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 17 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, performance continued once again to benefit from an overweight position in equities during 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 were 7.5% 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, which all appreciated over 10.0%. Among individual stocks, strong gains came from Cognizant Technology Solutions (+31.0%), Burberry Group (+30.0%), EOG Resources (+28.0%), WhiteWave Foods (+32.0%), 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 also sold two stocks, Dean Foods and Coca Cola, and an ETF, the Vanguard High Dividend Yield Fund, which were used as a source of funds for higher conviction names, including those residing outside the U.S.
The purchase of Dean Foods was made primarily to gain exposure to its WhiteWave Foods division (organic and plant-based beverages and food products; non-dairy creamers) ahead of the IPO and spinoff of WhiteWave Foods to investors. Secondarily, we believed that the core Dean Food's milk business was undervalued. With the spinoff now complete and Dean's stock price appreciation of over 25%, we eliminated our position in Dean Foods but retained WhiteWave Foods.
Coca-Cola's revenue growth rate has been slowing over the course of the past several quarters as volume growth, especially within its carbonated soft drink division, has been sluggish. In addition, there is more critical commentary in the media, domestically and in key foreign markets such as Mexico, regarding sugary drinks and its impact on health and wellness. Mexico's Congress is now considering a 20% tax on soda, a move that would affect Coca-Cola FEMSA, a major bottler in which Coke has a significant interest. Following very strong long-term performance and with the current valuation appearing relatively full, we felt moving the proceeds from Coca-Cola into other internationally focused investments was appropriate.
A number of new positions were added to our portfolios during the quarter.
The iShares Nasdaq Biotechnology Fund tracks the Nasdaq Biotechnology Index, encompassing 120 biotechnology and pharmaceutical company stocks. The fund has an allocation of 50% large cap stocks, 30% mid cap stocks, and 20% early stage biotech stocks and the top 10 holdings comprise 56% of assets. While the Biotechnology industry has performed extraordinarily well over the past 12 months, we believe the market is still underestimating the earnings potential for this particular industry. Owning the ETF provides exposure to the positive secular biotech fundamentals, while adding broad diversification across the space that allows us to hedge against specific company or product risk.
We initiated a position in the currency hedged Japan ETF, Wisdom Tree's Japan Hedged Equity Fund. The ETF's underlying index consists of dividend-paying companies incorporated in Japan and traded on the Tokyo Stock Exchange that derive less than 80% of their revenue from sources in Japan. Japan's Prime Minister Abe is attempting to put the nation on a sustainable growth path through his program of monetary stimulus and fiscal reform. During the first half of 2013, Japan's real GDP growth rate approximated 4.0%.
Parker Hannifin manufactures industrial components such as fluid power systems, flight control systems, and instruments for contaminant monitoring. Order trends have been improving and third quarter results exceeded expectations. The company recently announced its largest single-year restructuring program in history. Parker has made significant investments in growth opportunities focused on the conversion to manufacturing systems instead of individual components and through a focus on new technologies.
Mining company Freeport McMoran Copper & Gold was last owned in our accounts in early 2011. Since that time the shares have declined by about 50% due to slower global growth (most importantly in China), modest additional copper supply, and some company specific missteps. Copper prices are down more than 30% over this same period. We established a new position in the shares now because of better valuation and our belief that copper remains a structurally-attractive, scarce resource which is expensive to mine in quantity. Moreover, Chinese copper demand has remained resilient.
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. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)