Portfolio Insight | 2nd Quarter 2017

Volatility was surprisingly low in the second quarter of 2017 as a global economic recovery, accelerating domestic earnings growth, and continued optimism regarding President Trump’s pro-growth plans fueled a steady march to new all-time market highs.

The S&P 500 index closed at 2,423 on June 30, posting a 3.1% total return for Q2.  In the present context of slow but positive GDP growth and a relatively high market valuation of 18x 2017 estimated earnings, the first half total return of 9.3% could be considered a solid full year gain.  Technology names like Apple, Alphabet, and Facebook led the move higher while energy names lagged the market by over 20%.

Trump Troubles

Continued political bickering was a major theme in Q2.  Surprisingly, this divisiveness, along with impeachment threats, a Russia investigation, geopolitical issues including terrorist attacks, and an erratic North Korea, have not derailed the market.  Negative news has, so far, been met with yawns and shoulder shrugs.  Is this an example of justified resiliency, or dangerous complacency?

Time will tell, though we do believe that the market is largely justified in discounting the constant political drama.  With the Republicans holding majorities in both the House and Senate, tax reform, along with deregulation and infrastructure spending, is likely to happen, though timing, details, and ultimate impact on the economy are difficult to forecast.

A Bear Market for Oil

Another major theme in Q2 was collapsing oil prices. Despite sustained strength in global demand and OPEC’s extension of crude oil production cuts, oil entered bear market territory in late June as WTI crude dropped to under $43 from a February high of over $54.  Investors seem fixated on US rig count and production growth, possibly over-estimating the importance of 9 million barrels/day of domestic oil production, which is roughly 10% of global supply.

Many of the lowest cost fields are being developed now, and decline curves are steepening.  We believe that demand, which has been strengthening as global economic growth accelerates, will remain solid, and that non-OPEC inventories will fall in the next several quarters—a delayed effect of cancelled projects over the last few years.  This should help bring the world market into balance and improve sentiment as focus shifts away from the US.  Further, Saudi Arabia has incentive to boost prices as it prepares to take its state oil company, Saudi Aramco, public in 2018.

Amazon Shocks Retail

Late in Q2, Amazon shocked the retail industry, and most investors, by announcing plans to acquire struggling, Austin-based Whole Foods Market.  Cashier-less stores?  Lower food prices?  In-store perks for Prime members?  All could be on the horizon now that Amazon wants to extend its dominance to the grocery industry.  Stocks of an already weak Kroger and a broad range of potentially “Amazon-able” retailers have been crushed as investors come to grips with the threats of disintermediation and deflation.

Dominant and ambitious companies like Amazon are increasingly likely to stand out from the crowd as we enter the latter stages of the current economic cycle.  With the Fed slowly pulling away the punch-bowl of ultra-cheap money by embarking on a new interest rate cycle, companies with strong fundamentals that can generate their own growth could be disproportionately rewarded by active investors.  This would be a welcome change from most of the post-2009 period when a rising tide lifted all boats and most stocks rose together, regardless of fundamentals.

Domestic Equity Outlook

Entering the second half of 2017, the now 8-year old bull market remains intact and could persist for at least a few more years.  Bull markets do not die of old age, but of high inflation and interest rates tightening credit conditions to a point that leads to recession.  Due to persistently lackluster economic growth during this recovery, inflationary pressures have remained limited and the Federal Reserve has been very patient with regards to hiking rates.  When inflation has overheated in the past, the Fed has often over-corrected with rate hikes in an attempt to bring cost pressures under control.  The current federal funds rate of 1.00-1.25% is well below levels normally associated with recession.

So, accelerating earnings, subdued inflation, and favorable credit conditions suggest there is no recession-induced bear market on the horizon.  That being said, a perfectly normal 5-10% correction could occur for a number of reasons.  Volatility could increase into the summer, especially if Trump’s pro-growth policies remain unimplemented.  Indeed, we believe that the equity markets will remain largely range-bound until the outcome of these reform efforts becomes clearer.  Second half stock returns are likely to be less robust than the 9.3% generated in the first half of the year, but we believe major averages could end 2017 higher than current levels.

