Investor Discussions - Q3|2014 Commentary
Wealth & Pension Services Group
Matt B. Bailey, CFA - Portfolio Manager
The third quarter of 2014 was full of action but failed to provide much in the way of returns outside of a few select markets. While the headlines for stocks looked good during the quarter, the underlying results were not as impressive. For instance, the difference in performance between the major indices in large cap stocks and small cap stocks was over 15%, and the average stock in the S&P 500 was down over 7% from its high. As for the Fed, they stayed true to their word by continuing to “taper” their bond purchases and signaling for a Q4 end to their quantitative easing program. Finally, increased tension was seen in both the Ukraine and Middle East, and Europe began showing some signs of economic weakness.
Economic data released during the third quarter continued pointing towards the US economy strengthening. Final Q2 GDP was in line with analyst expectations and printed a strong reading of 4.6%. This rebound came after a poor Q1 number linked to harsh winter weather. This chart illustrates how volatile this quarterly data can be and underscores the importance of staying focused on the longer term trend. We will be watching the Q3 GDP number closely but remain confident that the US economy is still healthy.
The US employment data continued to improve as the unemployment rate was steady at 6.1% (click here). From here, we would like to see signs of wage inflation as this would point to less slack in the labor markets. As we’ve previously noted, the underemployment rate, which tends to give a slightly more realistic view of the job market’s overall health is much higher at 12%. This suggests that many people have been forced to take jobs that are below their qualification level and that the labor markets have additional room to improve.
Another positive data point reported during Q3 was the consumer confidence number (click here). The latest reading of 86, although down from August, indicates that US households still have a positive outlook and perception of the current recovery and its future prospects. Much of this optimism can be linked to more people having jobs, housing prices increasing and the stock market’s recent strength. This is a good sign for the overall economy as personal consumption makes up roughly 2/3’s of GDP.
Lastly, housing has started to turn a corner and appears to be trending positively. Sales data for both new and existing homes has improved and the number of housing starts continues to increase. In addition, many areas have seen home values rise modestly over the last year, allowing trapped home owners to exit properties that were previously underwater. This new supply source should have a positive impact on tighter areas of the market where inventory has been low. Additionally, labor markets may benefit as more workers are able to move in order to take higher paying jobs.
Overall, the US economy continues to grow at a measured pace and most indicators are positive. We hope to see more companies hiring and increasing capital expenditures in the coming quarters. This would indicate that US companies are becoming increasingly confident in the future of the economy and their growth prospects. We think the economy should remain intact for the foreseeable future.
Outside the US, the global economic landscape began to show signs of near-term weakness as Europe, Japan and China all printed disappointing data during the quarter. This comes even as the European Central Bank (ECB), Bank of Japan (BOJ) and Chinese government continue to utilize very accommodative monetary policy. Deflationary data, a slowdown in manufacturing and high unemployment have all been seen within many European countries. This chart illustrates the recent weakness Europe has experienced within the manufacturing sector. With that being said, it’s important to highlight that they are still above the critical 50 level, which indicates expansion. Further east, a slowing real estate market has plagued China over the last few quarters and Japan’s Abenomics hasn’t produced the type of growth policy makers had expected. On a positive note, many countries have started showing signs of stability. Specifically, Mexico, Taiwan, Ireland and Canada have recently experienced positive momentum within their manufacturing sectors and have displayed signs of continued economic growth.
Overall, the global economic picture isn’t as pretty as many would have liked to see at this point in the economic recovery. In spite of this, utilization of loose monetary policy from central banks and US economic strength should help to limit the downside across the globe. Lastly, it’s important to realize that economic recoveries can be very volatile and tend to play out in a non-linear fashion.
Large cap US equities, as represented by the S&P 500 index, remained resilient as they once again outperformed most other equity markets and ended up 1.13% for the quarter. Other areas of the US markets were mixed, as the Russell 2000 Small Cap index and NASDAQ Composite index finished down 7.36% and up 5.53% respectively.
With the current bull market well into its 5th year, one has to wonder how much more upside is left. Internally, a number of technical indicators are pointing towards near term weakness, but overall the US market appears healthy. We see continued strength within domestic large caps over smaller firms, specifically within the technology and healthcare sectors. The energy sector has seen recent weakness but its valuations are attractive and suggest outperformance in the coming quarters. Lastly, we think value stocks have the potential to once again start outperforming growth names. This chart illustrates this point and also shows that value has historically outperformed growth more frequently and for long periods.
We still maintain an overweight to US equities, specifically large cap stocks. We plan to continue monitoring our indicators and the entire market for signs of deterioration but feel confident in its longer-term prospects.
