Investment Thoughts as 2017 Commences
The total return for the S&P 500 Index was 11.96% for 2016 and 3.82% for the fourth quarter. A substantial list of sentiment measures indicates a recent positive change in the global economy. The global sentiment is also improving in Japan and the U.K., and bourses have generally moved higher in Europe. The U.S. real GDP growth was revised to 3.5% annually for the third quarter of 2016. With the improved outlook, expectations are high for the Trump administration to boost U.S. economic growth in 2017. Less regulation and strong growth are bullish for U.S. corporate profits. Trump’s proposal for a major corporate tax cut is another positive for equities. On the negative side, the recent dollar appreciation hurts U.S. corporate profits as a third of the S&P 500 corporations’ earnings are sourced from abroad. Although a stronger U.S. economy will have a spillover effect to other countries, the U.S. will likely benefit the most from Trump’s fiscal stimulus plan. Another potential downside is the risk of trade wars resulting from anti-globalization policies aimed to boost the U.S. domestic economy.
The U.S. economy will likely grow above 2% in 2017, and the labor market should continue to tighten, pushing wage inflation higher. Full employment has only recently been attained and in order to pose a long-term inflation worry, it would have to stay near 5% for another three years according to BCA Research Inc., Special Report, December 5, 2016. Long-term inflation expectations have also increased since the election reflecting expected higher import tariffs. Inflation may increase but should not be significantly higher if the new administration succeeds in boosting demand and expanding the supply capacity of the economy. If businesses respond to increased demand with a significant increase in capital spending, the result will be faster productivity growth and less inflation. A stronger household sector leads to the robustness of the expected final demand anticipated by corporations.
The Federal Reserve will likely become more orthodox in its monetary policy if it is not the only option to stimulate the economy, as an easier fiscal stimulus policy is implemented. Although sizable tax cuts, increased infrastructure and defense spending, protectionism and a tougher stance on immigration are inherently inflationary policies, the Consumer Price Index (CPI) will most likely renormalize rather than surge. The Federal Reserve will likely not rush to abruptly tighten monetary policy with a resurgence of inflation in 2017 and a corresponding strong dollar. Although the output gap is almost closed, industrial production has diverged negatively from the output gap recently, suggesting that excess capacity still remains. The upshot is that inflationary pressures may stay contained for some time, especially if the U.S. dollar continues to firm. Inflation actually decelerates when the dollar is in a strong bull market.
The dollar had been relatively weak against most of the world’s major currencies over the past decade, which improved U.S. exports worldwide. Since 2014 the U.S. dollar has begun to appreciate and surged to a 14-year high in the wake of the Trump election and the Federal Reserve’s decision to raise interest rates by 0.25% in December 2016. A strengthening dollar is a sign of rising optimism for the U.S. economy as prospects of higher inflation and rising interest rates encourage investments in U.S. assets, reflecting growing hopes for better returns. A strengthening dollar increases the currency’s purchasing power. If imports are cheaper, U.S. consumers and companies that purchase components abroad have more money to spend. In turn, a strong dollar could increase retail sales, a driver of economic growth, and engender more confidence in the U.S. overall. However, the dollar rally could undermine the Trump agenda of creating more domestic jobs by making exports more expensive. Companies will eventually adjust by boosting capacity at foreign plants while reducing capacity at home, changing their supply chain, or increasing the use of automation.
The major secular investment theme during the past eight years was global deflation. However, the post bubble secular period of deflation and slow nominal growth seems to be ending in the U.S., and reinflation could be a prime investment theme for 2017. The global economy might still be in secular stagnation, but cyclical acceleration is clearly underway. Leading economic indicators (LEIs) around the world are strengthening in a unified manner that has not existed since the credit bubble. Global yield curves are steepening, which supports the forecasts of global leading indicators. The MSCI ACWI reported that in 2008 41% of global yield curves were inverted while only 2% are inverted currently. Historically steeper yield curves forecast faster nominal growth, flatter yield curves forecast slower growth, and inverted yield curves forecast recessions.
We expect that Central Banks’ monetary policies will continue to diverge in 2017. While the Federal Reserve is in a better position to increase interest rates, the European Central Bank (ECB) and Bank of Japan (BOJ) are expected to continue with easy monetary policies. Deflationary forces are present in Europe as the output gap remains wide at approximately 4% of potential GDP. Despite a 2.3% fall in the Eurozone’s unemployment to 9.8% since 2013, euro wages continue to decelerate from excess capacity in the European labor market. As a result, European income and consumption continue to lag the U.S even though there has been a recent expansion in credit flows from European banks to the private sector. The ECB increased the total size of its asset purchase program. Europe will likely continue its easy monetary policy for 2017. With monetary divergences backed up by economic fundamentals, interest rate spreads between the U.S. and Europe can be expected to become wider.
