market update call – audio transcript august 26, 2015 transcripts and... · the currency. first,...

MARKET UPDATE CALL TRANSCRIPT – August 26, 2015 Important disclosures provided on page 9. 1

Market Update Call – Audio Transcript August 26, 2015

Featured Speakers from U.S. Bank Wealth Management:

Timothy J. Leach Thomas M. Hainlin, CFA Terry D. Sandven, CFA Chief Investment Officer Global Investment Strategist Chief Equity Strategist Opening: This is a recording of the U.S. Bank Wealth Management Market Update Call held on August 26, 2015. The discussion featured views on China’s economy and the recent financial market volatility.

Tim Leach: Hello and welcome to this special market update discussion, which is hosted by U.S. Bank Wealth Management. I’m Tim Leach, Chief Investment Officer for U.S. Bank. We host special conference calls like this one whenever market conditions become significantly concerning to clients, and we’ve obviously been dealing with that over the last week or so.

Recent market losses in the stock markets in the United States and around the

world are a reflection of concerns that China, the second largest economy, may be slowing faster than anticipated, with potential negative ramifications to economies around the globe, and reducing the prospects for companies here in the U.S. and internationally, hence the impact on stock markets.

I wanted to start right up front with our executive conclusions for you and

then we’ll get into a little more detail with our speakers today. With respect to China—China does matter quite a bit in our modern global

economy. The Chinese economy, having grown so fast recently, is now 15 percent of the global economy and it’s because it’s been growing far faster than other large economies, and contribution to total world growth has been about 50 percent of total growth. So clearly, if there was an impairment in China’s growth rate, that would affect all other parts of the global economy.

Investment products and services are:


Another factor is that western investors generally do not understand or relate to China’s system and behavior well, and that’s resulted in broad-based distrust of information from China. So, with a consensus view on China that it’s still likely to grow in maybe the 6 percent to 7 percent range, that distrust tends to suggest to investors that there may be worse surprises to come. And that’s been compounded by the investment media, which has whipped up fears of dire outcomes—a hard landing, that kind of thing—driving some investors to sell out of stocks, and we’ve seen historical levels of volatility with the down markets that we’ve seen lately.

Importantly, our philosophy and advice to our clients is to focus on long-term

plans that are custom to each of our clients’ needs, and to stay with your plan through short-term volatility. Short-term volatility is inherent to investing in stocks. The exception to staying the course would be if current conditions indicated that economies or markets were entering a long-term destructive bear market phase, with eroded fundamentals.

So our goal today is to speak to the primary concerns that we’ve been hearing

from our clients, and to share our view that we do not see the recent stock market losses as being indicators that we are headed into a period of major long-term downside risks.

I’m joined on the call today by two of our senior investment specialists. First

is Tom Hainlin, Global Investment Strategist, and Tom is also a specialist on China. And Terry Sandven is our Chief Equity Strategist.

Because China is at the center of so much of the current events and concerns,

we’re going to start with China and focus the discussion then with Tom. So, Tom, I touched on the importance of China to the U.S. and the global

economy. But focusing on the idea that if western investors distrust what they hear about China, what are the signs of improvement that we have confidence in? And, how can we be sure that we are clearly seeing the risks in China?

Tom Hainlin: Well, you know, Tim, for right or wrong, I think a lot of the blame for what we’re seeing in the markets is being put on China’s doorstep. And frankly, a lot of that is self-inflicted. Markets tend to reward transparency and predictability. Here in the States, it’s not a surprise to anybody that the Federal Reserve is considering raising interest rates in September. That idea has been floated, analyzed, debated and reported on in the press and the financial community for months. So whatever they decide, at the very least, it’s not going to be a shock.

Now what we’ve gotten out of China has been completely the opposite. First,

they surprised people by intervening in the stock market to try to control it from going down. Then they turned around and they surprised people again by suddenly giving up control over their currency and letting it go down. So do they want more open markets? Or do they want less? So the signals coming out of Chinese policymakers seem very confusing, if not contradictory, and markets seem to trade as much on interpreting signals as it does on the actual economic reality on the ground. Hence, the sell-off.


