Quarterly Economic Review Third Quarter 2013
Despite a turbulent and circuitous path, most investment segments finished up in the third quarter. International stocks of developed markets were the stars of the show, gaining 11.6%. Aided in part by dollar weakness, these markets have nearly closed the year-to-date gap with high flying U.S. counterparts. Commodities, bonds, and emerging market stocks recouped some of their first half losses, but these categories remain down for the year.
Federal Reserve discussions in May and June laid the groundwork for a reduction, or â€œtapering,â€ of bond purchases in the not too distant future. Investors, globally, became consumed by the issue and a new period of market tumult was born. In July, the Federal Reserve provided clarification to the process and timing of tapering and suggested market participants had misunderstood and overreacted to initial Fed communications. Markets returned to a more settled state. Interest rates stabilized, albeit at higher levels, and domestic equity markets rose to new all-time highs. All major asset classes gained for the month with the exception of municipal bonds and long-term U.S. Treasuries.
Despite investment gains, July had its share of non-Fed related pressure points. Detroitâ€™s bankruptcy filing became the largest municipal failure in U.S. history, Chinaâ€™s growth continued to slow, political turmoil rose in peripheral Europe, and Egypt erupted into violence following a military coup that ousted President Mohamed Morsi.
In August, generally favorable economic developments were overshadowed by escalating tensions with Syria and the related potential for military strikes. Domestic monetary and fiscal policy issues added fuel to the fire. Fears of Fed tapering were renewed and increased noise out of Washington suggested a political battle was in store regarding the debt ceiling and governmental budgeting. Investment markets fared poorly. U.S. interest rates ticked higher, bond fund outflows continued to hit the record books, and a number of emerging market currencies were hammered.
Risks diminished in September and rising optimism carried investment markets higher. Widely expected Fed tapering was delayed and Russia brokered a diplomatic solution to Syriaâ€™s use of chemical weapons. Europe showed increasing evidence of a turn, Japanâ€™s economic engine continued to fire, and stabilization in China eased (perhaps eliminated) fears of a hard landing. Although, U.S. payroll growth weakened, investors paradoxically welcomed the news as a deterrent to Fed tapering. (Yes, the â€œbad is goodâ€ mindset was prevalent for much of the quarter.) As an encore, Lawrence Summers withdrew his name from consideration as the next Fed Chairman, leaving Janet Yellen as the likely front-runner. Markets rallied on their preference for Yellen along with enhanced political clarity.
At quarter-end, Congressional failure to approve a Continuing Resolution resulted in a partial shutdown of the U.S. government. The stalemate could go on until mid-October when the nation runs out of cash to pay its bills. By that time, Congress must also approve an increase to the debt ceiling in order for the Treasury to raise sufficient funds to pay government obligations.
While a shutdown is neither unprecedented nor unmanageable, failure to raise the debt ceiling is an acute risk with far reaching implications. In the absence of agreement, however, there are solutions that either President Obama or Speaker of the House John Boehner could take to avoid a catastrophe. While the options are admittedly unpalatable to these gentlemen, we can all hope at least one of these politicians rises to the occasion for the good of the country.
Economic Review and Outlook
U.S. GDP grew at an annualized rate of 2.5% in the second quarter of 2013.
The key drivers of growth were spending on durable goods, investment in housing and commercial real estate, and strong exports. Total government spending was a drag overall but far less than in recent quarters. State and local governments contributed to growth for the first time in a year and only the second time in 15 quarters. Housing grew at a 14.2% rate and is closing in on a nearly unbroken streak of mid-teens growth for two years.
Sequestration cuts of $85 billion did not appear as a major factor in the second quarter but may be observed when third quarter numbers are released. As discussed later, government cuts and higher taxes may also be factors behind a deceleration in the pace of job growth this year.
U.S. growth was reasonably broad based and certainly more attractive than in recent quarters. Surprisingly, however, the big news on second quarter growth came out of Japan and Europe.
