Economic and Market Conditions (Audio version)
By most measures 2014 was a good year for U.S. consumers. Unemployment declined, energy prices fell and equity markets performed well for the third straight year. Despite the good news, however, consumer spending remains modest, the housing market is sluggish, and consumers’ appetite for debt is small. Over the past four quarters consumer debt increased by about $250 billion. Compare this to 2006, when consumer debt increased by over $1.3 trillion in the second quarter alone.
Investors, too, seem atypically risk averse. Even with interest rates at historic lows, twice as much money poured into U.S. fixed income markets as U.S. equity markets in 2014. And U.S. investors maintained record levels of cash while equity markets hit all-time highs more than 50 times. Bank demand deposits are now over $1.1 trillion, more than double the level of October 2010 and more than triple the $300 billion at the end of 2006.
Consumer spending represents more than 70% of U.S. GDP. Therefore, a cautious consumer inhibits GDP growth. Real GDP growth will average approximately 2.4% in 2014. With inflation a remarkably low 1.3% as of November 2014, nominal GDP growth will be below 4%. While this level is significantly lower than prior economic recoveries, if we stay in this range or edge only slightly higher, equity investors need not fret. The strongest market returns have been linked to economies growing at a slow-to-moderate pace, the backdrop we have today.
2015 Outlook – Both Earnings and Multiples Matter
Current consensus is for S&P earnings to grow approximately 7% in 2015. If the consensus is correct and the multiple that investors are willing to pay for earnings doesn’t change, the S&P 500 Index would increase by approximately 7%, and with dividends, return roughly 9% to investors.
If the price/earnings multiple expands by one point and earnings increase 7%, the S&P would return over 15%. If the market multiple contracts by one point, the market would essentially be flat and investors would earn the approximate 2% dividend yield (which may be disappointing, but still likely above the rate of inflation).
Predicting the multiple that investors are willing to pay for earnings is difficult given the influences of sentiment and other psychological factors that impact investors’ short term thinking. However, in certain environments, the direction of multiples may be more predictable. Multiples tend to expand when the economy grows faster than costs. As long as inflation remains low and aggregate consumer income continues to grow modestly (through a combination of higher employment, a longer average work week, and some hourly wage increases), we believe there is a greater likelihood that price/earnings multiples will either stay flat or expand and U.S. equity markets will move higher.
However, although we expect the equity market to exit 2015 at a higher level than it begins the year, we expect it to be a bumpy ride. Volatility increased significantly in the fourth quarter of 2014. Two big sell-offs in October and early December saw the S&P dip to 1,860 and 1,970 respectively before rallying to end the year at 2,059. We expect volatility to continue as markets react to global and exogenous factors that are inherently difficult to predict. We are in a unique environment with the U.S. Federal Reserve potentially poised to raise interest rates while inflation remains extremely low. Typically, the Fed raises rates to prevent the economy from overheating and when inflation tends to be higher than desired, not lower. This uncharted territory is leading to more reactive and unpredictable
market moves in the short-term.
Although predictions of a pending Fed rate hike are receiving a lot of attention and will likely contribute to transitory volatility, in our opinion, neither the anticipation, nor the actual rate hike, should be interpreted as a negative catalyst for equity markets. At some point, a combination of rising interest rates and falling profits will lead to a reversal of equity market performance. We just don’t believe that will be in 2015.
The Era of Global Synchronization is Over
The U.S. economy continued to outperform those of most foreign countries in 2014. The relatively short-lived era of a synchronized global economy is behind us. Perhaps it only existed as a confluence of coincidences. Major markets around the world are experiencing very different economic conditions. While real GDP growth in the U.S. is accelerating, Eurozone economic growth is stagnating, China is slowing, and Japan is teetering between positive and negative growth despite aggressive stimulative policies. One of the expressed concerns for U.S. markets is whether weakness abroad will negatively impact U.S. companies. The S&P is a global index with between 25-35% of revenue derived overseas. However, the majority of this revenue is generated from economies that have been tepid for quite some time. Barring a major international crisis, we believe accelerating growth in the U.S. (albeit from very low levels) will more than compensate for continued weakness abroad.
Given the divergent global trends, we are maintaining our preference for the U.S. at this time. The largest other developed markets, Europe and Japan, are plagued with high debt burdens, as well as short and long term structural issues, including very unfavorable demographics. Both are in the process of devaluing their currencies, which means stock price increases must at least equal the currency depreciation for a U.S. investor to simply break even.
Many emerging market countries face equally daunting challenges. A continuing increase in the dollar relative to other currencies is particularly challenging for emerging markets with dollar denominated debt. According to the Bank for International Settlements, emerging market countries have issued $2.6 trillion of debt securities, three-quarters of which were issued in dollars. As the dollar appreciates, not only will the cost of servicing their dollar denominated debt go up, but they will also have to post more domestic currency as collateral. In addition, many of these economies are highly dependent on commodity exports. As commodity prices decline, these regions are hit even harder.