So as you pointed out, Tim, there’s already a general mistrust in data being reported by China. How fast is their economy really growing? How much unemployment do they really have? What’s the status of the housing market? And how much debt is really out there? But really, whether China’s economy is growing at 7 percent or at 6.5 percent or really at 6 percent, I think the major risks in China are reasonably well understood—economic collapse, banking system collapse, competitive devaluations or social investment spiraling out of control.

In what we’re watching, we’re really not seeing these flashing warning signs

of those risks. We’re seeing property values firming. We’re seeing local governments issuing bonds at low interest rates and using those proceeds to pay down bank debt. We’re seeing the central bank lowering interest rates and reserve requirements for banks, which is injecting liquidity into the system. We’re seeing a pick-up in loan growth, which means there’s demand for loans out there. And we’re even seeing action taken on social and environmental issues.

So what we seem to have right now is this dichotomy between the stock

market gyrations on the one hand and economic reality on the other. And I think a lot of that is due to these confusing policy signals, a lack of communication and transparency and a poor job of inspiring international confidence. So, as I said, I think there’s some self-inflicted wounds going on that’s spilling across all risk assets but, they’re not necessarily fatal wounds for China’s economy.

Tim Leach: I appreciate that, Tom. So, given some of the actions, as you just stated, that

the Chinese are taking, how do we try to understand some of these actions? For example, one of the most recent that seemed to set off this downdraft in stock markets, the devaluing of their currency?

Tom Hainlin: I think there’s three different parts to understanding China’s actions around

the currency. First, for all the headlines, historically China really hasn’t been much of a currency warrior. If you go back to the emerging market crisis of 1997-1998, China didn’t devalue like a lot of other countries did. It held its dollar peg and effectively saw a huge currency appreciation relative to the rest of Asia. In 2005 they finally let go of the peg, and then over the next eight years their currency appreciated about 35 percent relative to the dollar and about 50 percent relative to all of its trade partners. So in light of that history, the recent devaluation of a few percent was pretty small, and if that was intended to be a shot in a currency war, in our view, it was a pretty weak one.

Now the second part has to do with understanding China’s various domestic

agendas. China’s inclusion in the International Monetary Fund’s basket of reserve currencies really seems to be a strategic national goal. And the next five-year vote for who is in that basket, which is called the SDR (Special Drawing Rights) is coming up in November. Now having a currency in that basket is pretty much symbolic. It doesn’t really have a lot of real world value, but China’s inclusion seems to serve two distinct agendas. China’s nationalists


get this international currency that’s a symbol of national pride and international prestige. And, China makes it onto the world’s stage.

Now China’s reformers get more market pricing of the currency, which takes

away, one more state controlled price and hopefully continues to lead to a more efficient economy. So nationalists get this symbol of international prestige while reformers get this more market-determined currency.

Finally, the third part has to do with understanding China’s ambitions both regionally and globally. Now their plan is to build roads, railways, bridges and ports all across Asia. And their attempt seems to be to encourage greater economic development of their neighbors, which would create greater economic integration with China, greater financial integration with China, and ultimately greater use of China’s currency and China’s banks for financing of working capital and trade. But that requires a more international currency, which gets us all the way back to the devaluation, which is why, in our estimation, we didn’t think it was really about being competitive on the exports or really about the state of the economy. It was more strategic than that.

Tim Leach: Okay. So focusing then on the real kind of fundamental Chinese economy, Tom, what is the state of the state? What is the reality of the Chinese economy relative to its slowing trends?

Tom Hainlin: Well clearly China’s economy is slowing. We can see that in the data—

exports, retail sales, industrial production, fixed asset investment—all of which slowed in July. And in particular, a measure of China’s manufacturing activity, called the Purchasing Managers Index, or PMI, was quite weak last Friday. And that release seemed to coincide with the continued market sell-off that stretched into this week.