Japan grew 2.6% in the second quarter following expansion of 3.8% in the first. During the third quarter, inflation rose at the fastest rate in over four years, jobs data reached a five year high, and industrial production rose at a 3.2% clip.
The Bank of Japan suggested the economy is starting to recover modestly. Business leaders clearly agree based on the recent Tankan business survey turning positive after six quarters of negative readings. Amazingly, this previously moribund economy is now leading the growth charge among developed nations.
As for Europe, the euro zone unexpectedly grew 1.1% in the second quarter, its first expansion since the fall of 2011. Similarly to Japan, Europeâ€™s turn has continued in the third quarter. Manufacturing growth in Italy, Ireland, Germany and other nations accelerated sufficiently to drive the regionâ€™s entire manufacturing base into expansionary territory in July. That pace accelerated in August to the fastest in over two years. Furthermore, the number of unemployed Europeans has edged down slightly and the regionâ€™s consumers have gained confidence. Industrial production is climbing, business optimism is up, and tax revenues have started to grow again. Recessions in Italy and Spain are slowing at a faster pace than expected and Spainâ€™s manufacturing sector has begun to expand.
While Europeâ€™s economics have improved, the road ahead is not free of challenges. Business investment and household incomes are weak and the unemployment rate sits at a high of 12.1%. Weak lending out of deleveraging banks does not help. Furthermore, the political situations in Italy and Spain are tumultuous and Greece is not yet out of the woods. The nation is now the subject of a likely third bailout and another debt restructuring may be needed in the future.
The International Monetary Fund (IMF) suggests the risk of a euro breakup has passed, but a weak recovery is on the horizon. As a result, they are encouraging both greater regional reforms and more stimulus. The IMF believes the European Central Bank (ECB) should lower interest rates, purchase assets, and provide another round of long-term loans to European banks. The rather precipitous decline in the ECB balance sheet, shown below, certainly provides room to comply.
In the Bizarro world where Japan can rise from the ashes to drive developed market growth, it is entirely plausible for China, the heretofore bastion of global economic strength, to have problems. The Chinese governmentâ€™s target of 7.5% GDP growth this year would be the nationâ€™s slowest since 1990. Considering China is now the second largest economy in the world, slower growth is to be expected. The primary problem is the uncertainty surrounding the countryâ€™s ability to actually hit the target. Secondary considerations include the quality of resulting growth and the stimulus measures taken by the government to meet its goal.
Chinaâ€™s year-over-year growth decelerated from 7.9% in the final quarter of 2012 to 7.7% and 7.5% in the first and second quarters of 2013, respectively. The pace of decline and weak economic releases early in the third quarter were causes for concern. Trade figures in June were poor and the manufacturing purchasing managerâ€™s index fell to 47.7 in July. This was the third straight decline, an 11 month low, and represented a manufacturing sector in contraction. At the time, economists suggested Chinaâ€™s growth rate might slow to 7% in the second half of the year and questioned the ability of China to meet its annual growth goal.
As the quarter progressed, signs of stabilization emerged. Industrial production rose, exports were favorable, retail sales were upbeat, and the purchasing managerâ€™s index moved back into expansionary territory. Third quarter growth is now expected to show improvement.
In the process of meeting its 7.5% target, however, China has likely failed in the mission to improve the quality of its growth. Reported numbers imply no progress on the objective of shifting from an investment and export oriented economy to one led by consumption. For now, the Chinese economy is more of the same and business as usual.
Circling back to the U.S., third quarter growth is likely to come in below 2% and modest acceleration should be seen in the final quarter. Full year growth is forecast to be just below 2%. Of course, the government shutdown is a wild card which will weigh on the economy, particularly if it lasts more than a week or so. Expect fourth quarter GDP to take a hit of at least 0.15% for each week of closure.