Finally, the spread between the world’s cheapest markets and most expensive markets based on earnings yield is quite low. Given this valuation tightness, economic fundamentals favor the U.S. We continue to invest globally, but, for now, are maintaining a higher weighting to the U.S. than we have for several years.
Oil’s Price Plunge
After more than three years of relative stability, the price of oil dropped roughly 50%, from $107 in late June to $54 at year end. What’s unusual about this decline is that it occurred during a period of relative global stability and modest expansion. Normally, a drop like this is associated with a worldwide recession such as that in 2008/2009.
Given the rapidity of the decline, we’ve moved from an underweight to a market weight in the energy sector. If the price of oil rebounds from this extreme fall, we’d likely underweight again because we believe we are in the midst of secular changes in both the supply and demand for this commodity.
On the supply side, despite decreases in energy capital spending, production continues to rise in many regions, including the U.S. Fracking, in which a mixture of water, sand and chemicals is injected into shale formations to release oil, is a relatively young technology with big gains in efficiency still to come. According to some research reports, the cost of a typical project has fallen almost 20% (from $70 per barrel produced to $57 per barrel produced) in just the past year. In our opinion, the North America energy revolution is one of the clearest examples of modern technology altering the dynamics in a well-established industry.
What Do We Worry About?
U.S. corporate profits rose to a new all-time high in the third quarter (the latest data we have). This is important because domestic non-financial profits have consistently peaked several years before post-war recessions. With profits logging new highs, the current cycle should last a few more years.
U.S. Debt? Yes, but trends are moving in the right direction.
Comparisons of U.S. debt levels as a percentage of GDP to other developed regions such as Japan and the Eurozone are favorable to the U.S. For the most recent 12-month period the U.S. Federal deficit improved to $436 billion, a new cycle low, and a meaningful improvement from over $1 trillion in 2010. The deficit is on track to improve to 2.5% of GDP in the fourth quarter of 2014, from 10.1% for calendar year 2009. We’re not out of the woods, but improving.
Inflation? A little.
Our concern is that the combination of improving employment, better sentiment, low gas prices and continued low interest rates will lead to a marked acceleration in U.S. GDP growth, spurring inflation. So far, U.S. consumers have been cautiously restrained and falling commodity prices have raised as many concerns about deflation as inflation. This is a fine line that bears watching.
A crisis in Europe? Yes!
In our opinion, the biggest risk to the macroeconomic outlook is a repeat of the euro crisis when some Eurozone countries were unable to repay their debt or bail-out their banks. The weakest were the PIGS (Portugal, Italy, Greece and Spain), but during the height of the crisis, fear of the potential breakup of the economic union roiled markets everywhere. Europe still has many structural issues including double digit unemployment rates, outsized debt levels and widely divergent economic conditions among member countries. It is unclear whether The European Central Bank has authority and support from all member nations. Stronger countries may not be willing to support weaker countries, and weaker countries may not be willing to make the sacrifices mandated by the stronger. Countries exiting the union is not unthinkable. If we see deterioration in Eurozone economic data, we would likely reduce positions in sectors most tied to global growth such as financials, commodities and industrials, and increase weightings in defensive sectors such as healthcare and utilities.
Fed policy largely impacts the short end of the yield curve, which has already risen significantly, primarily due to anticipation of a Fed rate hike. Longer term interest rates are much more influenced by events outside the U.S. Long term rates in China, Japan, most of Europe, Mexico, South Africa, Australia, Hong Kong, and India have all declined this year. In fact, out of 25 major economies, only two, Brazil and Russia, have experienced an increase in their 10 year interest rate in 2014. Low interest rates abroad will continue to influence U.S. rates. If the dollar continues to appreciate versus other currencies and foreign central banks further their easing policies in order to stimulate growth, yields on U.S. long bonds will continue to decline. With short rates up and long rates potentially declining further, we will have an even flatter yield curve. In this environment, there is no incentive to purchase long-dated bonds. We will focus purchases on short and intermediate term maturities.
While, nominally, all rates are historically low, the municipal bond sector remains relatively attractive and strong. A standard ratio used to identify the relative value between tax-exempt and taxable bonds is a comparison of yields of 10 year AAA municipal bonds and 10 year U.S. Treasury bonds. With the 10 year AAA muni at 1.89% and the 10 year Treasury at 1.97%, the ratio is 96%. This compares to the average ratio over the last 23 years of 81.8%. On the longer end, the 30 year ratio has averaged 76.7% and is currently 106%. This parity makes municipals particularly attractive given their tax-exempt status. Further, low overall borrowing by belt-tightening states and municipalities has reduced supply of new bonds while higher individual tax rates have increased the relative attractiveness of tax exempt bonds. The supply of bonds isn’t likely to surge in 2015, as there are still more bonds being called out of the market than being issued. These supply/demand dynamics make Chevy Chase Trust’s municipal expertise and access to all major dealer inventories particularly valuable.
2014 was a good year for both stocks and bonds. 2015 will have new challenges and, we believe, new rewards.