So, you add that weak PMI rating, with China’s surprised devaluation and

now you have this concern that China’s economy is really weak and they have to do this devaluation to prop up their economy. But, our base case is not that China’s going into a recession or experiencing a hard economic landing. We see growth slowing, but stable and firming somewhat. We see China continuing to transition from this investment-led industrial growth to consumer led and service sector level growth. Most people may not know this, but in China the service sector is already larger than the industrial sector. And we’re seeing healthy numbers come out of this service sector—the PMI, e-commerce sales, overseas travel numbers, and the property market, which is much more important in China than the stock market—has stabilized.

So what do we see going forward? China is one of the few countries in the

world in a position to lower interest rates. And this week we saw them lower both interest rates and the reserve requirements for banks. We see them continuing to use monetary policy stimulus to keep interest rates low and facilitate credit growth. This should allow local governments to continue to refinance bank debt, with low interest rate bonds, and enable fiscal stimulus.


And finally, lower interest rates should translate to lower mortgage rates, which should continue to put support into the real estate market.

So supportive monetary policy, supportive fiscal policy, stable property

values, strong services sector. We’re certainly not calling for a return to the rapid growth rates of the past, but we’re also not seeing the signs of a recession or a hard economic landing.

Tim Leach: Well, so that would really be consistent then, Tom, with the idea of a continuation of a gradual kind of slowing pace of growth for China. But even with a slowing pace of growth for China, its growth rate is still far faster than other large economies like the U.S. or in Europe or Japan. So with that as our thesis, and given that over the last few months the Chinese stock market has fallen dramatically. Typically a stock market in the U.S. has tended to be kind of a forecasting vehicle. Why then would the Chinese stock market falling so far not seem to be an alarm for the Chinese economy?

Tom Hainlin: China’s local stock market is dominated by domestic investors. Now they’re

starting to open up more to foreign institutions and investors, but the most recent data we’ve seen, 97 percent of China’s A-shares, or their local stock market shares, are owned locally. So, it is still quite a closed stock market.

Second, China’s local equity markets are still relatively immature. According

to their security regulator there is about 90 million brokerage accounts open and an estimated half of them don’t hold any securities. And in addition, many investors have more than one brokerage account so they can participate in both of China’s main stock exchanges—the Shanghai and the Shenzhen.

So you add that together and you get about, maybe 20 or 40 million

households in China that are invested in the stock market. And this represents maybe 1 percent to 3 percent of China’s total population. So really, you’ve got relatively small participation in China’s markets by its citizens. And that’s why there’s still so little wealth effect that we see from the equity markets within China.

Now finally—the volatility. We’ve seen the rise in the use of margin loans by

retail investors. Margin financing really only became available to most Chinese investors in 2013. This is likely amplifying volatility both on the way up and on the way down. So, taken together, unlike the United States equity market, China’s stock market probably is not really representative of what’s going on in China’s broader economy.

Now our concern is that this recent experience in China’s stock market scars

current investors and prevents future participation by local and global participants. And ultimately slows down the reforms of China’s financial system. But, again, that’s not our base case. We’re seeing these excesses being rung out and we see this as an opportunity for Chinese authorities to address some of the issues and vulnerabilities that are popping up in their developing stock market—like margin financing. Unfortunately for right now, China’s great export today might be volatility.


Tim Leach: I’m not sure that I see demand for that product, but I very much appreciate your comments.

Let’s springboard from the Chinese stock market right into the U.S. stock

market, with Terry Sandven. So, Terry, the U.S. stock markets over the last few years, barring the last few

weeks and months, have been relatively calm. And that has certainly, I think, made the recent stock market high volatility that much more jarring, that much more scary, frankly, to investors. So with that volatility in mind, what is our current assessment of stocks given the rise of that level of volatility?