In Japan, economic slack has dissipated, and the labor market is at full employment with unemployment at 3%. Japan has had a difficult time moving the output gap to positive territory because of fiscal austerity. Moving ahead, Japan’s GDP should move above trend, and payroll growth remains strong despite full employment, pointing to potentially higher wages. Before removing accommodations, the BOJ intends to let inflation significantly increase to support growth and a weakening yen. The British pound is weathering the dollar’s strength better than most other currencies. While the short-term outlook for the U.K. economy is exposed to the beginning of the Brexit negotiations in 2017 between the EU and U.K., longer term the U.K. present equity valuations appear to make them relatively attractive investments. The Swiss National Bank (SNB) is holding an unofficial bottom in the euro and Swiss franc exchange. Longer term the Swiss franc could appreciate sizably against other currencies, especially against the euro, because of the Swiss currency’s net international investment position of 120% of GDP and current account surplus of 11% of GDP.
When the developed world’s central banks continued a more accommodative monetary policy for most of 2016, emerging markets (EM) and China benefited. In 2017 emerging markets and China will likely be a source of deflationary shocks for the global economy as U.S. interest rates rise and the dollar becomes stronger. Emerging markets have accumulated too much debt to GDP, rising by 51 percentage points to 146% of GDP over the last five years. While the debt backed up new investments, capital has been misallocated, threatening future debt-servicing capacity. Return on equity in the EM has collapsed despite surging leverage ratios. Excess debt and excess capacity are deflationary and increase the vulnerability of the EM to positive (2016) and negative shocks. The Chinese credit appetite remains low and interbank rates are rising as the People’s Bank of China (PBoC) slows liquidity injections. The Chinese economy risks rolling over. Since EM trade more with Europe and Japan and less with the U.S., the EM weaknesses could further contribute to monetary divergences between the Federal Reserve and the ECB and BOJ.
The pool of investable equity assets has been reduced substantially over the last five years as a number of public companies have gone out of business, become private, merged, or have been acquired. At the same time the number of mutual funds, ETFs, hedge funds, and private equity firms has increased. There have been many more dollars trying to exploit a shrinking pool of assets at the same time that the competitive landscape has become more sophisticated.
In an article in the Financial Analysts Journal (FAJ) Volume 72 Number 6 2016, “Fundamentals of Efficient Factor Investing”, Roger Clarke, Harindra de Silva, CFA, and Steven Thorley, CFA, estimate that the combination of four fully invested factors: low beta, small size, value, and momentum, captures less than half (e.g., 40%) of the potential improvement over the market portfolio’s Sharpe ratio. Recently, factor sub portfolios have become very popular. The evolution of prepackaged portfolios, such as multifactor exchange-traded funds (ETFs), depends on the assumed correlation structure of factor exposures across the securities. In contrast, a long-only portfolio of individual securities, using the same risk model and return forecasts, captures most (e.g., 80%) of the potential improvement. According to the authors, a long-only constrained investor with views about equity market factor returns and risks still needs a portfolio constructed directly from individual stocks using nonmarket factors.
The results of “Fundamentals of Efficient Factor Investing” confirm the importance of individual security selection in a portfolio and reaffirms Martin Investment Management, LLC’s investment philosophy. We offer an opportunity for wealth creation over time by selecting a focused portfolio of individual securities using a fundamental bottom-up investment process. When a company is bought, we are paying for its future expected performance. A company’s intrinsic value is not only a function of current levels of profitability and growth, but also where its productive and invested capital is migrating over the long-term. Martin Investment Management, LLC believes that growth and valuation are very important concepts in the investment process. The investment team seeks to find quality companies for which the market has mispriced the economic cash flows that are being discounted or are trading at a discount to their intrinsic value by using its long established multi-stage investment process. In 2017 Martin Investment Management, LLC will continue to be very focused and disciplined in its equity selections with the goal of using the power of compounding of returns over the long term.
Wishing you health, happiness, and prosperity in the New Year!
