FOURTH QUARTER 2012
The Economic Climate
The fourth quarter of 2012 registered subdued performance from the securities markets, caused by the uncertain outcome over discussions in Washington to resolve our so-called "fiscal cliff." Both businesses and consumers appear to have deferred spending. Hurricane Sandy also dampened the resolve to spend.
On January 2, 2013, President Obama signed into law "The American Taxpayer Relief Act of 2012," which also provided some relief for the capital markets. Since the beginning of the year, U.S. stocks have appreciated about 5%, while the interest rate on U.S. treasuries has nudged up slightly.
There are five parts to the fiscal cliff, only two of which are now complete. The completed steps include the extension of the tax cuts enacted by former President Bush for all individuals earning less than $400,000 and households earning less than $450,000. For incomes above these levels, the marginal tax rate will rise to 39.6% from 35.0%. Payroll taxes for employees will also rise to 6.2% from 4.2%. Emergency unemployment insurance benefits were extended for another twelve months. Other parts of the cliff, yet to be agreed upon, include automatic spending cuts or sequestration (deferred to March 1, 2013), a decision to raise the ceiling on the $16.4 trillion of U.S. treasury debt outstanding (recently suspended until May 18, 2013) and a bill from Congress authorizing the U.S. government to spend in the current fiscal year. The leading credit rating agencies will be looking to see if legislation to address these remaining issues holds the prospect of reducing the budget deficit to a level which could stabilize the ratio of government debt/GDP. The prospective revenues raised in the completed tax package could shrink the deficit from approximately 7% of GDP to 5%, but more is needed. Hence, the uncertainty for investors is not yet over; some combination of additional tax increases and spending cuts is required. If a credible program is not passed, the rating agencies could take immediate action.
The revenue-raising measures taken in the taxpayer relief package could dampen U.S. real GDP growth by 1.0-1.5% in 2013. If taxes had been raised for those below the top rates, GDP forecasts could have been slashed by another 1.0%. Hence, markets were relieved that some clarity was provided and the economy was not bludgeoned by the full impact of the cliff, which some had estimated as 4.0% of GDP.
If one looks through the fiscal cliff, it is possible to discern some incipient signs of recovery, lending conviction to the assumption that the U.S. economy will still grow by 2.0% or so in 2013. The World Bank issued their forecast on January 15, 2013 that the global economy will expand by 2.4% in 2013 compared with 2.3% in 2012, including a 5.5% gain in the emerging markets.
Signs of improvement across the globe include:
- Expectations for 2013 Eurozone GDP growth have fallen during the course of the past twelve months to virtually flat, with some of the smaller countries still mired in recession and high unemployment. Car sales, as measured by auto registrations, dropped 8% in 2012, climaxed by a sharper fall of 16% in December. However, the prospect of stabilization across the 17-country territory has improved markedly with the drop in interest rates in troubled countries, such as Ireland, Greece, Spain, and Italy. For example, new two-year Spanish notes were recently issued for under 2.50% compared to 3.28% for a similar maturity issued in October 2012. On January 23, 2013 Portugal’s 10-year bond yield fell to the lowest level since September 2010 (Financial Times, 1/24/2013).
- Through most of last year, investors were also concerned about a slowing pace of GDP growth in China, compared to the prior trend of 10%. Indeed, it appears that an aging workforce, rising employment costs, and the need to address social policy issues will depress future growth. However, exports increased 14% in December, the fastest pace in seven months. Fourth quarter GDP growth accelerated to 7.9% over last year, compared to a 7.4% gain in the prior quarter.
- In the U.S., household wealth is recovering along with the lift in home prices; the most recent reading from the 20-city S&P/Case-Shiller home price index was 4.3% above the previous 12-month period, accelerating from the 3.0% gain in the prior month. Light vehicle unit sales rose 13% above last December to 15.3 million, continuing a trajectory towards the previous December highs of 16.5-17.5 million units sold in 2002-2006. State and local governments, which account for just over 10% of GDP, are expected to increase payrolls in 2013, according to Moody’s Analytics Inc. (Bloomberg News, January 8, 2013). According to The Fiscal Survey of States (Fall 2012) published by the National Association of State Budget Officers and the National Governors Association, "Fiscal 2013 will likely be a turning point for state tax collections with general fund revenues projected to surpass prerecession levels for the first time since the onset of the recession."
Our working assumption for investment strategy is that economic and market conditions will be viewed as improving in 2013, resulting in less trepidation for investors. Short-term, we expect continued volatility as the outstanding fiscal cliff issues - primarily spending cuts - are debated. However, looking beyond this immediate challenge, economic conditions in Europe are bottoming, reaccelerating in China, and holding to steady - albeit modest- gains in the U.S.