We focus on investing in companies with accelerating business fundamentals, which tend to generate above average returns over time.  We apply a consistent, disciplined investment process, targeting companies with positive catalysts, valuation upside, and improving relative performance.  In addition, we utilize sophisticated risk management tools to build a diversified portfolio that seeks to generate both capital appreciation and income.

While many asset classes and sectors currently appear expensive versus history, active managers can uncover undervalued securities in certain areas of the market and tilt portfolios towards opportunities with the most favorable risk/reward profile.  We continue to believe that annual returns for US stocks will begin to normalize to a 5-7% range, below the robust post-2009 gains but likely outpacing those of bonds and cash.  We use asset classes like MLPs, REITs, preferred stocks, and bonds to supplement the equity holdings of many clients.

Taxable Fixed Income Outlook

Fixed income returns during the first half of 2017 were generally positive but lagged those of equity returns.  While short-term interest rates have moved higher in conjunction with the Federal Reserve’s two rate hikes this year, longer-term Treasury yields have, to the surprise of many, actually moved lower.  After starting the year at 2.45%  and moving as high as 2.62% in March, 10-year Treasury yields have since fallen to just 2.31%.  The decline in longer-term yields reflects investor expectations for slower economic growth and lower inflation over the short and medium-term.  Recent disappointing macroeconomic data has included worse than expected retail sales, housing starts, nonfarm payrolls, vehicle sales, and consumer sentiment.

We tend to agree with Fed Chair Janet Yellen that the recent weakness in inflation data can be attributed to transitory factors (such as lower cell-phone data plans) and that labor market strength will lead to higher inflation in the near future.  However, we also continue to believe that improving economic growth and the Fed’s tightening policy (including the reduction of its $4.5 trillion balance sheet later this year) will push interest rates gradually higher over the longer-term.  Although some observers may interpret this “flattening” of the Treasury yield curve as a bearish economic signal (an inverted yield curve tends to be good leading indicator of a recession), the current yield curve is still not close to actually inverting (see graph below).

It is also important to note that even when the yield curve does invert, a recession is generally 1-2 years away.  Further, the general tightness of corporate credit spreads relative to Treasuries suggests that, from the bond market’s perspective, a US recession is not likely anytime in the near future.

Rising interest rates present a challenge for bond investors because bond prices fall as rates rise (and vice versa).  However, since we buy each bond with the intention of holding until maturity, and because the face value of a bond is returned in its entirety at maturity, rising interest rates cause only temporary “paper” declines in the prices of our fixed-income holdings.  To take advantage of higher interest rates in the future, we have positioned the bond portfolio with a high proportion of short-to-medium duration securities.  Our strategy is to reinvest the proceeds from maturing shorter-term bonds into longer-term, higher yielding instruments.  We also utilize floating rate bonds, whose coupons will adjust higher as interest rates rise.

US corporate fundamentals remain solid, supported by macroeconomic factors and global demand.  Given their current risk characteristics, we favor high-quality investment-grade corporate bonds over higher-yielding junk bonds.  Likewise, it is our view that carefully selected high-quality corporate bonds, diversified across industry groups, offer a superior risk-adjusted yield versus comparable Treasuries.  Although, given the current level of interest rates, fixed-income returns are likely to remain relatively low for the foreseeable future, bonds continue to play an important role in providing both current income and stability to a well-diversified portfolio.

Global Asset Class Returns

Market returns in 2017 have surpassed expectations, with international markets leading the way after a decade of underperforming the US.

A Global Perspective

The preeminence of US markets, a product of currency stability, innovation leadership, and military strength, is well understood.  US equity markets historically exhibit less volatility than global markets and are of higher quality as defined by a variety of profitability measures.  However, our unavoidably domestic view can cloud the value of markets beyond our borders.   Recasting the world map by market capitalization highlights the fact that roughly half the value of the world market is overseas.

