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The Central View
April 2015
Tenuous Times
Tenuous Times
The juxtaposition of trends in equity valuations here and abroad, interest rates and currencies create a multitude of potential
outcomes— the drivers of which could have widely varying outcomes.
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Are domestic equity valuations unreasonably high?
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Will a decline in earnings or a peak in corporate profit margins pull down domestic equity markets?
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Will the divergence in monetary policies, particularly foreign central bank easings, drive up foreign equity markets?
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Will an increase in domestic rates by the Fed wreak havoc on the equity and bond markets, here and abroad?
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Will the dollar continue to strengthen and foreign currencies continue to decline? What will be the impact of each?
“In investing, what is comfortable is rarely profitable.”
- Robert Arnott
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Domestic Equity Valuations
Domestic equity valuations appear expensive
on an absolute basis. However, valuations
appear justified on a relative basis.
Since 1950, when inflation was in the 0-2%
range the S&P 500 has averaged a P/E ratio
of 17.9X. With inflation running at 0% or 1.7%
(excluding food and energy), then current P/E
valuations seem reasonable.
When inspecting P/E valuations based on
“forward” looking ratios, the S&P’s P/E ratio
of 16.9X is just slightly above its historical
average.
Equities also look attractive to many other
asset classes, particularly fixed income. As
such, the TINA principle still applies – There
Is No other Alternative.
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Corporate Earnings – Good or Bad?
Top line revenues for domestic large cap stocks
(i.e., S&P 500) were anemic for the fourth
quarter of 2014. Corporations continue to
generate more attractive earnings per share
growth through margin improvements and stock
buybacks. However, underlying growth is more
in line with the overall good trajectory of the
economy when considering the negative
impacts of declining oil prices on the energy
sector and the negative impacts of the
strengthening U.S. dollar.
When excluding the energy sector, the
remaining nine sectors generated more robust
4.3% revenue and 8.3% earnings growth.
When segmenting S&P 500 companies into
those that had 100% of revenues from the U.S.
versus those that generate more than 50% of
revenues from abroad, we saw a tremendous
U.S. dollar headwind and a difference of 5.2%
growth versus a negative 3.0% contraction in
revenues. Finally, when evaluating small cap
companies (i.e., S&P 600) that are highly
leveraged to the U.S. economy, we see an even
stronger story with 9.7% revenue and 16%
earnings growth.
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Corporate Profit Margins
Corporate profits as a percentage of GDP
are near all-time highs, based in part on:
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Long-term secular issues
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Advances in technology and productivity
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Corporate cost-cutting
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Low interest rates
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Reduced labor costs
Many consider a decline in corporate profit
margins as a negative sign that equities are
due for a correction. Historically, this
tendency doesn’t occur until three or four
quarters after a meaningful decline.
While profit margins can go up and down in
the short-term, the initial stages of declining
margins can be a good sign in that it means
that jobs and wages are increasing, thus
providing the next leg in the economic cycle.
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European Central Bank (ECB) Stimulus
As of March 31, 2015, the
Eurozone’s leading economic
indicator,
PMI
(purchasing
manager’s index), showed an
uptick for four consecutive
months and registered at 52.2.
Readings above 50 indicate
economic expansion.
While we are encouraged by
these results, we are realistic
that a unified monetary policy
will also need more unified fiscal
policies among the regions’
varying governments. Until we
see prolonged credit and
economic growth, as well as
more
orchestrated
fiscal
policies, we are hesitant to
overweight the region from a
long-term strategic standpoint.
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Currency Impact
The United States economy continues to gain
momentum so the Fed stopped its quantitative
easing program last fall and is expected to raise
short-term interest rates this year. This move
towards monetary policy tightening is divergent
to much of the rest of the world. There have
been nearly 540 central bank easings since the
beginning of 2014. Combined with better budget
and trade deficits in the U.S., the result has
been one of the sharpest increases in the value
of the dollar in memory.
Consequently, equity returns in local currencies
have been dramatic. However, as a U.S.
investor, we experienced a tremendous
headwind (non-hedged).
For example, the German and Italian market
returns witnessed a 14% decline in their returns
due to currency headwinds in the first quarter.
While we believe that Europe may continue to
strengthen, we must consider a continuing
currency exchange when allocating client
assets to the region.
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Fixed Income & Interest Rates
Global bond interest rates have
witnessed significant declines with
marketable declines in Europe due to
the anticipation and delivery of the
ECB’s QE program.
