divergent - capinv.com · 4 nor is such sentiment confined to the general public. market...
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A Quarterly Publication March 31, 2014
Capital Investment Services of America, Inc.
700 North Water Street, Suite 325 Milwaukee, Wisconsin 53202-4206
414/278-7744 800/345-6462
[email protected] www.capinv.com
In This Issue . . .
Major economic trends continue to
diverge from the patterns
established over the past 10-15
years.
Slower and less commodity
intensive growth in China may
well mean the “commodity super-
cycle” is over.
The Federal Reserve (i.e. the Fed)
is signaling they are about to
diverge from the zero interest rate
policy.
Manufacturing, the dollar and the
trade deficit may offer pleasant
surprises.
Economic growth is slow but high
quality and durable.
A low economic expectations
backdrop exists in the U.S.
No Fed-induced sugar high.
Higher interest rates won’t kill the
expansion anytime soon.
U.S. demographics are not a
headwind for economic growth.
Student loan worries are
overblown.
Stock market corrections are more
common than Christmases.
Divergent
The movie release of the popular book of the same title, Divergent,
has now hit the “big screen”. While we confess to knowing little
about the storyline of the book and movie, we suspect it is safe to say
that it is not about the contemporary investment environment. Yet,
the term divergent strikes us as both a timely and apt description of
the current investment and economic scene.
Consider:
Major economic trends continue to diverge from the patterns
established over the past 10-15 years. For much of this period,
emerging market economies, particularly the so-called BRIC
nations of Brazil, Russia, India and China, drove global growth.
Now these economies are saddled with growth-smothering
excesses that accumulated in the boom years. To varying
degrees, the economic troubles in these countries will likely
require a considerable amount of time to remedy. In contrast,
with few signs of similar excesses that are a threat to the
domestic economic expansion, the U.S. looks set to become
(once again) an economic growth leader.
Slower and less commodity intensive growth in China may well
mean the “commodity super-cycle” is over. Rising and volatile
commodity prices lifted the fortunes of most commodity
exporting countries, while triggering commodity inflation for
developed nations’ economies. Commodity price relief as it
unfolds will be very beneficial to U.S. consumers, producers,
and the valuation of U.S.-traded stocks.
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The Federal Reserve (i.e. the Fed)
is signaling they are about to
diverge from the zero interest rate
policy that has been in effect since
the 2008 Financial Panic.
Improving fundamentals
underlying the U.S. economy have
increased confidence that
extraordinary monetary policy
actions are no longer appropriate.
The Fed policy shift represents a
significant divergence from the
policy actions of many of their
global counterparts. The European Central Bank looks poised to join Japan in pursuing still more
extraordinary monetary policy actions in hopes of keeping deflationary pressures at bay. Meanwhile, a
different constellation of issues—inflation along with bad debt, over-capacity, and commodity excesses-
-are forcing many emerging market economies towards more restrictive credit policies.
Manufacturing long has been considered a sore spot within the U.S. economy. We believe evidence
continues to mount that a productivity-driven manufacturing renaissance is occurring. Some analysts
are even making the claim that investors’ new “emerging market” may well become that area of the U.S.
often derided as the “rust belt”—middle America!
The trade deficit—as measured by economic statistics—has been a persistent drag on U.S. economic
growth. Here, too, indications suggest trends are set to diverge from the long-run pattern. U.S. based
manufacturers are at the forefront of adopting new technologies that are remodeling both the production
and nature of an increasing number of goods and services. The domestic energy revolution continues to
blossom as well. Trade no longer may be a drag on domestic growth measures.
A common forecasting technique we humans
use to deal with uncertainty is to simply
extrapolate the recent past into the future.
And, while this technique often works well,
when trends diverge from past patterns,
investment expectations and risk/reward
profiles of investments shift—often
dramatically.
We suspect the economy and financial markets are in the midst of one of these periods. And, while some of the
divergent trends have already been underway for a while, it is still “early innings” investment-wise, as we now
discuss.
High-quality economic growth
The slow pace of the economic expansion is not news, of course. The fixation on the pace of growth is
understandable, but overlooked has been an important attribute about the character of growth.
BMW said it will spend $1 billion to boost production at
its South Carolina assembly plant by 50 percent in the
next two years. One more sign that the United States
has become a competitive site for manufacturing and
an attractive staging ground for exports.
Forbes, 3/28/14
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One of the underlying “drivers” behind these divergent growth trends is technology-induced productivity gains.
Technology has enabled an unprecedented ability to share information and “idea recipes” for innovation.
Virtually any problem is now open to the free market of creative minds across most of the world’s population.