Navigating A Complicated Financial Market
The U.S. and world economies continue with mixed signals and slow growth. The final estimate for the second quarter U.S. Real GDP showed economic growth at an annual rate of 1.4% up from 0.8% in the first quarter of 2016. At a global level, the growth benefits of the extraordinary monetary stimulus over the past years have been even more disappointing than in the U.S. China is struggling to grow over 5%, Europe 1%, and Japan 0%. The headline U.S. unemployment rate remained at 4.9% in August 2016, and a broader measure of unemployment, which includes discouraged and underemployed workers, also remained unchanged at 9.7%. Despite the anemic growth rates, the S&P 500 Index rose 3.85% on a total return basis and the MSCI EAFE USD Net Index increased 6.43% in the third quarter of 2016.
In the second quarter of 2016, U.S. productivity contracted by 0.5%, making this the third consecutive quarterly decline. According to the August 9, 2016 issue of the Wall Street Journal, during the eight years between 2007 and 2015, productivity growth averaged just 1.3% annually, which was less than half the pace that was seen in the seven-year period between 2000 and 2007. Productivity is still contracting in the Eurozone, Japan, and Canada. Global aging demographics, increased regulation, trade restrictions, and debt overhang are hurting productivity. Paul G. Mahoney, former Dean of the University of Virginia Law School, addresses the cost of securities regulation in Wasting a Crisis: Why Securities Regulation Fails, by the University of Chicago Press in 2015, in which he argues that financial regulation imposes millions of dollars in costs by hindering competition, with the largest impact on smaller firms. The outlook for growth seems to be more of the same, just strong enough to forestall recession, not strong enough to ease the market’s reliance on an unnaturally accommodative monetary policy.
In its August 8, 2016 Weekly Report, BCA Research, Inc. outlined the two speed economy with consumption continuing to grow and non-consumption related GDP in recession. Consumers are benefiting from low fuel costs, historically cheap borrowing rates, and increasing capital availability. Balance sheets have been repaired with the personal savings rate higher than the average of the past 15 years. Financial wealth gains, led by the equity market, are creating a positive wealth effect. Wage growth is outpacing nominal GDP growth, consumer income expectations are climbing, underscoring that the barriers to increased consumption are gradually falling. The upshot is faster consumer spending especially if the U.S. dollar supports real purchasing power.
The slow speed economy is best expressed by the comments of the Economic Output Composite Index of Manufacturing Data and Services that the U.S. economy has remained in a rotation of inventory drawdowns since 2009, which leads to restocking cycles. This provides a temporary boost to economic activity but very quickly fades, and the economy softens once again. There have been fewer advances that propel innovation and productivity gains, and the more recent innovations lose their dynamic growth power as they turn from game changers into products with trivial value. The result is an intense search for investment opportunities, with businesses not making long-term capital investments in their businesses. Business spending for future expansion is difficult when the sales forecasts are so murky.
In its August of 2016 meeting in Jackson Hole, the Federal Open Market Committee (FOMC) left existing interest rates unchanged, but the members expressed their differences on when to implement another interest rate increase, and a December 2016 hike continues to be debated as long as some growth is evident. Both the low labor participation rates and the low productivity in the U.S. fuel the arguments of the proponents of the great stagnation hypothesis that rates should not rise presently. Opponents of keeping interest rates low believe that easy money operates by creating safe but low interest liquidity, and easy money can encourage speculation. Monetary policy appears largely exhausted. The Federal Reserve cannot address structural problems in the economy or ameliorate the various disequilibria, but it can buy time.
In “Bid Farewell to Buybacks,” August 29, 2016, BCA Research comments that equity share buyback announcements have plunged. There is little financial incentive to issue debt to retire stock. The message is that companies are increasingly challenged to generate sufficient free cash flow to take on even more leverage to retire equity and/or engage in other shareholder friendly activities. It is entirely normal for net share repurchases to drop sharply when corporate debt is growing faster than profits, as has been the case for the last several quarters, except for the health care sector. FactSet’s Buyback Quarterly reports for 137 companies in the S&P 500, or almost two fifths of those doing buybacks, that the amount spent buying back shares exceeded what the companies actually earned. Overall spending on buybacks accounted for more than 70% of total S&P 500 earnings, which is not sustainable. Actual buybacks are down 7% year on year in 2016.
Although the U.S. equity markets have become much broader in 2016 than 2015, when Facebook, Amazon, Netflix, and Google (FANG) were up 50% while the equally weighted S&P 500 Index was down more than -0.7%, opportunities for quality investments appear to be declining. The result is an intense search for investment opportunities that create alpha. At this time, the U.S. earnings per share (EPS), excluding the energy sector, managed to rise by 1% in the second quarter of 2016. A weaker than expected growth rate is anticipated for 2017, given that present corporate profits and economic fundamentals are decelerating.