As a whole, the labor market was disappointing in the third quarter. Initial jobless claims, although down, were unreliable due to technical reporting glitches at the state level. The unemployment rate also moved down, but this metric has flaws as well. A decline in the labor force participation rate distorts the unemployment rate and renders labor market conclusions less meaningful. Unfortunately, the participation rate continues to decline.
The resulting moving target is a problem for economists, investors, policymakers, and others that use the unemployment rate to make decisions. In the extreme case of the Federal Reserve, policy guidance has been defined and publicly articulated in terms of the unemployment rate. At least some of the misunderstanding of Fed actions, or inactions, is due to the fact that the unemployment rate does not tell the whole story. Ben Bernanke has said as much. How far off is the official unemployment rate? The following graph illustrates an adjusted unemployment rate based on holding the participation rate flat at the level just prior to the Great Recession.
The blue bars, outlined by the black descending line, depict the officially reported rate of unemployment. The ever expanding red lines adjust for individuals that have left the labor force. Based on this analysis, no progress has been made on the unemployment rate.
Clearly, the labor market has far more slack than the headline number suggests, and one should be dubious as to the degree of actual labor market progress.
Importantly, Bernanke understands this fact and has repeatedly commented that the labor market is weaker than what is implied by widely watched data, notably the unemployment rate.
Job growth in excess of the rate of population expansion is the antidote for high unemployment and labor market slack. Yet job gains have been modest, at best, throughout the recovery. Moreover, the three month moving average of non-farm payroll additions suggests even that pace is slowing.
On a final note, the downward trend in payroll gains corresponds with the timing of recently enacted tax hikes and government spending cuts. While causation is hard to prove, the data certainly parallels these fiscal headwinds.
The consumer remains fairly content and supportive to the economy. Growth in personal consumption expenditures has remained positive, albeit modest, throughout the economic recovery. Consumer confidence eased modestly in September, but remains near a postcrisis high. The personal savings rate has steadily moved higher following a plunge in January. Debt levels are contained, net worth hit a new high of $74.8 trillion in the second quarter, and the ability to meet fixed obligations (rent, mortgage, car payment, etc…) remains near the best levels in recorded history dating back to the early 1980â€™s. Sequential retail sales growth has generally remained positive over the past year and auto sales have touched pre-recession levels.
Housing remains healthy, but challenges are evident at the marketâ€™s fringes. Importantly, most housing related data series are, at best, just beginning to reflect market dynamics following the substantial rise in mortgage rates. Likewise, abrupt changes in market dynamics, such as a spike in mortgage rates, can create a sense of urgency among market participants that often temporarily distorts/delays eventual equilibrium levels. Acknowledging a lack of data clarity that will only come in time, the following is an initial read on how the housing market is reacting to the jump in mortgage rates:
- Year-over-year price gains have stabilized in the low 12% range, but sequential monthly price increases are deteriorating. Annual gains are sure to deteriorate as well.
- The number of markets experiencing sequential price gains has begun to recede.
- Sales of existing homes remained strong through August, but new home sales took a substantial hit in July.
- Real estate agents have reported slowdowns in sales traffic in August and September.
- The Mortgage Bankers Association reported mortgage refinancings are off by over 70% (a negative for consumption) and purchase loan applications are down 15%.
Higher mortgage rates are not the only challenge to housing:
- Financial buyers, undeniably a substantial factor behind rapidly rising prices, have reportedly begun to step back from the market amid higher prices and correspondingly diminished investment opportunities.
- The pace of apartment rent increases is slowing, and a wall of new supply is coming online over the next two years. Apartments will provide alternatives and thus competition to homes.
- Household formation remains a problem. The number of people living in other peopleâ€™s homes for economic reasons rose in 2012 and is well over double the pre-crisis level.
- Lastly, in the span of only a few months, the confluence of higher prices and elevated mortgage rates has made housing less affordable than it has been in years.
Over the past two years, the housing market has been a valuable contributor to auto sales, job gains, economic growth, consumer confidence, and the creation of household wealth. The headwinds discussed in this section are an unwelcome development for a recovering and fragile economy.