Innovation is the oxygen which productivity growth needs to
“breathe”. And, productivity gains are, in turn, the raw
ingredients for a rising standard of living via both rising wages
and the increasing affordability of goods and services.
As a result, productivity-inspired growth is high-quality,
resilient growth. This stands in contrast to growth fueled by unsustainable borrowing-to-consume behavior
such as that which defined the prior U.S. economic expansion, or borrowing-to-build excessive capacity as now
appears to afflict China (see quotes nearby).
Since the current economic expansion began, there have been threats to growth from geopolitical developments,
economic troubles abroad, and economic intrusions from Washington D.C. Throughout, the underlying growth
trend has proved resilient.
There will, no doubt, be more unpleasant bumps in the road ahead, and the implications of each will have to be
assessed along the way. But, the resilient character of the underlying growth dynamics suggest the duration of
the expansion from this point forward will still likely be measured in years rather than days or weeks.
A low expectations backdrop remains From an investment perspective, an important question to keep in mind is: how is reality unfolding relative to
expectations? Investor sentiment tends to rise, along with stock valuations, when reality consistently exceeds
expectations.
The stage still remains set for “better than expected” outcomes in the U.S. economy. With the rise of the
perceived “emerging markets century”—to borrow a bold book title published during the emerging markets
boom, the view that “our best days are behind us” has been a common U.S. economic sentiment. The Financial
Panic only reinforced the view about domestic prospects.
This downbeat and fragile state of the general psyche still persists. Five years into the economic expansion, a
recent NBC News/Wall Street Journal poll indicates that nearly 60% of polled adults believe the U.S. economy
is still in recession.
“China has 95 Empire State Buildings
worth of empty office space.”
Cornerstone Macro
Most analysts believe that the Chinese economy will once again expand by more than 7 percent
this year, despite ballooning private sector debts. But the pessimistic minority has history on its
side. Only five developing countries have had a credit boom nearly as big as China’s. All of
them went on to suffer a major economic slowdown.
Five years ago it took just over $1 of debt to generate $1 of economic growth in China. In
2013 it took nearly $4 – and one-third of the new debt now goes to pay off old debt.
“China’s Dangerous Credit Addiction”, Financial Times, 1/15/14
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Nor is such sentiment confined to the general public. Market “bubbles” are being fretted almost constantly as
Chart 1 suggests.
Chart 1: Investors are alarmed by both good (new highs in stock prices) and bad news.
While the level of fear, uncertainty, and doubt we have noted over the past few years has lessened a bit, and
general valuations of U.S.-traded stocks have risen, expectations about the future of the economy remain
modest at best. Against a backdrop of low U.S. expectations, the divergent trends still have a rather “low bar” to
clear to deliver favorable surprises and trigger more improvements in general investor sentiment.
Investment opportunities
Stock valuations are also likely to get a boost from additional factors, as well. The normalization of interest
rates and a narrowing trade deficit will likely help fuel a rise in the exchange value of the dollar. A rising
dollar, along with productivity growth and commodity price relief, provides a favorable backdrop for corporate
earnings growth, profit margin durability, and the overall valuation of U.S.-traded stocks.
Chart 2 nearby reflects the interplay we have noted on prior occasions between stock valuations (P/Es or
price-to-earnings multiples) and commodity inflation. While commodity price inflation compressed P/Es of
U.S.-traded stocks last decade, we expect commodity price relief will provide a tailwind behind general
stock valuations in the period ahead.
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Chart 2: Commodity Prices and P/Es
Source: FactSet
So far, most price relief has occurred in non-energy related industrial commodities. An unusually cold and
snowy winter across much of the U.S. has boosted prices of natural gas and many agriculture products. Mean-
while, although oil price volatility is down substantially from prior years, geopolitical issues have kept oil prices
firm.
More seasonal weather should help take the edge off heating costs and the price of ag products. Oil price relief
may also be on the horizon as the nearby Barron’s magazine cover story suggest.
Moving from the general to the more specific We believe favorable risk/reward investment
profiles exist in many firms that are providing
the modern-day “tools” that enhance
productivity growth. Such tools may include
sophisticated measurement instruments, product
design software, big data, and cloud-based
applications, as well as direct digital
manufacturing and 3-D printers.
Opportunities to benefit from the manufacturing
renaissance also may be found in select
construction/engineering and transportation
businesses. In addition, lenders that provide the
financing that enable manufacturers to buy the
new tools and fund necessary capital expansion
plans stand to benefit as well.
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Lastly, opportunities also exist in select growth businesses that are driving transformative changes in selective
niches in the retail, healthcare, and technology markets.
