Economic and Market Perspectives

Q4 2015

The net impact of continuing U.S. dollar strength, declining global demand for U.S. products and the slumping energy sector contributed to disappointing preliminary measures of U.S. manufacturing in mid-September as manufacturing activity growth slowed to its weakest point in nearly two years. Manufacturing employment also appeared to take a breather with forecasted manufacturing payroll growth up only slightly—at its weakest level since July 2014.

While the goods-producing sector of the domestic economy disappointed expectations, the services sector turned in somewhat stronger results helping to push estimated third quarter GDP growth to an annualized 2.4%. This follows the rebound in second quarter GDP growth of 3.9% after sluggish first quarter growth of 0.6%.

The September jobs report also did not meet expectations, with the U.S. economy adding only 142,000 jobs versus a forecast of some 203,000. This release came on the heels of a downwardly adjusted 36,000 new jobs added in August. While the unemployment figure was unchanged at 5.1%, the labor participation rate dropped to 62.4%—the lowest reading since October of 1977.

Is the U.S. economic recovery continuing to build steam, track sideways, or come off the rails? Will the slowdown in China’s economy derail growth here at home? Faced with mixed indicators that seem to point more to uncertainty than to clarity—reasonably healthy economic activity and a shallow recovery versus disappointing wage growth, inflation stubbornly below its 2% target, low labor force participation, and continuing underemployment—the Federal Reserve (Fed) elected not to raise rates at its September Federal Open Market Committee (FOMC) meeting.

Domestic equity markets, which usually react positively to dovish Fed policy news, reacted in the opposite direction with the S&P 500 index losing nearly 2% the day after the Fed’s "no hike" decision was announced following the September meeting. Meanwhile, the increase in crude oil prices and reduction in U.S. dollar strength seen in the second quarter reversed course over the last three months with West Texas Intermediate crude oil prices sliding to new post-recession lows in mid-August and the U.S. dollar nearly hitting the ceiling versus global currencies set back in March.

Over the quarter, U.S. Government debt markets saw renewed demand for U.S. Treasuries—particularly at the long end of the curve—driving yields on 20-year bonds from 2.83% at the end of the second quarter to 2.51% at the end of the third quarter and third quarter returns of 30-year U.S. Treasuries of 5.1%. In an environment of falling global equity markets, domestic government bonds once again proved to be the safe harbor investors flocked to despite a historically low interest rate environment.

Hold off on Downsizing
Source: U.S. Department of the Treasury

A combination of China-angst and tepid domestic growth led to a dramatic sell-off in U.S. and global equity markets during the third quarter with many broad equity indices giving up all of the gains recorded in the first and second quarters and then some. Investors ended the quarter wondering if equity markets were naturally correcting for stretched valuations following a seven-year bull market or if another global economic crisis was on the horizon.

Equities and Bonds

Fraying at the European Union (EU) Edges

We begin this Economic and Market Perspectives where we left off last quarter with a reflection on the situation in Greece.

The third quarter started with concern over economic conditions in Greece which faded once a deal was reached and technical default was avoided. Greece seems to be resigned to austerity after the once defiant—but now acquiescent—Prime Minister Alexis Tsipras and his Syriza party were re-elected and essentially gave up on the prior strategy of playing hardball with the “troika” of the International Monetary Fund, the European Central Bank and the European Commission, which had called the Greek government’s bluff.

With a bailout program of around €83 billion of rescue loans on the table, the Greek parliament will have to implement many of the austerity steps they had railed against, including additional pension cuts, industry privatization and taxing farmers. One positive, if not surprising, sign is that Tsipras has kept most of his economic team in place and appears to be resolute about making an honest effort to meet the troika’s demands.

But just when it seemed as if the dust had settled on Greek debt issues, the underpinnings of the EU were threatened yet again by a massive wave of economic and political asylum-seeking migrants, mostly from Syria, desperate to escape war and, hopefully, find refuge in Europe. In late September, the EU voted to accept 120,000 asylum seekers and to distribute them among member countries. Notably, four of the 28 EU members (the Czech Republic, Hungary, Romania, and Slovakia) voted against the plan but, by EU rules, must comply. Slovakia promptly said they would not.