U.S. monetary policy (anticipated and actual) completely drove the progression of global capital markets during the quarter. The end result to the nail biting, statement deciphering, hand waving, portfolio positioning, and forecasting of Fed action in September was, of course, no action at all. Be that as it may, the period from mid-May through mid-September might serve to be as informative as a visit from the ghost of Christmas future. Regardless of the timing, the Fed will taper its bond purchases eventually. The securities, asset classes, currencies, and countries that were helped/hurt by fears of tapering are likely to be similarly influenced by actual tapering.
The second benefit to the past few months is a reiteration of the Fedâ€™s requirements for reduced monetary stimulus:
- The labor market, comprehensively defined, needs to show greater health and less slack.
- Inflation needs to accelerate to a level closer to the Fedâ€™s 2% target. (In the case of a dovish Janet Yellen Fed, perhaps beyond.)
- Economic growth must pick up from paltry levels to a rate more conducive to self-sustainability (i.e. Fed life support is no longer needed).
- Fiscal policy, if not outright stimulative, should have a pathway devoid of challenges (i.e. no government shutdowns or debt defaults in the near future).
Without a doubt, the Fed will also keep an eye on the impact of mortgage rates on the housing market and will be mindful of how dramatically the capital markets can [over]react to shifts in monetary policy. Following news that Lawrence Summers stepped down as a candidate for the Federal Reserve Chairmanship, it is widely expected that Obama will nominate Fed Vice Chair Janet Yellen. Dr. Yellen is an accomplished economist, has nearly a decade with the Fed, is a monetary dove, is favored by investors, and is well aligned with current Fed policies.
Congressional failure to approve a Continuing Resolution by the start of the new fiscal year resulted in the partial shutdown of the U.S. government on October 1. Government shutdowns are not unprecedented (there were 17 between â€˜77 and â€˜96), but this is the first in 17 years. They generally do little lasting damage and the same is expected in this case. The stalemate could go on until mid-October when the nation runs out of cash to pay its bills. By that time, Congress must also approve an increase to the debt ceiling in order for the Treasury to raise sufficient funds to pay government obligations.
Congressional Republicans have tied government funding to Obamacare in an attempt to defund, delay, or at least modify the health law. While Republicans have driven the ship, Democrats have done little to alter its course as they believe a government shutdown may have negative consequences for the GOP.
While the shutdown is manageable, failure to raise the debt ceiling is a far more acute risk with significant ramifications to the capital markets, the value/ status of the U.S. dollar, and the future cost and ability of the U.S. to borrow. In the absence of agreement, there are two avenues that could avoid a catastrophe. Under the first, Obama could unilaterally raise the debt ceiling through either one of two constitutional elements. In the past he has shot this option down, but it could be revisited. The second option lies with Speaker of the House John Boehner who has declared he will not allow the U.S. to default on its debt. Boehner could bring a â€œcleanâ€ (i.e. without Obamacare defunding) Continuing Resolution to a vote in the House. This would likely pass although only with the assistance of Democrat votes. Passage of a Continuing Resolution without a Republican majority may have negative implications for Boehner within his party.
Governments, Politicians and World Events
A new period of political uncertainty is ahead for the Arab worldâ€™s largest nation. Egypt erupted into chaos when its military ousted President Morsi.
In response to Syriaâ€™s use of chemical weapons and the deaths of 1,400 people, the U.S. hardened its stance on the Assad regime and stepped up plans for a possible military strike. Through last minute intervention by Russia, the U.S. agreed on a framework for the international community to take control of, and destroy, Syriaâ€™s arsenal of chemical weapons.
Some believe losses will need to be taken on Greek debt by governments and/or the IMF. Germany has ruled out another debt restructuring for Greece, but acknowledges a third bailout is likely by early 2014.