Inefficiencies are constantly changing the markets by their nature and challenging investment decisions, but there are some semi-reliable factors for patient investors. Martin Investment Management, LLC believes that wealth creation is primarily derived from the long-term compounding effects that result when a company makes investments in projects that have high returns on capital. In “A Five-Factor Asset Pricing Model” Journal of Financial Economics, 116 (2015), pp. 1-22, Nobel Laureate Eugene Fama and Kenneth French attempt to demonstrate that between 71% and 94% of investment variability of returns in their dataset is explained by adding profitability and investment factors to their traditional three-factor equity pricing model of market risk, size, and value. Another article, The Financial Analysts Journal FAJ, Volume 72, Number 4 July/August 2016, summarizes that the bulk of practicing investors find long-term investing impractical, as set forth by John Maynard Keynes 40 years ago: “most of these persons are in fact largely concerned not with the most superior long-term forecasts of the probable yield on an investment over its whole life, but with foreseeing changes in the conventional basis of evaluation a short time ahead of the general public. They are not concerned with what an investment is really worth to a man who buys it for keeps, but with what the market will evaluate it at under the influence of mass psychology three months or a year hence.”
Martin Investment Management, LLC believes in the value of using a disciplined investment process in the equity markets and viewing the investments as partial ownership of businesses for the long-term. With an investment process combining factors of growth, including quality and profitability, with fair equity price valuation, the firm believes that it is able to find companies that have the ability to reinvest at a strong rate in the future and have the potential to create value for shareholders. The firm believes that there is a greater margin of safety in buying stocks at a discount to what they are worth. The discipline of patience is important to compound the wealth created by a company not in last year’s or next year’s earnings but in earnings over time. Martin Investment Management, LLC believes presently that equity returns compare favorably to most fixed income returns in this period and regards that most equity valuations are reasonable, except for a small percentage of stocks that are trading on market momentum.
An important tenet of the firm’s investment process is viewing investment holdings from a long-term perspective of three to five years in order to identify and clarify the ideas that are ultimately included in the portfolios. Generating a comprehensive view of the investment environment represents one way to distinguish the investment process, which reviews structural trends such as debt and demographics as well as cyclical short-term variables to consider a more complete investment backdrop. For every idea, the portfolio team reviews the bottom-up fundamentals, understands the catalyst for growth, and assesses a company’s valuation in the marketplace. The equity investments are intended to seek a compounded positive return over a three to five-year period.
Martin Investment Management, LLC is delighted that many of its holdings were recently featured in the September 2016 issue of Fortune, “How These 50 Companies Are Changing the World and Making Money Doing It.” One of the longer-term holdings of Martin Investment Management LLC’s strategies, is Nestle, the world’s leading seller of bottled water. The company sources its water locally, helping the farmers of developing economies in more than 50 countries. Nestle has worked not only to purge slavery and child labor from its supply chain but to become a nutrition, health, and wellness company cutting fat, sugar, and sodium from thousands of products and fortifying many products with essential minerals and nutrients that are in especially short supply in low and middle income countries. Innovation can arise from highly liquid publicly traded companies, which have the potential to positively impact the world while delivering financial return to shareholders.
Wishing you a pleasant fall season!
A World of Hype and Hope
The Importance of Wages, Income, and Corporate Earnings
The U.S. economy continues to muddle through with an increase of 1.1% in Gross Domestic Product (GDP) for the first quarter of 2016 and with the rate of job growth and corporate earnings remaining lackluster. However, the consumer sector has exhibited encouraging strength in the second quarter of this year. The U.S. consumer, who continues to benefit from current low energy costs, is driving more than two thirds of the U.S. economy’s growth with a May increase of 0.3% in consumer spending and a revised April increase of 0.8% adjusted for inflation. The April increase in consumer spending, propelled in part by automobile purchases, was the largest increase since August, 2009. Consumer expenditures will be three to four times greater than first quarter of 2016. Given recent economic data released by the Bureau of Economic Analysis, consumer spending in the second quarter of 2016 appears to have increased by 4.0% over the same quarterly period one year ago, supporting overall economic growth this year. The U.S. Manufacturing Purchasing Managers Index (PMI) continued to rise in June with the new orders component up to 57.0, the sixth monthly increase. The present inflation rate is up slightly but well below the Federal Reserve’s target of 2.0%. Economic growth periods tend to last longer when inflation is low. Because inflation is at a relatively low rate, this suggests that the business cycle expansion period may last longer than usual. The S&P 500 Index had a total return of 2.46%, and the World Index (USD) Net increased by 1.01% in the second quarter of 2016, while the EAFE Index (USD) Net declined -1.46% during this same period.