Some analysts view the inability of the EU to craft a common approach to the migrant problem as more threatening to the future of the European Union than austerity-motivated threats by Greece and others to abandon the euro. Serving to fuel this concern has been the rise of far-right and nationalistic parties, particularly in Britain, Denmark, France and Sweden, making an EU-wide resolution to Europe-bound migration even more difficult.

Central to the EU’s philosophy and function is the concept of borderless travel and a common, consensus-based approach to resolving conflicts and policy differences. Polls clearly reflect these attractions: in a 2014 poll of 15- to 24-year-old Europeans, “free movement”, the euro, and "peace" topped the list when asked what the EU meant to them.

Nonetheless, borderless travel was abandoned as several EU countries resumed border screening and the “opt-out” of some EU members to the migrant plan calls into question the ability of Brussels to exercise governance over the entire bloc. Just when European equities overall seemed to have found their footing, as shown below, with manufacturing activity and GDP on the rise, the combination of the migrant crisis and continuing concerns over slowing growth in China left markets around the world reeling.

Eurozone on the Mend
Source: Markit Economics, Eurostat, PMI readings over 50 indicate growth

A Tale of Two Ports

What do the ports of Tianjin, China and those located in western U.S. states have in common? Beyond size and importance to global trade (Tianjin is the 10th largest port and the 29 ports on the west coast are a key entry point for parts and goods needed for North American commerce), both experienced significant disruptions in 2015—western U.S. ports were shut down for several months by a labor dispute and a massive chemical fire destroyed much of Tianjin’s Binhai New Area port in August.

Where the two differed was in the response of authorities to these events. While the west coast strike was covered extensively in the media with regular updates from government agencies as to the strike’s impact on business and progress on negotiations, Chinese authorities censored news of their port disruption. Global companies seeking information as to the extent of damage found it difficult to get answers. Even now, estimates of the damage caused by the Tianjin explosion vary from 18,000 to 20,000 containers destroyed and as many as 10,000 vehicles burned.

The Tianjin fiasco falls in the midst of questionable currency interventions and Chinese policy responses to falling domestic stock markets that included searching the offices of investment firms, restrictions on securities sales, and censoring media coverage of the equity market’s decline. So far, these steps have only been successful at highlighting the futility of a communist government trying to “manage” the natural order of a capitalist marketplace. While emerging economies are often expected to be somewhat opaque in disclosing information that may be perceived as inimical to financial markets, the actions taken by Beijing as China’s domestic markets plummeted are a concern for investors everywhere.

As a major driver of global economic growth, China is viewed as a vital source of demand for commodity-producing nations and corporations looking for a market with a fast-growing middle class. But China’s increasingly dominant role in the global economy, and its goal of graduating into the highest sphere of developed nations requires a more transparent and less manipulative approach to capital markets regulation.

The Fed’s Paradox

Closely watching developments overseas, the Fed remained dovish at its September FOMC meeting and, despite many who hoped for a hike in short-term rates, left rates unchanged.

One possible explanation for the U.S. equity market’s uncharacteristically negative reaction immediately following the Fed’s announcement of its decision not to raise rates for the first time in seven years is that investors view the policy decision as an indication that the U.S. economy may be more vulnerable than assumed. Traditionally, investors have worried that a tightening of monetary policy would begin before the economy found solid enough footing and could ultimately derail a recovery. At least in this instance, it appears the tables may have turned. With the Fed’s long-tailed preparation for higher rates, inaction served to express more concern about the economy than what was priced into the market.

History shows that the relationship between the U.S. central bank and capital markets could easily be described as inter-reliant. At least part of the objective of dovish monetary policy is to generate economic growth through what’s known as the ‘wealth effect’. By lowering the cost of money and reducing uncertainty through easing monetary policy, the Fed expects capital markets will benefit, which in turn will enrich consumers’ investment portfolios and allow them to feel better about spending on goods and services. Hawkish policy, on the other hand, is expected to have the opposite effect and cool the economy when growth outpaces capacity, with the ultimate goal of achieving a not too hot, not too cold “Goldilocks” economy.

