THIRD QUARTER 2013
The Economic and Political Climate
Volatility is back. While the U.S. equity market returned approximately 5.0% during the third quarter, it was punctuated by a 3.0% drop during August. After recovering in September, and gyrating in early October to the vicissitudes of our policy makers in Washington, year-to-date equity returns are still up above 20.0%. Gains continued in October.
Interest rates and bond returns have also been fluctuating. After starting the year at 1.76%, the yield on the 10-year Treasury note jumped to 2.50% at the start of this quarter. It spiked to nearly 3.00% during the quarter and ended where it sits today at 2.50-2.60%.
Economic indicators, such as indices of manufacturing activity in the U.S., China, and the seventeen Eurozone countries have been ticking upward over the past several months. Business confidence has also gained in Europe and Japan. In the U.S., auto sales remain strong, household wealth has reached a new peak, and gains in domestic oil production have put a lid on the price of gasoline.
Policy uncertainty and its potential impact on corporate earnings and investor psychology are troubling the market. Investors are concerned about the timing of a change in Federal Reserve policy to a less stimulative agenda affected by a reduction or "tapering" in bond purchases. This could ultimately lead to higher interest rates. Furthermore, Congress has merely authorized budget authority for the current fiscal year (begun on October 1st) through January 15th and postponed the federal government's debt ceiling decision until February 1st. The whole drama we have just witnessed could be repeated again at year end unless a newly appointed House-Senate committee can reach agreement on a range of budget issues.
During the past 50 years, the U.S. has suffered through seventeen partial shutdowns of the federal government, on average lasting 5-6 days. The current episode surpassed that and may negatively affect annualized real GDP growth by 0.5% or more. Damage to consumer, business, and investor confidence may prolong the impact. While it is difficult to imagine that our elected representatives in Washington would risk default and further erosion of the U.S. government's credit rating, the situation remains unpredictable.
Getting less attention is the gradual but tangible improvement in the global economy. As we move into 2014, Europe is likely to swing from negative to positive growth, the slowdown in China's growth rate appears to have stabilized at 7.0%-7.5%, and policy initiatives from Japan's new administration have already resulted in an acceleration in growth to approximately 4.0% during the first half of this year. Putting it all together, global real GDP growth in 2014 could reach 3.0% or more compared to 2.5% in 2013, subject to any extraordinary impact from the imbroglio in Washington.
As a longer term asset class, equities continue to look more attractive than bonds. While the lack of compromise in Washington may cause a more meaningful correction in equity prices following a gain of over 20% from the beginning of the year through September, we think this is likely to have a relatively short duration. At a price earnings ratio of 16.0x-17.0x trailing twelve month earnings, U.S. equity valuations seem reasonable or fair; certainly not cheap by historical standards, but not excessively valued such as in 1999-2000 during the internet and technology bubbles. Furthermore, we do not see the conditions which could cause a significant collapse in corporate earnings, such as during the financial crisis of 2008-2009. (However, recent political developments could have a negative bearing on the outlook company's hold for their next quarter.)
An improving global economy should provide the framework to support better corporate revenue growth in 2014 compared to recent trends which have been sluggish. On a relative basis, equity valuations have increased in attraction outside the U.S., and we have been adding to our international exposure. We remain more cautious on the outlook for bonds, based on the assumption that the Federal Reserve, soon under new leadership, will ultimately pull back on its policy of "quantitative easing," thereby raising the probability of higher interest rates over the next two years.
At the Total Account level, all of the composites were behind their benchmarks on a relative basis for the third quarter. International stocks reversed their earlier course, outperforming the U.S. markets in the quarter. Relative to our global equity benchmark (80% S&P 500 Index and 20% MSCI ACWI ex-US Index), equity returns of 3.5% compared to 6.2% (5.2% for the S&P 500 Index and 10.2% for the international component). The best performing equity sectors in the quarter came from cyclical areas, including Energy, Technology, and Materials. Among individual stocks, strong gains came from Cognizant Technology Solutions (+31.0%), Burberry Group (+30.0%), EOG Resources (+28.0%), and Schlumberger (+23.0%). Bond returns were ahead of the benchmark due to our continued short duration. (See Model Performance Chart)
Significant Portfolio Changes
During the quarter, we sold the SPDR High Yield Bond Fund from our portfolios. The proceeds from the sale were swapped into the Federated High Yield Bond Fund, which has a current yield of 7.0% and a shorter duration. This offers greater protection from a rise in interest rates.
We gradually sold our position in Travelers due to strong appreciation and decelerating pricing trends for Property & Casualty insurance. This view was confirmed following the company's presentation at the Barclays Financial Services Conference in September.
We also sold Baxter International. Following very healthy gains in 2012, we had reduced the position in late 2012 and early 2013. Baxter's performance has lagged in 2013 as concern has grown around increased competition in the market for products used to treat hemophilia patients, and we believe the market is set to become more competitive than we had previously expected with the entry of several new competitors expected over the next one to three years.
Two new names were added to the portfolios during the quarter.
Swiss health care company, Roche Holding manufactures and markets diagnostic and therapeutic products with a focus on the prevention, early detection, and treatment of diseases, including cancer, transplantation, and autoimmune and inflammatory diseases. Roche has good potential for sales and earnings growth through 2015 from its core oncology products, emanating from the consolidation of biotech firm Genentech in 2009.
Our addition of the energy company Royal Dutch Shell was somewhat contrarian as sentiment is poor (the company missed production targets and withdrew guidance) and the stock has significantly underperformed year-to-date. We find the valuation compelling and on a relative basis Royal Dutch Shell trades at 57% of the S&P 500 forward P/E compared to the 10-year average of 63%. The dividend yield is 5.4% and we expect very modest growth (low-single digit) in the dividend. Our view is that incoming CEO Ben van Beurden will look to improve financial returns by divesting non-core assets and using the proceeds to repurchase stock. We purchased the "B" share class of the U.S.-listed ADR as this share class' dividend is not taxed by the Dutch government. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)