Terry Sandven: Well, Tim, on balance, our view is that the macro and fundamental environments are still supportive of equities. Earnings are increasing, albeit at a moderating pace. Valuations are reasonable. In fact, the S&P 500 trades at roughly 16 times 2015 estimates and that estimate is not at extreme highs. Interest rates remain low. At present, the 10-year Treasury yields roughly 2.1 percent. It’s hard to envision interest rates moving meaningfully higher in an environment where global growth is slow and inflation is generally restrained. Also, the list of compelling alternatives to equities appears limited. In fact, as of this morning, 52 percent of S&P 500 companies offer dividends currently yielding above the 10-year Treasury yield of 2.1 percent. So this presents a compelling case for equities. I think it provides investors with competitive income appreciation potential and a degree of support to current price levels. Additionally, the classic signs of a frothy market are not evident. I think of heavy inflows from bonds to stocks— which are not occurring. Initial public offering and merger and acquisition activity levels are not excessive, and inflation fears are limited.

So, in total, our view is that the equity market weakness that we’re currently

experiencing is not the beginning of a prolonged market downturn, but rather part of the normal ebb and flow within a longer-term upward trending market.

I should incidentally, Tim, note that our year-end price target for the S&P 500

is 2100, which is based on a P/E, price earnings, multiple in the range of 18 times our 2015 earnings estimate of $117.

Tim Leach: Okay, so I appreciate that Terry. Kind of tying this back to comments that Tom just made about China and the idea that the Chinese economy is very large and slowing, how sensitive are U.S. companies to the Chinese economy and, therefore, potentially effected by that slowing?

Terry Sandven: Well, China is important to U.S. stocks because for many multinational U.S.

companies, China represents a key component of earnings growth, and earnings growth is a key driver to higher stock prices. At present, the U.S. seems largely an earnings-driven market and that’s opposed to being propelled by Fed driven liquidity. In other words, a Fed that continues to lower interest rates, or price earnings multiple expansion.


So, as such, an improving global economy is required to drive earnings, and higher earnings are needed to support higher stock prices. Tim, to illustrate, I mentioned that earnings are increasing, but at a moderating pace. According to Bloomberg, consensus estimates reflect about a 5.1 percent increase in earnings this year, 2015, over 2014, while early consensus estimates for 2016 over 2015 levels are considerably more robust—currently projected to increase 10.7 percent. So for earnings to increase, call it 10 percent in 2016 over 2015 levels, I suspect we’ll need to see conditions in China begin to show improvement as we enter 2016.

Tim Leach: Very good, Terry. So with that assessment of stocks, what are the key things

that clients should be looking forward to to really be drivers or catalysts for the stock market?

Terry Sandven: Well there are several upcoming catalysts likely to impact equity prices. I’m

focused primarily on four. The first is another round of economic indicators. The August employment

report is scheduled for release on September 4, and I think that’s a key indicator. As you know, the monthly employment report is the granddaddy of all jobs-related reports, and with the unemployment rate currently at 5.3 percent, focus will be on average hourly earnings as an indicator measuring the extent to which inflation may be creeping into the marketplace, thus serving as a justification for Fed action, either to keep rates unchanged or begin lift-off. And I suspect, per Tom’s comments, we’ll probably also need an updated read on economic progress in China over the next month or so and, insights from China’s PMI, the manufacturing data that Tom referenced, could provide that.

A second catalyst is the Fed’s FOMC, the Federal Open Market Committee,

meeting set for September 16-17. In fact, Tim, we should probably spend just a moment discussing interest rates.

The current debate is whether the Fed raises rates in September, December or

perhaps not until 2016. The futures market is pointing towards lift-off in December, and for good reason. We have low core inflation, falling inflation expectations, we have mixed signals of manufacturing strength, both in the U.S. and abroad. There’s fear of slowing in the overall pace of global growth and, of course, most recently the current market dislocation, and so on. A rate hike in September is also compelling and seems justified. In aggregate, the U.S. economy seems strong enough to warrant something other than crisis-level rates. Also, a rate hike in September would remove the near-term uncertainty associated with the timing of lift-off and signal from the Fed that the U.S. economy remains on a growth trajectory in an otherwise slow growth global environment. Now that said, perhaps most importantly, beyond the initial rate hike, is the pace of subsequent Fed hikes, which we believe will be in small increments and implemented over a prolonged period.