With US equity indices and earnings expectations near all-time highs, domestic stocks appear somewhat expensive relative to history though valuation multiples can remain high during periods of low inflation.  Compared to international markets, US stocks are trading at a 30% P/E premium, double the 15% historical average.  Given these elevated levels and the potential for rising interest rates, we believe that most US asset classes are more likely than not to see valuation compression (which should be more than offset by earnings growth and dividends) from current levels.  Conversely, international valuations are in line with long-term averages, suggesting less potential for further compression, global markets are recovering from multi-year lows, and global earnings expectations are roughly 25% below previous peaks.  This suggests that international markets should benefit from faster growth and a recovery from an earnings trough.

Global Capitalism at Work

World economic growth and corporate earnings are accelerating, and consumer demand is improving both in the US and abroad.  Middle class expansion in fast growing emerging economies is driving a megatrend of rising global consumption, and this global synchronized recovery is powering strong market returns outside the US.  Current broad-based economic growth is resilient, but not without risk.  Falling oil prices and a stronger dollar disrupted global market expansions before.  Increasingly interconnected global markets have been susceptible to contagions and domino effects, resulting in heightened volatility.  China, whose growth will inevitably slow as it transitions from an investment to a consumer-driven economy, remains a wildcard.  We believe a “home country” bias to the US is warranted given higher overseas risks, though the benefits of diversification, faster growth, and lower valuations make international allocations attractive for many clients.

REIT Commentary

Equity REITs, as measured by the MSCI US REIT Index, produced a total return of +1.7% in the second quarter. In the first half of 2017, the MSCI US REIT Index produced a total return of +2.7%, which compares to the S&P 500 at +9.3%.  The S&P 500 once again outperformed REITs due to the fear of interest rate hikes, though REITs outperformed the broader market in June, the month in which the rate hike actually occurred.

The malaise affecting anything associated with retail brick-and-mortar further separated public market pricing of retail real estate from hard data in the quarter.  As of June 30, the shopping center and regional mall sectors comprise two of the largest over-weights in the REIT portfolio.  While the growth of e-commerce will continue to cause store (and even mall) closings, we believe the high quality locations with well-capitalized owners will survive and thrive.  Although investing in this out-of-favor segment today carries significant headline risk, there could be numerous catalysts over the next 12 months that will demonstrate the public market mispricing for these companies.

Municipal Bond Commentary

The Fed has just raised the Fed Funds Rate for the fourth time in the current tightening phase, and short-term interest rates like the 2-year Treasury yield are increasing. What does one do with municipal bonds now?  We have heard this question many times over the last several months, and the short answer is “hold tight and continue investing.”

While it is true that bond prices decrease as interest rates rise, the bonds’ market value will most likely suffer “paper” losses only.  A decrease in price as a result of increased interest rates does not mean that the quality or security of the bonds is any lower than before.  We buy municipal bonds, as we do taxable bonds, with the intention of holding them until maturity.  Again, a bond held to maturity will pay the bond holder 100% of par, or face, value, plus accrued interest.  If interest rates move higher, we will invest the proceeds of maturing bonds into higher yielding securities.

Current interest income received from bonds does not change as a result of price or interest rate fluctuations. Therefore, we look to purchase bonds of issuers that will have strong financial conditions both today and into the future. We will look to take advantage of lower prices by purchasing bonds of issuers we consider to be high quality, and we will continue to monitor the financial condition of each issuer until their bonds mature.

 


Bradley J. Eixmann, CFA, beixmann@chiltoncapital.com, (713) 243-3215

Brandon J. Frank, bfrank@chiltoncapital.com, (713) 243-3271

R. Randall Grace, Jr., CFA, CFP, rgrace@chiltoncapital.com, (713) 243-3223

David M. Underwood, Jr., dunderwood@chiltoncapital.com, (713) 243-3216

Matthew R. Werner, CFA, mwerner@chiltoncapital.com, (713) 243-3234

 

 

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