As encouraging as these signs may be, we must observe this positive data with a certain degree of skepticism. Could these elevated levels of consumer spending and confidence be driven by pent up demand, which will dissipate later in the year? An unusually slow recovery has trained even optimistic economists to be cautious when predicting the renaissance of the American consumer. Tepid inflation suggests businesses still lack the demand necessary to raise prices, though consumers, supported by rising incomes, appear to be on more stable footing. Further evidence of the longevity of rising consumer demand can be found in an increase of bigger ticket purchases such as cars, homes and other major household items.

With dovish policy now potentially injecting more uncertainty into markets rather than less, the Fed is presented with a dilemma of either dampening investor confidence by keeping rates low or risking further upward pressure on the U.S. dollar by beginning rate normalization in the face of dovish policies by foreign central banks.

The Celtic Tiger Roars Again?

While the people of Greece appear to have accepted the inevitability of austerity measures, it remains to be seen whether sun-dappled Greece will be as resilient to the pain of austerity medicine as their fellow EU citizens in rainy Ireland. But in the case of Ireland, and to a lesser extent Spain and Portugal, austerity imposed by the troika is turning out to be less insurmountable than originally thought.

Ireland to the Fore
Source: Haver Analytics
*Q2 2015 vs. Q2 2014 % change **most recent (%) ***July 2015 vs. July 2014 % change

Although Ireland seems to be outpacing its neighbors to the south and the EU overall, it is worth noting that the Emerald Isle’s implementation of austerity measures imposed by the troika in 2008 preceded efforts on the part of Spain (2012) and Portugal (2011) to control runaway fiscal deficits and outstanding public debt. To be certain, all three economies have a considerable amount of recovery ahead of them. However, these countries should stand as evidence for Greece that economic recovery under an environment of austerity need not be written off as impossible.

All three countries have benefitted from the decline in energy prices—most notably oil—to help improve input costs and boost margins and profitability. But even Ireland is not immune to global macroeconomics and the decline in China and other emerging markets.

The Irish farming industry is a major contributor to the country’s economic and cultural well-being, but with China, the world’s largest dairy importer, expected to reduce milk imports by 40% in 2015, hard times may be ahead for Irish farmers. Adding to the dairy farmers’ woes is Russia, formerly the second largest dairy importer, which has banned imports from all EU countries. As most food commodities are priced in U.S. dollars, the greenback’s strength has also dampened Irish spirits.

Economic Highlights

  • Second quarter U.S. GDP rebounded strongly from a slow start to 2015, advancing 3.9%. Final readings for first quarter GDP were revised upward from –0.2% to 0.6% following a revision to the seasonality adjustment.
  • Job growth began to slow in the final two months of the third quarter even as the overall unemployment rate declined to 5.1%. Initial estimates indicated the U.S. economy added 142,000 non-farm new jobs in September and 136,000 in August–well below the average of 214,000 per month for the first seven months of the year.
  • Wage growth remained anemic despite the declining unemployment rate. Through September, average hourly wages increased just 1.9% year-over-year.
  • Consumer price inflation remains subdued below the Fed’s 2% target. Through August, the Consumer Price Index (CPI) advanced just 0.2% year-over-year. Excluding food and energy, prices advanced 1.8%.
  • Consumer sentiment declined over the quarter to its lowest levels in 11 months on rising levels of stock market volatility. The University of Michigan Consumer Sentiment Index fell from 96.1 to 87.2.
Economic Forecasts

By David Wines

Credit Spreads Widening

Risk aversion continued to rattle the corporate bond market over the third quarter as credit spreads widened for both investment grade and high yield bonds.

Spreads in the investment grade bond market (as measured by the Barclays Option Adjusted Investment Grade Corporate Index) moved, on average, from a low near 100 basis points above U.S. Treasuries in late 2014 to their current level near 165 basis points. Similarly, spreads in the High Yield bond market (as measured by the Barclays Option Adjusted High Yield Index) moved, on average, from a low near 240 basis points above U.S. Treasuries in 2013 to their current level near 662 basis points.

Spread widening in both the investment grade and high yield bond markets was driven by expectations that the secular decline in interest rates observed over the last several decades is coming to an end. Seeking to avoid devaluation when rates rise, bond investors trimmed their positions to reduce risk. Similarly, potential buyers of bonds demanded higher yields for assuming the added risk of what is expected to be a rising rate environment. Both forces combined to put upward pressure on spreads.

