Market & Economic Review - Second Quarter 2015
First Quarter Review
In the first quarter there was a pick-up in volatility and dispersion amongst asset class returns predominately due to Central Bank policies. The ECB came out with a larger than expected QE program in January that boosted European markets. Japan continues on their course of easy monetary policy, as there is evidence that is has been working. Japan topped the list of markets whose earnings revisions were guided higher, while inflation was well below the 2% goal that has been set. In the U.S., the Fed has sparked some volatility in Treasury markets with a change in its language during the last two meetings. Early in January the 10-Year U.S. Treasury rallied significantly with yields going from over 2% to 1.7% then back to 2% by the end of the quarter. The fall in rates could be attributable to the weakness in the energy sector, strong Winter weather (again), and a sense that the Fed may not raise rates until later in the year. At the March meeting, the Fed got rid of the language regarding a “patient” approach to lifting rates, and indicated that they would not wait for inflation to show up before making a move to raise rates. This seemed to indicate that the Fed could likely raise rates in late summer, even if the metrics are not quite warranted.
The first quarter was completely different than the previous year in regard to asset class performance, with the exception of commodities. The S&P 500 was the low performer as International, Small Cap, and Hedge Funds all out performed. Diversification has finally started to payoff, as we have seen some continuing divergences across markets. The move by the ECB in January and continual accommodative policies by Japan allowed for International equity markets to catch up with the U.S. as the MSCI EAFE index was up 4.9% versus 0.95% for the S&P 500. The returns for those that hedged out currency risk were even higher as the Euro fell over 11% during the quarter. EAFE’s performance (in local currency) for the quarter had its largest outperforming quarter relative to the S&P since early 1998. The strong dollar was a headwind for U.S. companies and a tailwind for foreign companies.
Rates continued to be volatile in the first quarter, with the 10-Year starting the quarter around 2.25%, falling to 1.75% in January, and then ending the quarter just under 2%. Much of the volatility centered on energy prices and when the Fed was going to raise interest rates. The Fed has recently indicated that they are looking to be ahead of the curve when it comes to inflation heating up. This likely means that they will start to raise rates before the headline CPI exceeds 2%. It is probable that the Fed is monitoring employment costs in addition to CPI. When looking at energy as a component of inflation, history has shown that energy prices tend to move fairly rapidly and can move inflation from flat to over 2% in less than a year.
We are positioned to withstand a steady rise in rates with our duration target in the 4- to 6- year range. Good quality municipal bonds make up the bulk of our Fixed Income portfolios, and we believe they are positioned to do well relative to Treasuries. We are currently underweight exposure to High Yield due to looser covenants and narrow spreads and are investing in corporate bonds opportunistically.
The dollar’s strength in the quarter benefited overseas markets much more than U.S. markets. The Euro declined over 11% versus the dollar, which was the largest quarterly decline since the Euro came into existence in 1999. A weaker Euro and Yen translate into more exports for those countries and better earnings for businesses. In addition, there has been a rise in domestic sales for both Germany and Japan in the recent quarters, indicating that domestic demand is picking up due to quantitative easing. Growth continued to outpace Value in both Large- and Small- Cap, in fact Large-Cap Growth outperformed Large Cap Value by the largest differential since the 1st quarter of 2009, and the Large Cap Growth-to-Large-Cap Value ratio is at its highest since late 2000. Within the S&P 500, Healthcare and Retail were the top performers, while Utilities and Energy were the laggards.
One issue that we have become a little concerned with is the fact that top-line revenue has been tepid, while earnings-per-share (EPS) growth has continued. This has predominately been brought about due to a record level of stock buyback programs. In a stock buyback program, a company uses cash or debt to purchase back shares of its own stock. This helps improve earnings per share, as the share count is reduced, for the same amount of earnings. This can be a good strategy for firms who see their stock as cheap and a better use of capital than reinvesting into their businesses. The problem is that this strategy has become more of a financial engineering play—whereby management is incentivized base on EPS growth in the short-to-intermediate term—rather than a sign of true strengthening.
IBM is an example of a company using buybacks as a financial engineering tactic. There was very little top-line growth, and management bought back shares to prop up EPS artificially. This worked for a while until it was no longer sustainable, and investors caught on and punished the share price. Apple has been a good example, however, as they continue to grow very profitably and see a buyback as a good investment. Unfortunately, buybacks tend to happen when share prices are high not when they are cheap.
Currently buybacks and dividends within the S&P 500 represent nearly 100% of the earnings for 2014. In fact, dividends and buybacks combined have exceeded the peak in 2007. If one takes dividends and buybacks as a percentage of the S&P market value, the yield is around 5%, while Treasuries are around 2%. Typically shareholder yield has been a couple of percentage points below Treasuries, but now it is 300 bps over! What all of this means is that the low interest rate environment has led to distortions that are likely not sustainable. Buybacks have been the majority of purchases in the equity markets, as net inflows into ETFs and mutual funds have been dwarfed by the trillions of dollars bought back over the past couple of years. Easy debt and low rates have allowed for this, and time will tell how sustainable it will be. We continue to see value in Japan and Europe relative to the U.S.
In the first quarter we moved tactically towards Europe, Japan, and Emerging Markets. We believe that the easy monetary policy in Europe and Japan is conducive for a rally in equities. We have started to see Alternative Investments behave like we would expect them to in a market where the S&P is slightly positive. Both Long/Short and Absolute Return strategies outperformed the S&P 500 for the Quarter. Many of our managers are seeing opportunities to be both long and short in areas such as Energy and Technology. The one area we are still waiting to see turn is in our value-oriented strategies. The first quarter continued to be led by more expensive growth oriented stocks, while firms that are cheapest based on price-to-book and other metrics continued to underperform. This underperformance is on par with that of the 1999 to 2000 period. Our long term investment horizon allows us to focus on the fundamentals and not get caught up in the chasing of hot areas that are looking expensive. We expect to see volatility in equity and fixed income markets, as central bank policies between the United States and the rest of the world start to diverge.