First Half 2014 – J.C. Goodgal, Inc. Client Letter and CommentaryAugust 15, 2014
Equity Market Performance
The first quarter of 2014 produced positive equity market returns. For the first quarter ending March 31, 2014, the Standard & Poor’s 500 Index (“S&P 500”) produced a total return [including dividends] of 1.8%. The Dow Jones Industrial Index (“Dow”) and the Nasdaq Composite Index (“Nasdaq”) produced total returns of (0.2)% and 0.8%, respectively. Measuring only capital appreciation, the S&P 500 produced a return of 1.3%, while the Dow and the Nasdaq produced returns of (0.7)% and 0.5%, respectively.
The second quarter of 2014 produced positive equity market returns. For the second quarter ending June 30, 2014, the S&P 500 produced a total return [including dividends] of 5.2%. The Dow and the Nasdaq produced total returns of 2.8% and 5.3%, respectively. Measuring only capital appreciation, the S&P 500 produced a return of 4.7%; while the Dow and the Nasdaq produced returns of 2.2% and 5.0%, respectively.
Through the first half of 2014 the equity market produced positive returns. For the first half of 2014, the S&P 500 produced a total return [including dividends] of 7.1%. The Dow and the Nasdaq produced total returns of 2.7% and 6.2%, respectively. Measuring only capital appreciation, the S&P 500 produced a return of 6.1%; while the Dow and the Nasdaq produced returns of 1.5% and 5.5%, respectively.
Through the twelve months ending June 30, 2014, the S&P 500 produced a total return [including dividends] of 24.6%. The Dow and the Nasdaq produced total returns of 15.5% and 31.2%, respectively. Measuring only capital appreciation, the S&P 500 produced a return of 22.0%; while the Dow and the Nasdaq produced returns of 12.9% and 29.5%, respectively. Rates of return have slowed over the last 12 months on a rolling basis.
2013 was a remarkable year for U.S. equity markets; it was unexpected given the slowing economy in the fourth quarter of 2013 and the U.S. economy’s reliance on the Federal Reserve’s Quantitative Easing (“QE”) program. 2014 has continued this trend through June 2014 in spite of equity market returns slowing on a rolling 12 month basis. The equity markets generated lackluster investor returns through the first quarter of 2014, followed by strong returns in the second quarter. Even though investors have been uneasy about the Federal Reserve’s tapering/unwinding its QE program, by the time the Fed announced that it would reduce its monthly bond purchases/QE at the end of last year, from $85 billion to $75 billion starting from January 2014, investors considered such action positive for equity markets. The U.S. Federal Reserve has remained steadfast in the application of its tapering program, reducing bond purchases by $10 billion per month, unperturbed by wider global economic uncertainty or transient domestic conditions. The path towards monetary tightening seems well set as the economy seems to be slowing to approximately 2.5% GDP growth (from 2.9%).
An investor should not feel comforted by the fact the U.S. economy appears solid or that the U.S. Federal Reserve conveys the notion that it is all knowing and perfect in its execution of policy decisions. In fact it appears the Federal Reserve is actually telling equity and fixed income markets: “We don’t know what we’re doing so how can you be so sure”? Highlights of the Federal Reserve Open Market Committee (“FOMC”) minutes from its June 17th-18th meeting indicate: –
- QE will end in October 2014, assuming the U.S. economy stays on track ($15 billion will be final monthly QE amount);
- Some Federal Reserve officials saw investors as overly complacent on risks;
- Many Federal Reserve officials are against ending Mortgage Backed Securities (“MBS”) re-investments before they increase interest rates;
- Federal Reserve officials are split on the best way to signal its first interest rate hike;
- The FOMC advanced its discussion of an exit strategy, but it still centers on interest on reserves;
- Supervisory tools should address excessive risk;
- The Federal Reserve sees balanced jobs growth and inflation risks;
- The Federal Reserve sees the U.S. economy rebounding in second quarter of 2014, but capital expenditures and the housing sector may remain soft.Professional investors have begun to more vocally express concern with the Federal Reserve’s monetary policies towards asset accumulation and risk taking. William Larkin, a money manager who oversees $520 million at Cabot Money Management, said in a telephone interview with a reporter, “The reach for yields is going to get worse. She (U.S. Federal Reserve Chairwoman Yellen) had all these opportunities to at least put the runway down and lower the landing gear and at least talk about raising short term rates. But she didn’t take that route”.