In addition to the re-pricing of bonds due to expected higher rates, the domestic high yield bond market came under additional pressure due to the fact that 13% of the high yield benchmark consists of debt issued by energy sector companies. Lower oil prices have significantly eroded profitability in the energy sector and diminished the ability of many firms to service their outstanding debt, leading to a general re-pricing of risk in the energy sector and pushing energy-related bond spreads, on average, to above 1000 basis points relative to U.S. Treasury securities. Relative to the 662 point spread of the broader non-investment grade corporate bond market, energy issuers appear to be in distressed territory

Spreads Widen
BofA Merrill Lynch US High Yield Master II Option-Adjusted Spread©; source Federal Reserve Bank of St. Louis

Fed Fatigue?

Few observers were surprised when the Fed failed to tighten monetary policy on September 17th. Citing the recent strain on global economic output and anticipating downward pressure on inflation as a result, the decision was to wait rather than act, leaving both equity and bond investors with more questions than answers. Will weak economic growth outside the U.S. impact what has been a strong labor market at home? Will slowing global growth brew deflation abroad, causing the U.S. to re-price goods and services? Could tightening in September cause additional volatility in global markets that have already experienced significant upheaval?

These questions weighed heavily on FOMC voting members and influenced the decision to delay tightening. Without clear bearings, investors were sent adrift, creating the ingredients for instability in U.S. capital markets.

Understanding that nebulous guidance from the Fed fosters uncertainty, Chairwoman Janet Yellen sought to offer more detail beyond what she initially presented following the September meeting. In a speech on September 24th, Yellen said the Fed was ready to raise rates this year and that global financial conditions would not get in the way. This added some degree of clarity on what to expect from the two remaining Fed meetings in 2015. Investors, however, have two questions for the Fed–when will it begin tightening and where it will end. Even after the Chairwoman’s speech, the answer to the latter question was no more known than it was before.

The answer to the second question is the subject of tremendous speculation–both outside as well as inside the Fed. Without clarity on when a second rate hike may occur, and how many subsequent moves there will be, we expect the Fed-guessing game will play meaningfully into investor anxiety for several quarters to come. What might shine light onto the Fed’s path and remove uncertainty? Signs of higher inflation will certainly help. Looking at the Fed’s most preferred measure of U.S. inflation, the Personal Consumption Expenditure Core Price Index, we find the index up 1.3% through August year-over-year. The Fed feels best when the index is at 2.0%. In our opinion, 0.7% is not much ground to cover.

With strength in labor markets expected to continue despite disappointing September numbers, we will be watching inflation closely. Any meaningful move upward should bring more certainty to the pace of tightening and possibly where it might end.

China Changes Treasury Course

Over the course of three days beginning on August 10th, the Chinese yuan devalued from 6.2 to 6.4 against the U.S. dollar as a result of significant disruption in China’s markets. The yuan had remained below 6.4 since September 2011. After building up a significant position in U.S. Treasuries over the last several decades, and in order to keep the yuan from further decline, The Peoples Bank of China began selling Treasuries and using the dollars to buy yuan. This action helped stall a further downdraft in Treasury yields, which had been pressured by a global flight to quality trade amidst the late summer equity market selloff.

The implications of the move beyond what occurred in August deserve close attention. China is the largest foreign holder of U.S. Treasuries at roughly $1.25 trillion. Their willingness to unload Treasuries in August introduces the potential for future supply risk should they see a need to support the yuan further. If the normal course of Fed-driven events pushes U.S. rates higher, China’s sales of Treasuries could push yields up more rapidly than market participants expect. To be clear though, this is a peripheral risk to the bond market going forward, but it needs to be monitored.

Fixed Income Strategy for Q4 2015

Fixed Income Strategy

Fixed income sector allocation remains unchanged from the previous quarter. Recent spread widening in high yield and U.S. corporate bonds have improved the attractiveness of both sectors. In general, spreads in both sectors are expected to stabilize relative to the prior quarter. Municipal bonds remain attractive when compared to taxable fixed income securities. With tax-exempt bond yields remaining in excess of 90% of U.S. Treasury yields of comparable maturity, we continue recommending a modest overweight to the sector. Duration strategy remains modestly short of the benchmark. Although uncertainty remains regarding the longer-term course of Fed policy, we anticipate initiation of interest rate normalization over the months ahead.

