FIRST QUARTER 2013
The Economic Climate
During the first quarter of 2013, the U.S. equity markets continued to rally over 10%, as three of the issues underlying the fiscal cliff unfolded and passed. Clarity was received on the tax issue as the President signed the American Taxpayer Relief Act on January 2, 2013. Automatic government spending cuts (sequestration) took effect in March, as did an Appropriation Bill to continue federal spending through the remainder of this fiscal year. The remaining issue, an increase in the federal debt ceiling, is expected to be put to a vote in May.
While the implementation in 2013 of $85 billion in spending cuts, a tax increase on the wealthiest and reinstatement of the payroll tax for employees may result in a 1.0-1.5% drag on the economy, the International Monetary Fund is still projecting a modest increase approaching 2.0% for U.S. real GDP growth. On a global basis, the IMF is looking for a gain of 3.3%, revised down from its previous forecast of 3.5%. This at least matches the 3.2% gain in 2012. With Europe still stuck in the second year of recession, the lift to global GDP is coming from the emerging markets.
The bright spot for the U.S. economy remains housing. The inventory of single family homes has dropped some 50% from its high in 2006-2007. Coupled with greater affordability, sales and prices are once again rising. The S&P/Case-Shiller 20-City price index gained 8.1% in its latest period, marking the largest year-over-year increase since 2006. Sales of existing single family homes slipped 0.6% in March from February, but are 10.3% ahead of a year ago.
There are few signs of a recovery in Europe: auto sales dipped to a 20-year low in March and the unemployment rate is a record 12.0%. However, interest rates on sovereign debt have been dropping, facilitating the ability of countries such as Italy and Spain to refinance their debt. Recently, Italy was able to issue 10-year government debt at a yield of below 4.0%. This has not occurred since November 2010.
A recent plunge in commodity prices has renewed concerns about the sustainability of global growth. The price of both copper and gold has been clipped by more than 20% since their peaks in February 2012, while the oil price has fallen about 10%. After an uptick during the fourth quarter of 2012, China's real GDP growth during 1Q 2013 eased to 7.7% from the 7.9% pace of the previous quarter, sparking new concerns about China's role as the engine of global GDP.
We believe equities remain the preferred investment among the range of competing assets where few are cheaply priced. At today's low level of interest rates (1.70% for a 10-year Treasury note), some bonds are priced to return less than the prevailing rate of inflation. Moreover, principal could suffer if interest rates rise. Stock dividend yields are competitive with bond rates and equity valuations are in line with historical averages. Moreover, strong balance sheets and high cash levels afford the wherewithal to bump dividend payments; the proportion of earnings paid out in the form of dividends is below 40% compared to an historical average of about 50%. For U.S. companies, dividend payments were raised by approximately 12.0% in the first quarter of 2013 over the year ago level.
Risks to our strategy include a further collapse in the Eurozone economies as well as heightened geopolitical uncertainty regarding Iran and the Korean Peninsula. A further risk – more measurable – is a disturbance to the upward trend of corporate earnings. The earnings level for the S&P 500 index of companies has surpassed its previous peak, driving stock prices higher over the past 16 months. Earnings increased nearly 8.0% during 4Q 2012, but are projected to expand only 1.0% in this year's first quarter. Wall Street is looking for better growth during the remainder of the year, but profit margins are already at or near their prior peak. Furthermore, the full impact of sequestration is not expected to take effect until this year's third quarter; furloughs began at the Federal Aviation Administration in April.
As a result of the massive stimulus provided by the central banks of developed countries, most recently Japan, the return on low risk investments is negligible. We are trying to be vigilant in an effort to guard against "stretching for extra yield" or taking more risk to gain the same expected return. We see this as perhaps the greatest challenge to investing today. Therefore, while we remain overweight equities relative to bonds, we have been actively rebalancing portfolios if they have breached the top end of equity allocation guidelines.
U.S. stocks posted a strong first quarter total return, with the S&P 500 increasing 10.6% on top of its 16.0% gain in 2012. Most of the major foreign equity markets trailed those of the U.S., with the notable exception of Japan. Bond returns, as measured by our taxable benchmark, were marginally negative, as interest rates, after rising, came back to approximately the same level at which they started the quarter. The Dow Jones Industrial average had its best first quarter in 15 years. Bonds recorded their first negative quarter in seven years. During the quarter, the S&P 500 stock price index (excluding dividends) surpassed its all-time record high achieved on October 9, 2007.
At the overall portfolio level, performance again benefitted from an overweight position in equities. Relative to the S&P 500 Index, equity returns were ahead, helped by our underweight position in Apple and strong performance in financial names. Bond returns were ahead of the benchmark due to the narrowing of the gap between corporate yields and treasuries which occurred during the quarter (i.e., corporate bonds outperformed treasuries). (See Model Performance Chart)
One name, IBM, was sold during the quarter. The company has a relatively low dividend yield and payout ratio, and while it has been able to drive strong earnings growth despite sluggish revenue trends, we feel that this will become increasingly difficult to achieve going forward as further margin improvement opportunities diminish.
Three new names were added to our portfolios during the quarter.
Ford recently reported strong fourth quarter results which were ahead of expectations for the full company and for the North America, South America, and Asia segments, with solid product momentum and improving profitability in those three regions. The results and outlook in Europe were worse than expected and Ford also issued a 2013 earnings outlook that was below expectations, due to a reduction in European market expectations, headwinds from noncash items such as higher pension expense (due to low interest rates), and expected currency devaluations in South America. We believe the restructuring actions Ford is undertaking in Europe (18% capacity reduction and 13% headcount reduction) are a significant positive factor that should improve the company's long term earnings power, and are more important than a moderately deeper than expected loss in the current cyclical downturn. Ford recently doubled its dividend and the stock now yields 3.1% (28% payout ratio). The balance sheet has improved, with $10B in net cash. Our view is that recently released fourth quarter earnings, while disappointing, properly adjusted expectations regarding profitability in Europe. Valuation is attractive, as we believe the current auto sales cycle can continue to strengthen.
English retailer, Burberry Group, has performed well from both its initial 2002 listing and its 2008 crisis lows as a brand transformation and 15-year turnaround have been a clear success. However, Burberry has only recently entered a sustainable growth phase where it has multiple drivers to take market share in the luxury goods category and meaningfully improve margins and product mix, thereby leveraging its brand equity around the world. Given accelerating activity in China, a potential bottoming in Europe, and 12-month forward same store sales estimates that may prove conservative, Burberry may be entering a period of accelerating comparable sales results. Asia Pacific accounts for approximately 40% of sales.
The Matthews Asia Dividend Fund uses a fundamental, bottom-up approach that seeks to identify companies in Asia (both developed and emerging markets) with the ability and willingness to pay dividends, to construct a portfolio that provides a mix of current yield and long-term dividend growth. The fund managers' view is that cash dividends for Asian emerging markets companies represent a sign of investment quality and capital discipline. We share this view and see the fund's approach as philosophically consistent with ours. Matthews was founded in 1991 and focuses exclusively on Asia, with an investment team based in San Francisco (with extensive travel to Asia). Investments in Japan and China represented 19.1% and 32.1% respectively of the fund's value as of March 31st. The current yield is 3.2%. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)