Alex Merk, a money manager wrote in a Financial Times article, “Alan Greenspan suggested home prices could not fall; Ben Bernanke suggested the subprime mortgage market problems were contained; and Janet Yellen argues complacency in the market is not a problem. The current Federal Reserve chair, just like her predecessors, might well live to regret those words.
Complacency is the absence of fear; in the markets, it is reflected in low volatility. When asset prices rise on the backdrop of unusually low volatility, investors unaware of dormant risks are lured into the markets. And because there is such low perceived risk, investors are tempted to gear themselves up, i.e. borrow money to invest. However, at the first sign of volatility flaring back up, which could come from any number of reasons, those investors might sell out of their positions in a heartbeat screaming, “I didn’t know this was risky”!
This bull market has been constantly reinforced by the success of the “buy the dip” strategy. Eventually, given the leverage of market participants at this stage, selling will encourage more selling rather than more buying. The longer the low volatility uptrend continues, the higher the chances a stock market correction turns into a stock market crash.”
These investment professionals are arguing that a pause in the U.S. Federal Reserve’s accommodative stance towards monetary policy would increase the sustainability of the equity markets’ upward trajectory. Unfortunately, it appears the best short result for stronger equity markets would be a slowing economy causing the U.S. Federal Reserve to extend its QE program (a counter-intuitive outcome) or continuation its monetary accommodation. However, this will result in further risk taking and asset accumulation. Such a result incentivizes the accumulation of debt and the bidding up of asset prices from current levels. The ultimate outcome would be an equity market implosion resulting in significant asset deflation.
We are also approaching mid-term elections and it is doubtful the Federal Reserve will change its monetary stance, otherwise it will be vilified by both parties. For the balance of the third quarter of 2014, it appears the U.S. Federal Reserve and its European counterpart, the European Central Bank (“ECB”), is taking the path of least resistance and encouraging risk taking and asset accumulation. Should a market correction be in the offing, given the current approach of the Federal Reserve and fiscal policy makers, investors should expect that it may be more severe as a result of policy decision made in the first half of 2014.
Global Economy – Commentary
The U.S. and China are the two largest economies (in terms of single countries) on the planet. In the last decade the U.S. nearly engendered a global financial apocalypse, driven by excessive housing debt and a systemic under-appreciation of credit risk. A global cataclysm was only narrowly averted and imposed a period of severe recession followed by slow growth, the consequences of which spread globally with the impact varying by region and country. China has, as yet, only had a broadly benign effect on the world economy, providing at times a source of cheap exports, a stabilizing area of growth and strong stimulus when other major regions have faltered.
Despite the warning signs that are persistently cited, China’s economy has yet to see any major disruption of its growth path. Admittedly, China is now slowing, but that should be expected and welcomed as a sign of stability. However, the underlying driver of China’s growth should be a primary concern to economic and financial policy makers. The sustainability of China’s growth is questionable as it remains dependent on investment and credit. Furthermore, the linkage between Chinese local government debt, property prices and the banking system represents a potentially huge systematic financial threat – Caveat Emptor.
Global Economy 2014 – United States / Asia / Western Europe
2014 has seen some icy winds blowing through the global economy, both physically and metaphorically. The U.S. experienced an extremely harsh winter impair business activities from consumption to housing construction. In turn this obscured the true strength of economic growth. Meanwhile, scrutiny and skepticism concerning the fundamentals of several emerging market economies has intensified.
