SECOND QUARTER 2013
The Economic Climate
The global economy continues to recover, albeit at a pace below its long-term trend. The International Monetary Fund (IMF) recently revised its forecast for real global GDP growth downward for 2013 and 2014 by 0.2% to 3.1% and 3.8% respectively. The reduction from its previous April forecast was larger for some of the major emerging markets countries, such as China (by 0.6% for 2013) and Brazil (by 0.8% for 2013).
The recovery in the U.S. continues to be led by housing and auto sales. Gains in the value of residential real estate, as measured by the 20-city S&P/Case-Shiller index, have exceeded 10%. Vehicle sales recorded a 15.9 million unit annual rate in June compared to the 2009 trough of 9.0 million units. Recent job growth has also been healthy, as evidenced by average additions to nonfarm payrolls of 196,000 in each of the past three months. Our federal budget deficit as a percentage of GDP has been cut by more than half since its peak in 2009, with a debate on the extension of the Federal debt ceiling coming this fall. In the first quarter, U.S. real GDP growth measured a modest 1.8% and is expected to hold at about that level for the year.
Europe remains in a state of contraction. The IMF is projecting a decline of 0.6% in real GDP this year. However, recent forward guidance from European Central Bank President, Mario Draghi, that the Bank's goal is to have interest rates remain at present or lower levels for an extended period of time should give investors and companies more confidence in the policy framework.
China, the world's second largest economy accounting for a 13% share of global GDP, is transitioning to a slower secular growth rate of 7.0-7.5%, based more on consumer spending and less on infrastructure and industrial development. The transition will not occur without some volatility and corporate tragedies. China Rongsheng Heavy Industries Group Holdings Ltd., one of the country's largest shipbuilders, has recently reported a first-half profit loss, resulting in layoffs and a liquidity squeeze. In June, both exports and imports fell from the year ago period. Nevertheless, overall GDP growth in China amounted to a respectable 7.5% during the second quarter.
Trends in Japan, the globe's third largest economy, have turned positive in response to the more accommodative policy from the administration of Prime Minister Abe. Real GDP growth in the first quarter was over 4.0% and gains in retail sales, housing starts, and industrial production have occurred in May. Business confidence and corporate earnings are also improving.
Across our investment strategies (Growth, Balanced etc.) we continue to maintain an overweight allocation to equities relative to bonds. This decision has had the largest impact on total account returns and is based on several assumptions:
- The long-term decline in interest rates, as measured by the 10-year treasury rate of over 15.0% in the early 1980s falling to under 2.0% this year, is ending. While Federal Reserve Chairman Bernanke has recently tried to clarify his view that monetary policy will remain accommodative in the near term, his comments about tapering bond purchases have also begun to prepare investors for the eventual increase in rates, assuming continued improvement in the economy, a drop in unemployment to 6.5% and inflation of about 2.0%.
- The fiscal and political health of the major, developed economies outside of Europe are gradually improving. In June, S&P raised the long-term credit rating outlook on the U.S. to stable from negative. In July, Moody's upgraded their outlook on the U.K. banking sector to stable from negative.
- Among the major countries, China will still lead the world in global growth, although in any quarter the GDP number could slip below the country’s target of 7.5%.
- While geopolitical risk in the Middle East and other locations is heightened, its impact on the global economy through oil prices and other factors will be manageable.
- U.S. and other larger multinational companies have maintained a strong financial condition and are executing their business plans effectively. Earnings gains should continue to support stock prices, though - at the margin it is becoming more difficult. BCA Research (Global Investment Strategy, 6/7/2013) estimates that underlying earnings for the S&P 500 companies increased 150% since the March 2009 stock market bottom. However, in this year's first quarter, earnings per share (eps) increased less than 5% versus last year on a revenue gain of only 1%. Nevertheless, dividend payments have been bumped by more than 10% during the first six months of 2013. Corporate dividend payout ratios remain below average and total cash on balance sheets is above average.
As of mid-July, the U.S. equity market has appreciated nearly 20.0%, on top of last year’s 16.0% gain and surpassing the returns of most, major international markets. Bonds have essentially recorded flat performance for the year. A short term correction in these trends is certainly possible. We are looking for opportunities to increase our international equity exposure and are mindful of rebalancing accounts if equity ratios get out of bounds with established guidelines. As the inevitable withdrawal of monetary stimulus and its impact on interest rates have become more apparent to bond investors, the budding risk in the equity outlook is the sustainability of corporate earnings growth.
At the Total Account level, performance continued to benefit from an overweight position in equities during the second quarter. International stocks continued to underperform domestic markets during the quarter and year-to-date. Our equity returns for the second quarter were ahead of the 1.8% return of our global equity benchmark (80% S&P 500 Index and 20% MSCI ACWI ex-US Index). The S&P 500 Index returned 2.9% and the MSCI All Country World Index was down 2.9%.
The best performing equity sectors in the quarter were Technology, Consumer Discretionary, and Materials. Among individual stocks, strong gains came from Ford Motor (+18.0%), Microsoft (+21.0%), and VF Corp. (+15.0%). Taxable bond returns were ahead of the benchmark due to our short duration during a period of rising rates; the interest rate on the 10-year Treasury rose 65 basis points (.65%) for the quarter and 73 basis points (.73%) for the year. (See Model Performance Chart)
Significant Portfolio Changes
During the quarter, we sold Southern Company and Anheuser Busch. These sales were made primarily due to valuation. Southern Company was trading at a 22% premium to the S&P 500 compared to a 15-year average of a 9% discount, and is facing increased uncertainty over construction costs relating to two relatively large projects (Kemper and Vogtle). Anheuser Busch InBev appreciated 43% over the past 12 months (versus a 22% return for the S&P Consumer Staples sector and 14% for the S&P 500 during the same period).
One name was added during the quarter. Wells Fargo has one of the largest, most stable, and lowest cost deposit franchises in the U.S. and is poised to benefit from an improving domestic economy. The bank earns very high returns and has a balanced portfolio between fee and interest-based revenue. Meanwhile, Wells Fargo has incremental growth opportunities through its long-held strategy of increasing cross-selling to existing customers and through M&A in subscale businesses. The stock trades at a discount to the financials group on a P/E basis and has a significantly higher yield. (See Top 10 Equity Holdings Chart) (See Equity Sector Diversification Chart)