Because real U.S. GDP has been growing slightly less than 2.0%, corporations, which need about 2.0% U.S. GDP to generate profits, have significant headwinds. The U.S. economy becomes unstable when there are no profits, so risk is skewed to the downside. The Federal Reserve, moving at a glacial pace, will not likely increase interest rates until 2017, mainly because of demographics and debt issues, and the balance between controlled inflation and slow GDP growth. Investors will continue to gravitate to stocks that look like bonds and corporations with free cash flow growth and solid revenue profiles. Currently about two-thirds of the stocks in the S&P 500 Index have a dividend yield greater than that of the U.S. 10-year bond. Yield seeking speculation has increased significantly in financial markets. At present, investors can expect a conventional portfolio mix of 60% S&P 500 (5.0%), 30% Treasury bonds (1.45%), and 10% Treasury bills (0.25%) to return less than 4.0% annually over the coming years according to figures cited in the Wall Street Journal. This situation is likely to provoke a broadening pension crisis in the years ahead, due to underfunding and capital losses over the complete market cycle, as many pensions assume a much higher required rate of return. According to Strategas Research Partners, there is a slight chance of a U.S. recession in 2016, which increases to 40% in 2017 as economic indicators point to slower growth going forward. There is some cushion in 2016, thanks in part to the U.S. consumer, but the election may determine how the economy looks going forward.
Globally, the world is economically absorbing the Brexit shock, the failing Japanese policy of Zero Interest Rate Policy (ZIRP), and the weakening Chinese Yuan. The U.S. dollar and Japanese Yen are strengthening, which will eventually hurt exports of these countries. The U.S. Treasury rates have declined with a flight to safety. The yield on the U.S. 10-Year Treasury, a benchmark rate for many consumer and corporate loans, is currently at 1.45%, almost declining to the low of 1.38% in 2012 when worries about Spanish solvency rose. Most world countries have falling Leading Economic Indicators (LEIs) rather than increasing LEIs, which means most of the U.S. monetary tightening is occurring through the exchange rate rather than interest rates. The tightening of the financial conditions, spurred by the Brexit vote, is probably sufficient to tip U.S. GDP below 2.0% in the coming quarters. Because British trade has little impact on the U.S. economy, the Brexit vote will likely be less relevant to domestic corporate earnings.
According to BCA Research, the growing gap between rich and poor is the key driver for the populist backlash that empowered the Brexit leave side. The supply of low skilled workers is no longer falling in tandem with declining demand for such workers. Open border immigration policies have enlarged the potential supply of low skilled workers, while increased trade, technological improvements, and rampant outsourcing have reduced the number of well-paying blue collar jobs. Not only has increasing globalization led to a shift of income from low skilled workers to high skilled workers, it also resulted in an overall decrease in the share of national income flowing to labor. The flipside of this has been a rising share of income flowing to capital. Corporate executives and other captains of capital have benefited the most from globalization. This explains why the big surge in incomes has not come at the 95th percentile of the income distribution or even at the 99th percentile. Globalization has particularly benefited the 99.9th percentile and above.
In the U.S., weaker payrolls likely reflected the lagged effects of the soft patch in real GDP in the fourth quarter of 2015 and the first quarter of 2016. Although unemployment claims continue to fall, the participation of labor is starting to fall again after a brief bounce earlier this year. The current dynamics of the labor market have created a situation where wage inflation has been subdued even though the unemployment rate is below 5%. Because of the large number of people in part-time jobs wishing they could be full-time and the retirement pace of baby boomers at the top end of the pay scale, wage inflation is only 65% of what would be expected at this point in an economic cycle.
A recent article in the Financial Analyst Journal: Volume 72, Number 1, 2016, Ilia Dichev, John Graham, Campbell R. Harvey, and Shiva Rajgopal conclude in “The Misrepresentation of Earnings” that the characteristics of earnings quality include sustainability, predictability, few one-time items, and backing of actual cash flows. Their research was conducted by interviews with 12 Chief Financial Officers (CFOs) and a large scale survey of 400 CFOs, who represent the intersection of business operations and accounting rules. In any timeframe, as many as 20% of public companies use discretion within Generally Accepted Accounting Principles (GAAP) and distort earnings. These companies misrepresent as much as 10% of reported earnings. The CFOs identified several red flags that investors should be mindful of to identify poor earnings quality. These include the lack of correlations between earnings and cash flows, misreporting accruals, unsubstantiated deviations from industry norms, lack of controls, and poor governance. The most common reason for misrepresenting earnings was to affect the stock price.