By: Derek Izuel

Sunrise in the Land of the Rising Sun?

Japan, home of what many called the “Lost Decade”, may finally be on the mend. The Japanese equity market is in the midst of nearly a three-year rally that has seen the Nikkei 225 double from 8,900 to 17,880. At the heart of this rally is the country’s economic policy known as “Abenomics,” the three-year effort by Prime Minister Shinzo Abe’s administration aimed at stimulating economic growth and investment through increased inflation, currency devaluation, and policy reform.

One objective of Abenomics is the weakness of the yen versus global currencies, which in turn has helped drive up the Japanese equity market. What has been most noteworthy about the market move is that for the first two years of the stock rally, improving corporate earnings were virtually the sole driver of the advance. Valuations remained fairly stable as reasonably skeptical investors questioned whether Abenomics would actually gain maintainable traction over the long-term, and only bought shares when they saw positive effects on bottom lines.

Thus far in 2015, however, market appreciation has come fromvaluation expansion rather than from earnings growth. The market appears to be finally buying into Abenomics, believing it might work, and is now willing to subscribe to prospects of sustainable earnings growth over the long-term.

With the economy’s high sensitivity to foreign demand, the equity market rally hit a speed bump recently. Japan has the largest export exposure to emerging markets among all developed economies, and particularly to China. So it was not a surprise that while the U.S. market sold off roughly 6.4% over the third quarter, Japan was down over 13% in yen terms.

Despite the recent equity market decline, we remain positive on the future prospects of Japan’s economy and stock market. We expect to see a further round of monetary stimulus from the Japanese central bank later this year. We are also encouraged to see that foreign investors have become increasingly attracted to Japan. Foreign investors now hold 32% of Japanese equities–a positive trend that has continued since the early 90s. In combination with renewed interest from domestic investors, Japan’s equity market will have plenty of wind at its back going forward.

Have Graham and Dodd Left the Building?

Why have U.S. value-oriented stocks underperformed their growth counterparts so dramatically recently? Calendar years 2012, 2013, and 2014 all saw only modest differentials between Russell’s 1000 Growth and 1000 Value index performance. Yet, so far in 2015, however, large cap growth equities have outperformed by 7%.

Value Takes a Beating  
Source: Frank Russell
Source: Japan Exchange Group; foreign ownership of Japanese shares at fiscal year-end each April 

The value swoon over recent periods has not been confined to large cap stocks. Year-to-date, the Russell Mid Cap Value Index has underperformed the Russell Mid Cap Growth Index by roughly 4% and in the small cap space, value has trailed growth by nearly 5% per their respective Russell indices.

Conventional wisdom for when either style is likely to outperform the other is to favor value during the early part of the economic cycle and growth during the later stage. The foundation for this view is simple: when earnings growth becomes scarce, such as during the latter part of the cycle, investors tend to pay even higher premiums for firms with presumably less sensitivity to the economy and higher earnings growth rates.

So far, 2015’s U.S. equity-style leadership has played out accordingly. Investors have sensed the maturing of the economic cycle and gravitated toward growth-oriented sectors of the market.

At this point, the relative valuation of growth and value firms has widened considerably. At one end are healthcare and consumer discretionary firms that have maintained positive earnings growth outlooks. On the other end are energy and materials companies that have suffered from excess supply and a softening demand from overseas.

It is likely to expect that investors’ attention will eventually revert back to value names once global economic growth begins to pick up again. Amidst a back drop of aggressive stimulus from foreign central banks, we foresee improvement on the horizon and are comfortable being early as we have begun to tilt our domestic equity allocations in favor of value.

Equity Strategy for Q4 2015

Equity Strategy Table

Despite an improving U.S. economy and the political challenges in the Eurozone, we continue to favor developed non-U.S. equities with an emphasis on Europe and Japan. Undervalued economies that trade at lower valuations are generally better equity investments than richly valued economies with moderating growth concerns.