The spread of higher U.S. bond
interest rates to other sovereign debt
is attractive.
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Interest Rates - Yield Curve
Short-term interest rates are dictated by the Fed’s
setting of short-term lending rates. However,
longer maturity bond rates are dictated by the
market.
The Fed tends to increase short term rates in an
effort to manage healthy employment and
inflation. As this occurs, one would normally
expect that long-term rates would consequently
increase. However, countervailing forces are
currently in play as foreigners purchase higher
yielding U.S. bonds, which drives down longer
term interest rates. As such, we expect a
flattening of the yield curve (higher short-term
rates and stable longer-term rates).
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Out of Kilter
The expected demand for European sovereign
debt through the ECB’s QE program is
extremely meaningful when compared to the
related expected net issuance across
Eurozone countries. This demand/supply
balance is out of kilter. The imbalance has
driven interest rates extremely low in many
European countries. The spread difference to
U.S. debt is causing many foreign investors to
seek higher yielding U.S. bonds. The demand
thereof pushes U.S. prices up and interest
rates lower in the U.S. also. Many have coined
this QE 4 for the U.S.
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U.S. Corporate Cash Dilemma
Corporations create cash through the
issuance of:
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equities or bonds
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taking on loans
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net operating income of the business.
Management must then determine the best
use of that cash.
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Corporate Growth Activities
Capital Expenditures (Capex)
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Surprising to many has been the
increase in capex. Capex is now 60%
higher than pre-recession highs.
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While the typical capex cycle lasts
four to seven years, we believe
secular issues will extend this trend.
M&A activity
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Has steadily climbed since the 15year lows of 2009.
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$1.8 trillion in U.S. deals of all sizes
since the beginning of 2014.
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Strong balance sheets, low interest
rates  expect M&A activity to
continue.
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Shareholder Yield Activities
Buybacks
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According to Barron’s, companies in the
S&P 500 alone bought back more than
$550 billion worth of stock in 2014, an
increase of 16% over 2013.
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As Exhibit 13 illustrates, buybacks have
nearly tripled since the lows of 2009.
Dividends
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Have increased nearly twofold since
the lows of 2009.
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More recently, dividends for the first
quarter of 2015 surged 14.8% year-overyear (source: Ned Davis).
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Market Recap
In the first quarter, investment markets delivered positive returns across almost all asset classes. Stock markets
across the globe set record highs as major central banks continued accommodative monetary policies that kept
interest rates near historic lows. International stock markets outperformed the U.S. domestic stock market in contrast
to last year. Currency movements were significant in the first quarter as the U.S. dollar jumped 9%, while the euro fell
11%. Bonds beat stocks as interest rates continued to move lower across the globe to record low yields. Real assets
were mixed, led by gains in real estate as MLPs and commodities slumped. Overall, balanced investment portfolios
gained ground for the quarter.
Equities
Global equities advanced in the first quarter with the MSCI All Country World Index gaining 2.4%. U.S. equities rose
as the S&P 500 gained 1.0%, its ninth consecutive quarter of gains. International developed markets performed best,
climbing 3.2%, buoyed by fresh quantitative easing policies in Europe and Japan. Emerging markets gained 2.2%.
For the first quarter, the U.S. sector
leadership was consumer focused led by
gains in the health care and consumer
discretionary sectors. Utilities, energy and
financials posted negative returns. Small
and mid-cap stocks outperformed large cap
during the quarter as small/mid-cap
companies with higher domestic sales are
less impacted from a rising U.S. dollar than
large
cap
companies
with
higher
international sales.
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Market Recap
Fixed Income
Interest rates continued to trend lower in the first quarter as the yield on the 10-Year U.S. Treasury bond ended the quarter
at a yield of 1.92%, down from 2.17% at the end of last year. While the aggregate global bond index fell 2.2%, the Barclays
U.S. Aggregate Index gained 1.6%. The credit segment of the bond market outperformed as spreads tightened with high
yield gaining 2.5%, floating rate securities up 2.1% and emerging market debt advancing 2.1%. Municipals gained 0.6%.
Real Assets
Real estate continued to be strong. Global REITs
gained 4.0% as interest rates moved lower and
property fundamentals remain solid. MLPs
declined 5.2% due to weakness in the energy
market, particularly for exploration and
production companies. MLPs represent a play on
the growing energy infrastructure demand in the
U.S. Commodities continued to move lower,
falling 5.9% as the dollar advanced. Oil prices
have been cut in half since mid-2014 and ended
the quarter below $50 per barrel at $47.