Because accounting rules are increasingly complex, it is often difficult to discern management decisions versus reported earnings. For investors less attuned to accounting practices, there is concern that the increased use of non-GAAP earnings is a worrisome trend. The concerns are a growing problem as industry standards are falling as a result. These aggressive non-GAAP practices evidence a failure of transparency from the managers to the owners of these companies. Non-GAAP references in proxy statements for S&P 500 companies are presently 58% versus 27% five years ago. Based on calculations from Thompson-Reuters, the divergence between GAAP and non-GAAP earnings per share for the S&P 500 Index companies increased from $2.57 per share out of $27.47 in the third quarter of 2014 to $10.82 per share out of $18.70 in the fourth quarter of 2015. Companies that use non-GAAP are by definition more prone to beat estimates employing these dubious practices. Companies guidance is almost always presented in non–GAAP terms, thus giving the company wiggle room, to meet or exceed earnings expectations. Gaming GAAP whether to increase the stock price, boost executive compensation, or some combination of the two is unethical to corporate culture committed to transparency and responsibility. The SEC’s recent review of Regulation G will result in greater adherence to GAAP going forward.
Martin Investment Management, LLC continues to look for companies that can achieve high returns on invested capital without excessive leverage and unconventional accounting. We want to evaluate the intrinsic value of a company, rather than the book value, which is a nominal accounting value. Accounting numbers are the beginning and not the end to business valuation. Companies, which consistently practice transparent and conservative accounting, typically run their businesses in a similarly open and ethical fashion. Quality companies have relatively stable earnings streams. Although cash flow is important, over a five to ten-year period, a company must make investments to continue to grow their businesses. The economic goodwill from their investments is very important, as it tends to rise in nominal value proportionally with inflation. Martin Investments also believes in the importance of employing a long term investment horizon to the equity markets.
Wishing you a safe and relaxing summer season!
Martin Investment Management, LLC is a registered investment adviser. The information contained herein is not intended to be investment advice. Investment advice can be provided only after the delivery of Martin Investment Management, LLC's Form ADV and once a properly executed investment advisory agreement has been entered into by the client and Martin Investment Management, LLC. All investments are subject to risks; past performance is not a guarantee of future results. This information reflects the opinion of Martin Investment Management, LLC on the date of production and is subject to change at any time without notice.
The British Vote to Exit the European Union
The British voters supported the split with the European Union by a meager margin of 51.9% to 48.1% on June 23, 2016. The referendum outcome defied expectations and plunged the pound to its lowest level since 1985. An overwhelming majority of Members of Parliament, almost 500 out of 650, favor remaining in the EU as well as the voters of Scotland, Northern Ireland, and London. Britain will have two years to negotiate the terms of its exit, with talks to unwind agreements in areas as diverse as fishing quotas, financial services legislation, and health and safety standards established over decades. Opponents of the Brexit vote argued that a withdrawal could trigger a recession and economic and trade uncertainties for a decade. Brexit supporters’ main focus was to control immigration and support U.K. sovereignty over EU rule. The final result of the initial referendum is questionable as the details of the voluntary exiting are complex and difficult and have to be negotiated.
The U.K. is the second biggest EU country by economic output and third largest by population, after Germany and France. Because the EU is Britain’s largest export market, British companies are in unchartered territory whether or not they will continue to be able to sell into the EU bloc without new tariffs. Although the U.K. has global significance without the EU, it has only two years to renegotiate favorable trade deals. To leave the EU, the U.K. government has to invoke Article 50, which would be followed by long negotiations. The U.K. government is in no hurry to trigger Article 50, the start of the legal process of extrication from the EU and accountability to its laws. Conversely, the EU would like to communicate to the rest of the 27 members, that individual EU membership agreements are not an option, so there is presently little flexibility in negotiating the terms of exit. If the European Union Commission, primarily Commission leaders in Belgium, prevails the results will be more severe than if the European Union Council leaders of the original countries of the EU (Belgium, France, Germany, Italy, Luxembourg, and the Netherlands) renegotiate the existing trade tariffs. While Jean-Claude Juncker, head of the EU Commission, has suggested a hard stand against Britain’s exit, the EU Council shares interest with Britain to keep tariff agreements reasonable so that trade among the countries will not be compromised. A political stalemate will continue to September 2016 when the new prime minister in the U.K. is named.