Angela Merkel was elected for a third term as Chancellor of Germany. Prior to the election, Merkel went quiet on European austerity while becoming vocal as to her unwillingness to accept a restructuring of Greek debt as well as her thoughts on a European banking union. Post election dynamics will be interesting.
Capital Markets Review and Outlook
The fact that most investment segments were up for the quarter said little about the topsy-turvy process to get there. Nearly universal gains in July gave way to losses across the board in August. In September, the Fedâ€™s decision not to taper bond purchases sent investors off to the races again. The initial â€œQE foreverâ€ mania was short-lived, however, as investors took a moment to contemplate the Fedâ€™s message. Perhaps the risk of deflation, lackluster economic growth, disappointing labor market progress, restrictive fiscal policy, and the potential for a government shutdown and/or debt default are not indeed the ingredients for a healthy economic recipe or for continued investment gains. That said, when the dust settled, markets did finish up for both September and the quarter.
During the first half of the year, domestic equities dominated all other asset classes and dollar strength served as a headwind for international investments. In contrast, international developed markets rallied materially in Q3 and dollar weakness enhanced corresponding returns for dollar based investors. For the year, stocks of international developed markets have nearly caught up with U.S. counterparts. Unfortunately, the same cannot be said for emerging markets which are still in negative territory.
In the U.S., smaller capitalization stocks have outperformed and growth companies have been in favor. Growth stock outperformance was particularly notable in small caps where returns have been about 50% higher than those of value stocks. These relationships held for both the third quarter as well as the year-to-date.
Fixed Income Markets
The Barclays Aggregate Bond index gained 0.6% in the third quarter. To the chagrin of bond market fear mongers, the yield on the index was literally unchanged during the period as modest credit spread compression exactly offset slightly higher Treasury yields. The truly benign result, precisely one quarterâ€™s worth of the indexâ€™s 2.34% yield to maturity, stands in stark contrast to the doom, gloom, and fear of many market participants.
International bonds performed very well in the quarter, rising 4.4%. The key driver to the favorable outcome was dollar weakness against both the euro and the pound. The result lends credence to the value of both geographic and currency diversification within an investment portfolio.
On a go forward basis, two fixed income segments deserve particular attention. The first is an underappreciated, if not misunderstood, risk. The second is an overlooked opportunity.
Floating rate debt, also known as bank loans, has become a go-to solution to rising interest rates for many investors. The fundamentals of these securities are commonly misunderstood and the risks to this exceptionally crowded trade are mounting. Consider the following:
- Most loans are speculative grade credits and often involve risky borrowing levels.
- Coupons are adjusted but based on short-term rates. The Fed will have the operative rates anchored at zero well into 2015 or longer.
- Nearly all post-crisis loans have an interest rate floor. Even when the Fed raises rates, it will be some time before these floors are exceeded. Income generation will not move with the Fed.
- Assets in bank loan funds have soared 80% in the past 12 months – more than in the past five years combined! This is a small, trendy, overcrowded market with very poor liquidity characteristics. These are ingredients for a poor outcome.
- Highly levered and low-quality firms have entered the new issue market, with reduced investor protections, as a result of massive indiscriminant capital inflows.
- One-third of loans are trading at a premium, yet this debt is callable at par. Again, buying is indiscriminant and capital losses may result.
Owing to retail investorâ€™s fears of Fed tapering, municipal bond funds have suffered 18 straight weeks of outflows totaling $28 billion. Detroitâ€™s bankruptcy and Puerto Ricoâ€™s fiscal challenges only added to concerns. Detroit is unique, Puerto Rican exposure can be controlled (i.e. avoided), and muni bonds have baked in far more aggressive Fed action than other areas of the fixed income market. The resulting opportunity is clear in the following graph.
The tax equivalent yields shown assume a 33% federal income tax rate and include the 3.8% Medicare tax on taxable investment income. (Muni bonds are exempt from this tax.) Importantly, regardless of an investorâ€™s tax bracket, muni bonds with a 10 year or longer maturity have absolute yields IN EXCESS of taxable bonds. This very rarely happens but invariably leads to outsized returns.
