hear much more “jawboning” of extraordinary measures from monetary officials. Beyond that, they may need to pursue more direct intervention, selling Euro’s for Dollars to keep the exports rolling.
If the developed world’s economic engine can be represented by a three legged stool, then the third leg is represented by Japan. The Japanese Nikkei index was by far the best performing market among developed countries in 2013, soaring nearly 57%. Japanese Prime Minister Shinzo Abe’s ambitious plan to end years of stagnation and deflation through aggressive monetary and fiscal stimulus fueled this major rally. We have heard a range of opinions from strategists and portfolio managers with whom we work regarding the staying power of this optimism. While “Abenomics” is no-doubt popular among investors (most of whom are foreign), Japan has a multi-decade history of political turn-over which has posed a challenge for any long-term economic plan to take hold and finally produce real long-term economic results. Further, the recent implementation of a VAT tax will be an economic drag, and it remains to be seen whether the stimulus will continue to the extent of offsetting this hurdle. Longer term, Japanese demographics are actually quite unfavorable to sustained GDP growth given a very low birth-rate, a population in decline, and an aversion to immigration reform. The Nikkei is down 11% year-to-date, and we would be content to watch from the sidelines to see how long and short term economic pressures are reconciled.
Taken as a whole (i.e. from a broad index viewpoint), emerging markets remain problematic. CCR Wealth Management’s model portfolios continue to keep a footprint in emerging markets equities, although the footprint is modest, and we continue to advocate a managed approach rather than a broad-based index, or regional approach. Valuable, yet undervalued companies reside in Brazil, Eastern Europe and throughout Asia, though they are diamonds in the rough—and are best uncovered with a bottom-up fundamental “stock picking” approach.
In years past this Outlook communication went to great lengths to highlight China’s importance as an engine of world economic recovery post-financial recession. As a major consumer of raw materials from around the world, Chinese economic growth had much to do with dragging many different developing economies up the growth curve as a major destination for their exports. China is of course important today, though as growth continues to decline, the inverse effect of this association hampers emerging markets virtually everywhere.
In January we expressed a little more comfort with the near-term outlook for bonds—certainly in relation to our outlook of the prior two years. Year-to-date, the Ten Year Treasury yield has actually fallen roughly 12% and our core bond fund holdings are up 3%-4%.
We continue to think that as long as the Fed tapering continues on a steady pace, messaging from the Fed remains consistent, and that consensus for a higher Fed Funds rate remains pushed out to the second half of 2015, that bonds should achieve our low to mid single-digit return expectations this year.
There are two caveats we feel compelled to inject into this outlook; the first has to do with credit spreads of high-yield securities. As stock’s relative valuations are best expressed as a ratio of price to some fundamental multiple (often earnings), bond valuations are expressed as a yield spread accounting for credit risk (for the most part) over comparable maturity risk-free Treasury notes and bond yields. Spreads generally tighten (expand) as credit risk is perceived to be lower (greater) as a function of economic activity. As spreads tightened substantially since the financial meltdown of 2008, higher-yielding (riskier credit) bonds have appreciated nicely. CCR Wealth Management has had a significant center of gravity in the BBB rated bond category for most of the last six years.
Today we see credit spreads approaching levels last seen in 2006 and 2007 as leverage has returned from the abyss of the financial recession. We don’t wish to make structural comparisons between the natures of leverage today vs. that which did-in the housing and financial markets 6 years ago—but we would point out that today’s credit spreads are indicative of investors getting much less return per unit of credit risk today than they were 4-6 years ago, much the way a stock buyer would pay much more for a dollar of earnings by buying a high P/E stock.
The second caveat to our generally benign near-term outlook for bonds concerns the “out-of-consensus” risk of inflation we previously discussed. Inflation does great damage to bond returns which are fixed over specified periods of time. While being in higher yielding securities provides some buffer over inflation, market sentiment could sour on bonds broadly if inflation data shifts significantly.
We continue to suggest to investors that near-term return expectations from their bond portfolios should likely be confined to the yield of the portfolio.