International equities as a whole underperformed their developed market counterparts during Q3 with the exception of Japan. Within Europe, the STOXX Europe 50 index finished the quarter down 7.55% after weaker than expected economic data was reported. Lingering high unemployment within many countries led the ECB to take additional measure to stimulate growth including: quantitative easing and negative savings rates. Japan’s data wasn’t much better but the Japanese Nikkei 225 equity index was able to attract investor capital and finished the quarter up 3.90%.
Emerging Market (EM) equities, as represented by the MSCI EM index, started out the quarter strong but were hit hard during September and finished down 3.46%. Much of the underperformance was attributed to the strong US dollar, struggling commodities and lackluster data out of Europe and China. Additionally, it’s worth noting that global equity correlations tend to increase during negative periods, and the selling pressure emerging market equities experienced was likely related to Europe’s poor performance.
One bright spot was the MSCI Frontier Markets Index, which finished the quarter up 5.7%. This market contains countries too small to be considered emerging and tends to be uncorrelated to traditional equity markets. We maintain a small allocation to this space for enhanced diversification and the excess return potential.
We remain overweight developed international and emerging market equities. Most areas of the international space are still trading at attractive valuation levels, especially when compared to the US markets. Although momentum has recently waned within Europe, we feel that continued support from the European Central Bank (ECB) should limit downside risk. Also, recent dollar strength should bode well for European exports, making their goods less expensive in our markets. Additionally, the Emerging Markets appear oversold and are likely digesting gains from earlier in the year. Going forward we see solid prospects within the EM space as many countries have made significant political and structural reforms.
Interest rates remained top of mind during the third quarter as the Fed continued to reduce their quantitative easing program purchases and decided on a Q4 ending. The benchmark 10-year US Treasury rate stayed fairly range bound and ended the quarter nearly flat at 2.508%. The Barclays US Aggregate Bond Index once again benefitted from declining rates and finished the quarter up .17%. Higher risk areas of the fixed income market didn’t fare as well, as the BofA ML US High Yield Master Index and Citi World Government Bond index, both finished down 1.92% and 5.38%, respectively.
This quarter we made the decision to reduce our high yield exposure as the asset class showed signs of technical weakness. During late July, high yield funds experienced significant outflows linked to concerns that the asset class had become overvalued. They managed to rally back but have once again become weak. Although the fundamentals remain intact and defaults low, we prefer to step aside and allow the selling pressure to dissipate before revisiting the space.
We have not changed our view that interest rates should start to normalize higher over the coming quarters. We see stronger US economic data and the Fed ending its QE program as being the two main drivers of higher rates. As we’ve previously mentioned, “This normalization should benefit less interest rate sensitive investments as rates rise. Within the space, we favor credit focused managers with shorter duration (less interest rate sensitive) portfolios.” Additionally, we’re still cognizant that rates may move quickly in either direction, so we pay special attention to investment managers who can quickly navigate to different areas of the market as they see fit. Generally speaking, at this point in the market cycle, we view fixed income as a volatility buffer and not a driver of large returns.
Commodities were very weak during the third quarter, as the Bloomberg Commodity Index finished down 11.83%. Much of the weakness can be attributed to the impressive strength of the US dollar. Commodities and the dollar tend to have an inverse relationship, and the recent weakness seen abroad led to significant amounts of capital flows into the US dollar during the quarter. Additionally, inflation came in lower than many had expected after stronger data was released earlier in the year. These two factors have historically been very disparaging to commodity prices and this again proved true during Q3.
Currently, the US dollar appears to be extremely overbought and commodities very oversold. We’re cautiously optimistic that the recent negative momentum seen within the commodity complex will reverse and lead to higher prices in the near term. Furthermore, we plan to watch the inflation data closely in order to better formulate an outlook for the commodity group. If the data continues to be non-supportive, we will reduce or eliminate our position and revisit the asset class at a later time.
Our long-term view of the US and global economy remains constructive. Data coming out of the US remains strong and points towards continued growth. Outside of the US, the near-term outlook is mixed but intact as many central banks remain accommodative.
Equities continue to be our highest conviction idea, but with an understanding that volatility is likely to increase in the near term. Within fixed income, rates have stayed range bound over the last year but are poised to move higher as the Fed exits its current QE program and plans to raise short-term rates sometime next year. This has led us to underweight core bonds and focus on less interest rates sensitive opportunities. Lastly, the commodity sector remains the one area where the outlook isn’t clear. The direction of the US dollar should dictate where commodities go in the near term, but global demand and inflationary data will likely have the greatest impact on their long-term outcome.
As always, please feel free to contact us with any questions you may have.
Matt B. Bailey, CFA