Complementary Strategies advanced in
the first quarter, providing stability to portfolios by
enhancing diversification and reducing volatility
due to low correlation with other asset classes.
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Portfolio Implications
Overview
The following portfolio implications are intended to provide a perspective on the positive and negative attributes of our
asset allocation strategy decisions over various time periods. Many of the over or under weight characterizations relate to
our policy benchmarks, which are generally anchored to global market weightings for each asset class with some
modifications. Asset class returns represent underlying index returns with the exception of complimentary strategies
(alternatives) as footnoted. Client portfolio returns will vary based on their specific investment objectives, tax or other
constraints and the actual investment vehicles chosen.
Client portfolios are generally broadly diversified to capture numerous low or negatively correlated asset classes
and to capture various factors that are impacting market dynamics. We caution clients and advisors against
anchoring their broadly diversified portfolio against one specific benchmark or relative to benchmarks most
familiar to them. For example, the S&P 500 has performed well in recent years and it is easy for clients based in the
United States to have a home bias when the U.S. equity markets only represents approximately 50% of the global equity
markets (cap weighted). Similarly, investing in equities produces higher levels of volatility that must be minded, particularly
during periods of extended positive returns. Clients that are revisiting their risk and return appetite are advised to
complete an updated risk questionnaire and investment policy statement. We believe that the best possible benchmark for
clients is a nominal return based on cash flow needs.
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Portfolio Implications
Equities
Based on continued economic growth domestically, resurgent manufacturing activities abroad and attractive relative
valuation to other asset classes, we continue to suggest an overweight to equities in general. Our overall equity weights
are still over-weighted to domestic equities.
We are closely watching the direction of currencies and their impacts on foreign investments. While we believe the U.S.
dollar will continue to strengthen against foreign currencies, we do consider a potential consolidation period as a tactical
opportunity to selectively increase exposure to international equities. While we continue to favor equities, we reiterate
our position earlier in the year that volatility should increase in the domestic equity market, particularly as we remain
above historical normal valuations—warranted as it may be.
Fixed Income
Despite the headwinds of elevated debt levels, the end of quantitative easing and interest rate hikes by the Fed on the
horizon, other factors including geo-political unrest and foreign demand for higher yielding U.S. bonds may flatten in the
yield curve (higher short-term rates, steady long-term rates). Diverging monetary policies support this case. However, if
the Fed becomes more dovish (i.e., stimulative) then this base case loses its luster.
While we reluctantly accept the likelihood that interest rates will remain low, we are not comfortable with the absolute
yield or the risk/return trade-off with such historically low levels. As such, we maintain our overall under weighting to
fixed income. We have diversified our sources of income for investors generally and specifically away from interest rate
risks and into credit-oriented bonds with positive outcomes for clients for the last several years. Credit will continue to
provide superior returns as the economy strengthens and investors seek yield. International debt varies dramatically by
country. While emerging market debt is more immune from U.S. interest rates and currency fluctuations than in the
past, a continued increase in the dollar and any big moves in U.S. interest rates may create periods of increased
volatility. Be careful of chasing yields in international markets.
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Portfolio Implications
Real Assets
We increased our weighting to real estate based on continued global stimulus and continued economic growth in the U.S. We are
maintaining a full position in MLPs, while still recommending the avoidance of commodities. MLPs are a growing asset class that
is benefitting from the U.S. energy renaissance and increased investor adoption. Commodity pricing continues to reflect a
disinflationary environment, attributable to slack capacity in the labor market and soft loan demand. It is our view that the
persistently low-growth environment is not likely to spur cost-push inflation. And, the more recent run up of the U.S. dollar does
not bode well for most commodities. Higher yielding MLPs and REITs are fundamentally attractive and are also appealing to
investors seeking yield.
Complementary Strategies (Alternatives)
Complementary strategies (alternative investments) offer opportunities for better overall diversification and a healthier portfolio.
We believe that in an environment with lower overall growth expectations and challenges for fixed income markets, clients will
benefit from managers who can provide additional return and risk management opportunities. Many of the strategies we use are
designed for lower volatility, as a hedge in volatile markets and to perform well in rising interest rate environments.
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