To place the recent events in historical context, the U.K. had waited 16 years to join the European Economic Community in 1973 after it was formed in 1957. 1975 marked the last referendum, prior to the June vote, on whether to remain in the European Economic Community. The vote in 1975 passed by a margin of 2 to 1. In 1992, John Major signed the Maastricht Treaty, which expanded cooperation, created the European Union, and eventually led to the creation of the Euro. Major’s acceptance almost caused him to lose power in 1993. Britain’s EU skeptics won out in 1999 when the U.K. voted not to adopt the new Euro currency. In 2008, eight eastern European countries, newly added to the European Union, triggered a wave of immigration to the U.K., which strained public services. In England and Wales, the share of foreign born residents swelled to 13.4% of the population by 2011, roughly double the level in 1991. Since 2011, immigrants have been increasingly attracted to Britain, as its economy has been growing at twice the pace of the Eurozone.
At this time, there continues to be more questions than answers to specific issues. As for equities, current political uncertainty implies neither resolution, contagion nor escalation of the geopolitical risks. Although western democracies have historically supported and benefited from globalization and immigration, the new issues of physical security and the sustainability of public treasury and individual economic wellbeing give rise to immigration being perceived as a threat more than an opportunity. The anti-immigration opinions are higher in countries with greater unemployment. At worst, Brexit may serve to reinforce global growth divergences by leading to a significant slowdown in the U.K. and the Euro area GDP, particularly if investors begin to question whether other countries will eventually attempt to renegotiate their own deals with the EU. While most procurement executives do not foresee major disruptions, many are cautiously watching the situation closely and believe Brexit will hamper growth. Among those projecting a negative impact, changes in the exchange value of the dollar could be the most direct cause of their challenges. Changes in global demand is seen as a secondary cause and a change in demand for goods and services by their customers in the United Kingdom is seen as a possible, though somewhat unlikely, reason for not meeting expectations.
Martin Investment Management, LLC is a registered investment adviser. The information contained herein is not intended to be investment advice. Investment advice can be provided only after the delivery of Martin Investment Management, LLC's Form ADV and once a properly executed investment advisory agreement has been entered into by the client and Martin Investment Management, LLC. All investments are subject to risks; past performance is not a guarantee of future results. This information reflects the opinion of Martin Investment Management, LLC on the date of production and is subject to change at any time without notice.
With Or Without Central Bank Intervention
The terrible beginning of global equity markets in 2016 changed in mid February as the market began to rally due to a more positive perspective of future oil prices. The price decline of commodities, particularly oil, had driven the market down to new lows in the first quarter of 2016. There tends to be an inverse relationship between the U.S. dollar and oil. The current equity markets are a response to the volatility in the commodity markets. On March 16, 2016, the Federal Open Market Committee (FOMC) ruled against its projected rate hike trajectory of one point with four interest rate hikes in 2016 and maintained its benchmark short-term interest rate in the range of ¼ to ½ percent with only two rate increases planned for 2016. Later Janet Yellen reiterated the need for the Federal Reserve to "proceed cautiously" in lifting interest rates given weak corporate earnings, unfavorable market conditions, and weaker than expected overseas growth. In addition, an increase in interest rates would further strengthen the dollar against the currencies of the U.S.'s major trading partners. In the first quarter of 2016, the S&P 500 Index fell to 1829 before rising to 2060 for a 1.35% increase on a total return basis. The utility sectorin the first quarter of 2016 performed very well as investors sought income yield. The rate on the ten-year U.S. Treasury Note surprisingly was equally as volatile for the first quarter of 2016 as it dropped from 2.3% to 1.6%.
One of the key themes for investors in 2016 is the divergence between monetary policy in the United States and the rest of the world. The Federal Reserve is in a difficult position regarding normalizing rates, since the economic cycle may be moderating just as the central bank seeks to raise rates. Europe, Japan, and even China, are pursuing accommodative policies while the United States is moving slowly to a tighter policy. Global growth is reflecting broad based weakness in both purchasing and lending. Credit markets are still fundamentally challenged. Recently, the European Central Bank (ECB) boosted stock prices with its latest easing, but the implications for corporate earnings are much less certain. The U.K. growth forecasts may be at risk due to the Brexit referendum this June as the U.K. makes a decision on remaining in the European Union (EU). Japan's Abenomics lacks reflationary traction as personal consumption expenditures, and nominal and real wages are flat. The Chinese stimulus policy has been wide but is not rekindling final demand. Emerging market equities and currencies are still fundamentally vulnerable. Global growth or the lack of growth will continue to influence monetary policy.