We continue to advise an overweight position in equities relative to fixed income. While corporate revenue growth flattened during the past two quarters, investor expectations have become more realistic. Hence, Bloomberg has recently reported that of the S&P500 companies reporting fourth quarter results thus far, over 70% have exceeded expectations for earnings. The investment tracking firm, Factset, estimates the price/earnings ratio on forecasted 12-months earnings to be 13.0x, only marginally above the five-year average of 12.8x. We find this particularly attractive compared to the yield on the 10-year Treasury note of about 2.0%, which is below the yield on many stocks. Furthermore, corporate balance sheets remain healthy. We estimate that dividend payments for the S&P500 companies during the fourth quarter of 2012 were some 15-20% above their former peak.
Investment themes receiving emphasis include: 1) the benefits to U.S. manufacturing, regional banking, and the consumer from lower natural gas prices and our reduced dependence on imported energy; 2) exposure to faster growing emerging markets through global corporate leaders, such as Unilever and Anheuser-Busch Inbev, and exchange-traded funds; and 3) holding a shorter maturity bond portfolio, deemphasizing U.S. treasuries, to guard against a jump in interest rates.
For the year 2012, accounts with a bond component demonstrated superior returns relative to the static benchmark. Accounts invested in the All-Equity model trailed slightly. The equity overweight was a distinct positive, as equities appreciated 16.0% for the full year compared to a 4-5% gain for bonds. Equity performance was led by a selection of energy stocks (EOG Resources, Seadrill and Phillips 66), as well as two companies (Ariba and Cooper Industries) which were the subject of takeovers earlier in the year.
International stocks ended the year by finishing ahead of the U.S. market, gaining about 6.0% in the final quarter. Our holdings of foreign consumer-related equities, such as Unilever and Anheuser Busch Inbev, contributed positively to performance. We continue to increase our exposure to the international markets. (See Model Performance Chart)
During the quarter, we sold two names from our portfolios, Seadrill and Qlik Technologies. As noted above, Seadrill had performed well, and thus, we decided to realize the gains in the position. Qlik Technologies, a small capitalization software provider, was sold as we see the competitive situation as more challenging in the near term. These trades were designed to position our equity portfolios in a modestly more defensive manner as we approached the fiscal cliff, while maintaining an overweight exposure to equities versus bonds.
A number of new names were added during the quarter.
Based in Paris, the health care company Sanofi was formed through a number of mergers. The current management team has been in place since 2009 and has focused on cost reduction (€2b cost reduction program) and external R&D opportunities. The current team is generally viewed as more transparent and shareholder-friendly than Sanofi's former management. Sanofi's exposure to patent expirations (e.g., Plavix®) is passing in 2012, while remaining core growth platforms in diabetes (Lantus®) and the recently acquired Genzyme portfolio are growing faster and face less competition. Vaccines and Animal Health should continue to post moderate growth, and geographic mix is favorable with Sanofi deriving 30% of sales from emerging markets (mostly outside of China). Earnings growth should resume in 2013 and dividend growth and share repurchase opportunities should follow.
Adobe Systems is in the middle of two significant business model transitions, creating potential opportunity in the reasonably priced shares. One transition is the move towards delivering its core software for creative designers via the web by subscription, as opposed to the legacy business of perpetual license delivery. This is creating a near term hit to revenue and earnings and clouding the underlying strength of a business that is still growing at a solid high-single-digits pace. The second transition has been underway for a few years and has been built largely through acquisitions. Adobe has assembled the leading suite platform for digital marketing software and has only just begun to integrate the offerings with its core creative products. We feel that many observers underestimate the product synergies between these two segments and that Adobe will continue to hold a leading position in digital marketing while increasing its market share.
Effective January 2, 2013, New Abbott was spun off from the existing Abbott Laboratories. New Abbott is a diversified mix of global medical products businesses with a solid growth and margin profile supported by ample free cash flow and significant financial flexibility. The New Abbott will represent a diverse $22B collection of branded generic, diagnostics, nutritionals, and medical device businesses with significant emerging markets exposure. We expect New Abbott earnings per share of around $2.00 in 2013, with 5-7% revenue growth and 10%+ EPS growth over time.
As the dominant Internet advertising company, Google is well positioned to continue to enjoy above-market rates of growth in a segment that should continue to enjoy healthy growth for a long time to come. Although Internet advertising growth rates have slowed to the mid-teens, and are expected to further slow to the low double digits over the next five years, the growth runway is still significant, the industry is still relatively young, and areas currently viewed as threats may turn into opportunities - such as mobile. In a disruptive, fast-changing industry, Google has proven to be a nimble leader and innovator. Although it can be criticized for not leading in social networking, it has made some excellent moves – such as capturing a huge portion of smartphone search through the Android operating system, and the purchase of the strong YouTube asset.
In the fixed income portfolios, we initiated a relatively small position the Federated Emerging Market Debt Fund. It provides a higher current yield (3.78%) and better diversification compared to developed country debt. In many cases, emerging market demographics, growth rates and balance sheets are superior to developed markets. As such, the credit quality of emerging market debt is projected to improve. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)