The investment merits of muni bonds look favorable while the opportunity in floating rate loans appears less so. Keep in mind, however, that an all or nothing approach to investing rarely succeeds. Rather, a well diversified portfolio will stand the test of time. Appropriate position sizes of these and other types of securities, for your specific needs, should be discussed with a financial professional.
Hedge Funds and Alternatives
The HFRI Fund of Funds Composite index was up 2.1% for the quarter and 5.6% for the year-to-date.
Publicly traded REITs fell 2.9% for the quarter but remain up 1.8% year-to-date. Commodities, the laggards for the first half of the year, rose 2.1% in the third quarter. Aside from long-dated U.S. Treasuries, which are down 9.9% in 2013, commodities are the worst performing asset class this year, down 8.6%.
Though equity returns have been strong this year and following the financial crisis, one must be ever mindful of the downside risk inherent in assets with this kind of potential. Dramatic moves can, do, and will cut both ways. Considering it has been some time since the last bear market or even a correction, temptation may be running high to deviate from a prudently diversified portfolio, or to even question the validity of such an approach in the first place. Prior to doing so, reflect on the following:
- Over the previous 240 rolling 12 month periods, stocks have experienced 53 negative years (1 in 5) with an average loss of 17.4% and a maximum loss of 55.9%.
- Bonds have experienced 33 negative years with an average loss of 2.6% and a maximum loss of 5.2%.
- DIVERSIFICATION MATTERS when you have a 60% higher chance for loss and for those losses to be far greater.
This market commentary was written by Robert W. Lamberti, CFA who serves as Vice President of Investments for Summit Financial Resources, Inc. 4 Campus Drive, Parsippany, NJ 07054. Tel. 973-285-3600, Fax: 973-285-3666. Sources of Performance: MorningstarÂ®. Indices are unmanaged and cannot be invested into directly. The investment and market data contained in this newsletter is not an offer to sell or purchase any security or commodity. Standard & Poorâ€™s 500 Index (S&P 500) is an unmanaged group of securities considered to be representative of the stock market in general. The Wilshire 5000 Index is a market capitalization-weighted index of the market value of all stocks actively traded in the United States. The index is intended to measure the performance of all U.S. traded public companies having readily available price data. The MSCI Emerging Markets Index is an index created by Morgan Stanley Capital International (MSCI) that is designed to measure equity market performance in global emerging markets. Emerging markets are considered risky as they carry additional political, economic, and currency risks. Real Estate Investment Trusts, REITs, are securities that invest in real estate directly, either through properties or mortgages. REITs receive special tax considerations and typically offer investors high yields, however, have liquidity constraints. The Barclays Capital U.S. Aggregate Bond Index is a market capitalization-weighted index comprising Treasury securities, Government agency bond, Mortgage-backed bonds, Corporate bonds, and some foreign bonds traded in the U.S. Fund Category Performance is not inclusive of possible fund sales or redemption fees. Investment grade bond analysis included bonds with ratings of AAA, AA, A, and BBB. Municipal and Corporate Bonds are backed by the claims paying abilities of the issuer. TIPS are inflation-indexed securities issued by the U.S. Treasury in an effort to widen the selection of government securities available to investors. Past performance does not guarantee future results. Information throughout this Newsletter, whether stock quotes, charts, articles, or any other statement or statements regarding market of other financial information, is obtained from sources which we, and our suppliers believe to be reliable, but we do not warrant or guarantee the timeliness or accuracy of this information. Neither we nor our information providers shall be liable for any errors or inaccuracies, regardless of cause, or the lack of timeliness of, or for any delay or interruption in the transmission thereof to the reader. Opinions expressed are subject to change without notice and are not intended as investment advice or a guarantee of future performance. Consult your financial professional before making any investment decision.