Towards the end of the first quarter of 2014, when you thought it might be safe to go outside, the prospect of a financial crisis and associated contagion spreading from an emerging economy gained credence. Economic developments in emerging market economies had come to the forefront and investors were exiting these markets expeditiously. By early March, however, concerns over emerging market issues (and pretty much everything else macroeconomic or geo-political) were side-swiped by Russia’s ‘intervention’ in Ukraine. While concerns regarding Europe’s breadbasket (i.e., the Ukraine) remain, political tensions in the Middle East have recently overtaken dealing with Moscow’s expansionism/colonialism and Brazil losing its World Cup bid at the hands of Germany. The global economy is lurching from the precipice of one economic problem to another, while at the same time geo-political events create market uncertainties that are not easily quantifiable. Markets are relying on an accommodative U.S. Federal Reserve and ECB to navigate economic challenges that are before the global economy.
The U.S. was dealt a blow with a downward revision down of first quarter 2014 Gross Domestic Product (“GDP”). U.S. GDP, having previously been estimated by the Bureau of Labor Statistics growing at 0.1%, the revised data revealed the U.S. economy contracted at an annualised rate of (1.0)%. However, the second quarter of 2014 appears to be developing more strongly and the U.S. should see a rebound in GDP growth. While the U.S. economy may be on a more sustainable growth trajectory, recent data suggests growth will be below early year consensus estimate, causing GDP growth to be forecasted to be approximately 2.5% for 2014. A more positive sign for the U.S. economy came from Markit’s manufacturing Purchasing Manager’s Index (“PMI”). The PMI increased to a three month high of 56.4 in May from 55.4 in April, with the household sector leading the upturn. Demand for consumer goods is also rising, as are exports. The U.S. unemployment rate held steady at 6.3% in May and declined in June to 6.1%.
Japan‘s economy grew at an annualised rate of 5.9% for the first quarter of 2014 as consumers and companies got ahead of the 3% sales tax. Japanese businesses raised machine orders to record levels in March. The second quarter of 2014 is likely to see a short, sharp contraction as consumption levels retreat and residential housing investment falls, bringing full-year growth back to Japan’s more customary levels.
China’s economic health showed improvements in May after a sluggish start to 2014. The Chinese PMI rose to 55.5 in May from 54.8 in April with the upturn driven by the service sector. HSBC’s China Manufacturing Managers Index rose to 49.4 in May from 48.1 in April, but still showed modest contraction below 50. Elsewhere the property market has been showing signs of pressure with prices falling in may for the first time in nearly two years. The government has unveiled stimulus measures which allow banks to lend more deposits to finance agricultural areas or small business.
The objectives agreed during the 2014’s Third Plenum of the new (fifth) generation of Chinese Communist Party leaders hold significant bearing on the medium-term outlook for Chinese economy. The objectives are wide-ranging but essentially tied to bringing about a fulfilment of Xi Jinping’s, China’s President, concept of the “Chinese Dream” – a sustainable development of China’s middle class by rebalancing the economy from investment to consumption via political reform.
In order to achieve this (namely, the goal for China to become a “moderately well-off society” by the 100th anniversary of the Communist Party in 2021), the Chinese government has taken immediate action to support entrepreneurs and lessen the influence of local government in business. A key change has been made to land ownership rights, enabling landowners to sell their plots at market rates – this change is expected to result in the agglomeration of land into large and efficient farms, freeing up rural workers to move to urban areas.
Whether the Chinese government’s policies increase food production enabling its society to consume increasing amounts of protein and calories is doubtful. China’s population is expanding again as a result of a change to its “one-child” policy. Furthermore, China is not self-sufficient in the production of agricultural products (i.e., rice, grains and oil seeds, etc.) and should agricultural production globally not meet expectations, not only China, but the world will be challenged to feed the planet’s population. Global stocks of agricultural products are finely balanced and any negative change in production levels will impact societies that are not self-sufficient in the production of agricultural products.