In emerging markets, where equity valuations have appeared to be attractive relative to the U.S. market, we have been hesitant to increase our weighting based on the belief that structural and cyclical tides in emerging economies were moving out of favor. That indeed was the case, but we increasingly believe that the risk-versus-return opportunity emerging markets represents for an equity investor with a medium- to long-term horizon is attractive enough to revisit our thesis. We will be on a vigilant watch for signs that the global economy is strengthening sufficiently for an opportunity to overweight equities from emerging countries.

by Margaret Reid

U.S. consumers have endured much since the Great Recession–job losses, negative home equity, high debt-to-income ratios, and overall living costs that have risen faster than wages. Most of the stock market and home appreciation benefits have disproportionately accrued to higher-income consumers, while the majority of the populace has not participated in the consumer spending recovery since 2009.

The lower quintiles of income distribution are responsible for most of consumer spending, but have accounted for less than 25% of spending growth since 2008. Toward the end of 2014, however, tailwinds for low-to-middle income Americans began to build, including an improving employment backdrop, lower oil prices, rising minimum wages, and reduced household debt.

Consumer spending may now have more sustainable underpinnings if increasing consumer sentiment is incrementally driven by the low-to-middle income cohort which would benefit those companies that have lagged the recovery given outsized exposure to this income bracket. On the other hand, higherincome consumers may be facing growing headwinds as increased stock market volatility and global economic uncertainty could lead to reduced spending by the well-heeled.

U.S. consumers have also changed structurally–the demand for value for each dollar spent continues to be a priority despite better economic conditions; consumers also shop more online and are increasingly focused on healthy living. Americans are also beginning to spend more on experiences such as travel and entertainment versus non-durable goods like clothing. Personalization and innovation are also driving purchase decisions. The world is becoming increasingly more digital and more fragmented, and the millennial generation of 25- to 34-year-olds, a group that is comfortable with these trends, is entering the demographic sweet spot that will influence overall consumption trends.

Another bright spot continues to be U.S. housing, with significant pent-up demand for home improvement spending. As a share of wallet, spending on home maintenance, repair and remodels continues to be at cyclical lows.

Time to Remodel
Source: Cornerstone Macro Economic Research; home improvement residential investment as a % of total consumer spending

Since 2009, household formation has lagged expectations as millennials have chosen to live at home longer given high student loan debt and weaker job prospects. As shown below, the percentage of 25 to 34-year-old young adults living in their parent’s household began climbing in 2006 and is now at just over 14%, compared to a 20-year average of 12%. But given improving employment prospects and the aging of the millennial demographic, household formation should improve; driving increased housing turnover, and, in turn, increased spending on home improvement. Home improvement companies also benefit from less online competition than other retail categories, providing some relief from price and market share competition.

Hold off on Downsizing
Source: “Millenials in the Economy” Wells Fargo Securities Economics Group report, January 12, 2015

Outside of the U.S. it is a different story with particular implications for U.S.-domiciled global Consumer Staples companies. Developing markets have been the backbone of growth over the past decade but with China undertaking an economic transformation from an export-led to a consumer-led economy with uncertain and possibly disruptive outcomes, Brazil in recession with rampant inflation, and the stronger U.S. dollar, emerging economic and competitive risks may reduce the growth profile of global firms based in the U.S.

On the positive side, a deflationary commodity environment provides a margin tailwind, particularly for Consumer Staples companies that will rely on commodity input prices for growth. So far, however, U.S. dollar strength has undermined the benefits of lower commodity costs. With many of these companies trading at premium valuations relative to the S&P 500, prudent stock selection remains vital in this sector as growth may be more volatile, more costly and more scarce than in the past decade.

Overall, companies with advantaged online business models that offer perceived value, products and services that meet current trends, and/or are tied to increased consumer spending on experiences such as travel will likely see better relative growth over the next few years. Given increasing global macro volatility, we expect the recovery and preferences of the lower-to-middle income and millennial U.S. consumers to be positive catalysts for selected industries and companies in the U.S.

Economic and Market Perspectives Q4 2015

David Wines, CEO and Chief Fixed Income Officer
Derek Izuel, Chief Equity Officer
James St. Aubin, Head of Investment Strategy
Margaret K. Reid, Senior Investment Analyst

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