Investment worries
In the material that follows, we offer a bit of perspective on some of the investment worries of the day.
Commodity producers and some multinationals
Not all companies stand to benefit from commodity price relief and stronger dollar trends. Unless they have
sufficient unit volume growth, the earnings of commodity producers and their suppliers will likely be hard
pressed to overcome falling product prices. And for those companies whose growth engine relied upon global
commodity expansion, earnings disappointments may occur as weaker international end markets and
unfavorable exchange translation take a toll.
The new divergent trends are creating a different set of investment “winners”. What “worked” well investment-
wise last decade, may no longer be so rewarding.
What happens when the “sugar-high” ends?
Two potential risks revolve around the Fed’s movement towards normalizing monetary policy. One risk
concerns the view that the economy and market are only being held up by the Fed’s extraordinary actions.
Absent the Fed induced sugar-high of additional asset purchases, bad times are ahead, according to this view.
Table 1 nearby is offered as “proof” of this thesis. Since the Financial Panic of 2008, stock price advances all
have occurred during episodes of Fed bond buying programs. When prior Fed bond buying programs
concluded (identified as QE1 and QE2 in the table), stocks prices suffered sizable declines.
Table 1: Fed induced sugar-high?
Federal Reserve Asset Purchase Programs
S&P 500
Program Start End Change
QE 1 11/25/2008 3/31/2010 36%
Period between 3/31/2010 8/27/2010 -9%
QE2 8/28/2010 6/30/2011 24%
Period between 6/30/2011 9/21/2011 -12%
Operation Twist 9/21/2011 12/31/2012 22%
QE3 to taper announcement 9/13/2012 12/18/2013 24%
Since taper announcement 12/18/2013 3/31/2014 3%
Source: Bespoke Investment Group
While the risk of a stock market setback is always present, we are not in the sugar-high camp. The resiliency
argument offered earlier partially shapes our more favorable expectations, but other important factors contribute
as well.
The Fed of the 1930s allowed the financial system to collapse and trigger the Great Depression. The modern-
day Fed learned from that disaster and fulfilled a “lender of last resort” role in the aftermath of the Financial
Panic of 2008. Their liquidity-providing actions and the associated expansion of the Fed’s own balance sheet
filled a hole that developed within the financial system as private sector credit demands staged a sharp decline.
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But unlike the prior two periods when the Fed ended extraordinary bond buying programs (highlighted in red in
Table 1), private credit demands are now rising. Chart 3 below reflects this development. Incidentally, this
chart and additional analysis are provided in a recent Market Commentary entitled, “Household Deleveraging
Ending”, posted at capinv.com. To receive these concise, topical commentaries, a “Subscribe” feature is
provided at the lower left of the capinv.com home screen.
Chart 3: A rise in private sector credit demands means the Fed can and should back off.
Source: FactSet
With no hole left to fill, it is both appropriate and timely for the Fed to wind down its lender-of-last resort
activities. The economy no longer requires extraordinary support. The stock market’s relative resilience since
the Fed announced the tapering of its latest bond buying endeavors in December (last line in Table 1), suggests
“this time is indeed different”.
Higher interest rates and bond yields
The second risk associated with the Fed diverging from its long-standing zero interest rate policy relates to the
normalization of interest rates. Can the economy withstand higher interest rates?
With credit conditions gradually moving towards something resembling normalcy, we believe probabilities are
very much on the economy’s side. It is also important not to confuse the Fed’s current policy shift with the type
of “tight” money policies that typically render an expansion vulnerable to recession. The Fed is likely a long
way from tight policy of that magnitude and will remain so as long as inflation remains modest.
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History indicates the stock market handles rising interest rates reasonably well as long as the change in rates
signals growing confidence in the prospects for corporate earnings and the economy.
The investment implications for the bond market are less sanguine, however.
The rise in bond yields that has transpired over the past year has helped improve the risk/reward profile of
bonds in general. However, Treasury securities across the maturity spectrum remain priced with little cushion
to withstand the higher yields the normalization process will likely bring.
By the way, many municipal bonds (which experienced stiff price declines last year in the wake of the Detroit
bankruptcy and the fear that Puerto Rico will suffer a similar fate), and our remaining preferred stock
investments possess much more favorable risk/return profiles than most of the bond market in our assessment.
Generally unattractive bond market prospects beg the question, why own bonds? The answer is two
dimensional. First, low interest rate/risk exposure via short-term bonds, floating rate securities and the select
munis, and preferred stocks we own in varying amounts should weather the yield normalization process
relatively well. In addition, significant liquidity provides ample dry powder for bond purchases when the
risk/reward profile of the bond market improves.