A third catalyst are third quarter earnings, beginning in mid-October.

Following second quarter results, much attention now is likely to be directed


toward company management comments about the pace of global growth and, of course, particularly in China.

And lastly, the fourth catalyst that I’m focused on is seasonal tendencies for

sub-par performance in September. In fact, Tim, we are fighting the calendar. September, historically, is the worst performing month of the year. There’s a report out by Strategas Research Partners where they note that only in 45 percent of the time—this goes back to 1950—only in 45 percent of the time has the S&P posted positive returns in September. Now conversely, October, November and December are among the best performing months of the year. So looking beyond September, the odds favor positive fourth quarter performance.

Tim Leach: Well, and hopefully Terry as you said, with September, kind of being the

historically more troubling period, maybe the volatility that we’re experiencing now has kind of depleted that potential. No one knows, right, at this point. So finally then, given all of these factors, Terry, from an advice point of view for our clients, how should clients think about positioning stocks within portfolios?

Terry Sandven: Well, yes, that’s a key question. The Wall Street Journal last week published an interesting article highlighting five things that investors should not do. Don’t fixate on the news. Don’t panic. Don’t be complacent. Don’t get hung up on the talk of a correction. Don’t think you or anyone else knows what will happen next.

Additionally, as to what investors should do, for me, three items come to

mind. First, is look for tax loss selling opportunities by offsetting gains with losses. Secondly, consider portfolio upgrades by switching into investments or companies with compelling longer-term prospects, but whose share prices have pulled back during this recent correction. And then thirdly, for investors with cash on the sidelines waiting for a good entry point, in our view, the current environment presents an attractive environment to start layering into the equity market.

So, Tim, I’ll end with a generally well-known thought from Warren Buffet,

who has advised in the past, “be fearful when others are greedy and greedy when others are fearful.” And so to that end, when looking at the volatility experienced in recent days and weeks, it is clear that fear has returned to the marketplace, and being mindful of Buffet’s perspective, particularly given that inflation seems restrained, this could bode well for investors who can look beyond the current challenges and toward year-end and into 2016.

Tim Leach: Thank you very much Terry, and for your comments on the U.S. stock market. And thank you Tom, for your comments on China.

To wrap up, and from a conclusions point of view, while this type of sudden

high volatility in stock markets can certainly rattle most investors and even those of us who are in the business, our assessment is that this period is likely to be shorter term in nature. Clients should stay with their existing investment


plans. However, we encourage you to discuss your particular needs with your U.S. Bank advisor.

Additional details about today’s conversation and the recent market actions

can be found in a newly published situation analysis paper that we have posted. You can find this on our website or you may get a copy of it through contacting your U.S. Bank advisor.

As I wrap up the conversation, I want to thank you very much for your

relationship with us and for taking time to attend the call. And, again, please stay close and contact your U.S. Bank advisor if you have any questions. Good day. Thank you.

Closing: Thank you for listening. We invite you to join us for future calls. Details can be obtained from your U.S. Bank Wealth Management Advisor. Website: reserve.usbank.com

The information shared by speakers represents the opinion of U.S. Bank Wealth Management and does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described will continue or that the forecasts will come to pass. These views were presented on August 26, 2015 and are subject to change at any time based upon market or other conditions. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Data and research information and statistics have been gathered from a variety of sources. Any companies and organizations mentioned are not affiliated with U.S. Bank in any way. Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible difference in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investing in fixed income securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The risk is usually greater for longer term debt securities. Investments in lower rated and non-rated securities present a greater risk of loss to principal and interest than higher rated securities.

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