Given the circumstances, one may expect either food shortages to cause social strife, civil unrest or even wars to develop over the next 35 years as the global population grows from 7 billion in October 2011 to 9 billion to 11 billion in 2050 (United Nations Population Division Projections). The world will likely have to produce 100% more food by 2050 to feed a projected extra 3 billion people (the United Nations’ Food and Agriculture Organisation (“FAO”) To meet future demand, Monsanto is predicting that the world we will require more food to be produced in the next 50 years than what was produced during the previous 10,000 years.
Increasingly, global food requirements are expected to challenge commodity markets and policy makers. Climate change will not make the problem any easier to solve. As such, we believe agriculture, water [which is not explicitly discussed in this letter], and to a lesser extent, energy are investment sectors in which underlying fundamentals present opportunities to generate excess returns in spite of equity and fixed income market appearing buoyant.
The focal point of global economic news in early June was the ECB monthly meeting. This saw the ECB loosen monetary policy in response to continued low inflation. The thrust of ECB’s announcement was a cut in interest rates; the main refinancing rate was cut to 0.15% from 0.25% and the deposit rate to (0.1)% from 0.0%, forcing banks to pay to keep money with the ECB. Other measures were instituted including a program similar to the Bank of England’s Funding for Lending policy. Furthermore, preparations for QE were also announced, meaning large scale asset purchases are likely further down the road.
The European macroeconomic situation is looking brighter and the Eurozone currency union no longer appears to represent a slowly disintegrating politico-economic experimentgonewrong.Bond-spreadsare relativelystable. The excessive governmental debt of Eurozone countries is being addressed. The fiscaldrag the debt causediseasingand improvementsin competitivenessinsome regions of the Eurozone is reinvigorating exports. Europe is no longer on the brink of economic and financial catastrophe.
Post-2008, the Eurozone has, in both economic and geographic terms, typically been divided into two regions – the “core” and the “periphery”. Outside of Germany, sources of growth in the Eurozone have typically been scant. These definitions have served to represent and contrast the Eurozone’s “core” economies of Germany and France, along with the Benelux countries, against the highly indebted and frequently crisis stricken economies of the periphery, such as Spain, Italy and Portugal.
However, recent developments suggest these definitions are breaking down. Germany’s export-driven economy remains as strident as ever, but a lack of reform in France is dragging down the country’s competitiveness whilst Spain is experiencing a turnaround as it takes a more export-orientated approach.
2014 has seen equity markets reach peak levels, in terms of price/earnings ratios and relative to the underlying performance of the U.S. economy. Historically, nearly six years following the emergence of the 2008 financial crisis, the economy has underperformed most historic measures as compared to a normal economic recovery. We attribute a significant contributor to this underperformance to be the lack of entrepreneur business development, combined with a government that has sought to over-regulate the economy. In fact, the U.S. government under this Administration has to a large extent erected barriers-to-entry for small business development. Furthermore, the U.S. economic recovery has been a “seat of one’s pants” monetary experiment since the financial crisis of 2008. Its successes and/or failures are conclusively yet unknown. The economic recovery since 2008 has been a “work in progress” and will continue as such for some time.
Given current economic conditions, we expect increased inflationary pressures over the balance of this year in 2015 and slightly higher interest rates as the U.S. Federal Reserve continues to “prime the pump”. Our concern is that at some point, fixed income vigilantes may emerge from hiding and cause dislocations in fixed income markets. If so, equity returns may remain attractive in spite of higher interest rates. The equity markets should be supported by higher dividends generated by large capitalized companies being distributed to investors versus these companies seeking to increase their risk exposure by reinvesting capital in new business development.
In the meantime, we believe our focus on equity investments in agriculture, energy and soon to be involvement in the water sector offers a defensive investment approach with potentially significant long-term returns. We believe the fundamental supply and demand forces in these sectors present patient investors with attractive investment opportunities.