Secondly, despite low yields, bonds continue to fulfill their portfolio role within blended bond/stock portfolios
by dampening stock volatility when it is needed most. To show this point, we reproduce Table 1 below, but
have added a column that provides bond returns during those periods when stock prices suffered downturns. As
the data reflect, even with low yields, bonds provided returns that cushioned the sting of stock market setbacks.
Federal Reserve Asset Purchase Programs
S&P 500 Bond
Program Start End Change Market*
QE 1 11/25/2008 3/31/2010 36%
Period between 3/31/2010 8/27/2010 -9% 6%
QE2 8/28/2010 6/30/2011 24%
Period between 6/30/2011 9/21/2011 -12% 5%
Operation Twist 9/21/2011 12/31/2012 22%
QE3 to taper
announcement 9/13/2012 12/18/2013 24%
Since taper announcement 12/18/2013 3/31/2014 3%
Source: Bespoke Investment Group, Bloomberg LLP
*Vanguard Total Bond Market ETF (BND), Total Return
The U.S. has “bad” demographics from an economic growth perspective
Aging populations represent a potential issue for many nations. From an economic growth perspective, the
situation could become particularly acute in countries where either the working age population is at risk of
being dwarfed by the retired, or outright population declines may occur. Europe and China face the first
headwind while Japan is potentially threatened by both conditions (see chart next page).
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In the U.S. the situation is much more favorable, despite concerns to the contrary. The baby boomers and their
retirement from the work force are already having a profound impact on the economy. However, it is important
to keep in mind that as large as boomers are in number, younger demographic “cohorts” outnumber them:
Where Will Future Prosperity Come From?
Demographic cohort Profile Estimated Size
Baby Boomers (born 1946-1964) 75-80 million
Generation X (born 1965-1981) 45-50 million
Millennial (born 1982-2000) 80-85 million
Source: Cornerstone Macro
Historically, the age groups currently occupied by “GenXers” and the “Millennials” have been characterized by
starting the greatest number of new businesses as well as purchasing the greatest number of homes, autos, and
household furnishings. We suspect these same tendencies will be displayed with those currently in these age
groups. Lots of pent up demand already exists as the next charts suggest.
Source: Cornerstone Macro
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For those worried that the younger cohorts will not be able to find jobs, we note that employment in the 25-34-
year-old group now exceeds its pre-Panic peak and is headed in the right direction.
Many are worried that student loan debt is an insurmountable problem for this group. The following
commentary recently provided by Economist/Demographer, Dick Hokenson, of ISI Group suggests these fears
are overblow:
"The conventional wisdom appears to be that the vast majority of student loan borrowers are
being crushed because their loans are so large. The reality is quite different. Only 3.7% of those
with student loans have balances in excess of $100,000. A very sizeable minority (39.9%) have
student loan balances that are less than $10,000. As a result, the figure for the average student
loan that is quoted in the press is very misleading. According to calculations done by the Federal
Reserve Bank of Kansas City, the median student loan debt in the first quarter of 2012 was
$13,662 while the average debt was $24,218! The vast difference between the average and the
median reflects the impact of a very small percentage of borrowers who have very high debt
levels.” (ISI 3/6/14)
ISI offers other information (see housing chart below) as some food for thought for those worried the housing
recovery is over.
Source: ISI
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Stock market corrections more common than Christmas
Financial writer, Morgan Housel, offers some useful perspective on stock market movements:
“During the last 100 years, there have been more 10% market pullbacks than Christmases.
Everyone knows Christmas will come: think of volatility the same way.”
Lest anyone think we are Pollyannas.
It is not likely that business cycle dynamics have been, or ever will be, repealed. There is no doubt in our minds
that the current business expansion will end at some point as will the current stock market advance. It is also
likely that before then some current worries will indeed become big issues and financial market volatility will
occur.
Business cycles end when the combination of tight money policies of the Federal Reserve and accumulated
excesses of debt, inflation, product inventories, and over-optimism render an upswing brittle.
We are a long way from such conditions. In the meantime, investment opportunities beckon from the changes
unfolding from new and divergent business trends.
Established in 1981, Capital Investment Services of America, Inc. is a Milwaukee, WI based independent investment
counsel providing custom tailored portfolio management to individuals, businesses, and charitable institutions.
If you would like to be added to our mailing list, email us at: [email protected] or call us at 1-800-345-6462.
For additional information, visit our website at: www.capinv.com
The information contained in this report is based on sources believed to be reliable, but we do not guarantee its accuracy or completeness. The information is published
for informational purposes and does not constitute an offer, solicitation, or recommendation of an investment or advisory services.