Although the Federal Reserve prefers that future tightening in monetary conditions results from their interest rate increases, this tightening will likely occur through the change in the value of the dollar. Since 2014, the U.S. dollar has appreciated substantially against other major currencies, primarily caused by weaker global growth and better growth in the U.S. Since the Federal Reserveinitiated a rate increase last year, the dollar has increased despite dismal U.S. corporate earnings and a mixed economy. The Japanese yen, the Swiss franc, and goldalso have appreciated due to their perceived safety. However, many countries such as Sweden, Switzerland, Denmark, the Eurozone, and Japan have adopted a negative interest rate policy (NIRP). Even though many countries have depreciated their currency, these moves failed to improve corporate profitability and these countries' exports relative to the U.S. The recent decision by the Bank of Japan (BOJ) to lower its interest on excess reserves to negative 10 bps (basis points) and the ECB's decisions to be more accommodative make it even more difficult for the Federal Reserve to tighten, because any dollar increase is sensitive to even marginal changes in short rates, and magnifies the effects of tightening.
China had made a series of policy missteps in the summer and fall of 2015 with its currency and equity markets. For China, the key uncertainty is the size of the capital outflows by Chinese companies, hedging their U.S. dollar liabilities, and households, due to Chinese investors seeking international diversification in their portfolios since the liberalization of capital. China's reflationary efforts have stepped up a notch with fiscal spending increasing, particularly with infrastructure projects. However, the authorities continue to struggle with controlling the surge in leverage without letting growth slow much further. Monetary growth and fiscal spending are already at or above government targets. The pick up in government funding for real estate and infrastructure projects is offset by the drawdown from private sector economic activity. Loan demand remains weak as deflation remains pervasive throughout the country's manufacturing sector. Recently, Chinese authorities have become more constructive, soothing markets with lower targets for economic growth in 2016. The government is also addressing the property price bubble, bad loans in its banking system, lack of transparency, and the lack of new growth drivers to replace employment in manufacturing.
Although world oil consumption has continued to grow, it has not grown fast enough to meet the oil supply glut. Until the summer of 2014, the world had the highest inflation adjusted oil prices in its history for the previous seven years of approximately $132 a barrel of oil. As a result, billions of dollars were borrowed to finance speculative and expensive experimental technologies like fracking, which are now proven to obtain more oil from the ground. Productiongreatly exceeded demand, and oil prices fell. The factors in global oil production and drilling operations are complex, and therefore, forecasting is problematic. Many E&P oil companies are over-leveraged and may default on their financing. While the energy sector is not a huge part of the economy, the previous explosive growth in the sector coupled with anemic economic recovery has meant the recent weakness in this sector is a drag on GDP. Large oil producing countries such as Russia and Saudi Arabia now have huge debts and deficits, which is very problematic. Eventually oil supply will be rebalanced, but the oil market is just beginning to find a price where the surplus starts to get cleared at an accelerated rate. The second half of 2016 may prove to be more constructive, but presently most commodities have been on a volatile downward trend.
Central banks of the world have been very active over the last several years in reflating their economies. Their view has been that monetary accommodation pushes up financial asset prices, and lowers the cost of capital, thereby leading corporations to increase capital expenditures, and consumers to feel wealthier and to spend a little more. The problem is that relying only on monetary policy provided the impetus for financial rather than economic risk taking. Corporations preferred using the advantage of lower cost of capital to buy back shares rather than invest in capital projects. The central banks have influenced the equity markets, which have become particularly pronounced since the onset of the unconventional policies. The benefits of the central banks' policy interventions have come with heightened risks of collateral damage and unintended consequences. A continued focus on monetary policy has placed more pressure on the financial system. In Europe and Japan, negative interest rates are forcing investors to save more or take greater risk with capital in order to earn any return. The Federal Reserve needs to make a decision whether to be "data dependent" on U.S. employment and inflation or dependent on global economic weakness. When the Federal Reserve announced a series of rate hikes in 2015, it created a surge in the U.S. dollar, which hurt U.S. corporate profits and oil prices, thereby, straining economic growth. So if the Federal Reserve chooses to be accommodative, asset prices will continue to expand faster than the economy, and if the Federal Reserve chooses to increase rates too quickly, it risks the reversion in asset prices, loss of consumer confidence, and a possible recession. The Federal Reserve continues to hedge both positions with its actions and language, but the continuation of this policy is not sustainable in the long term.
The future of China, oil, and central bank policies remain the most important variables facing the world in 2016 as they could potentially cause significant downside risks to economies and risky assets. They will continue to be a source of volatility this year. Complicating these issues are the additional headwinds emanating from rising political uncertainty in multiple constituencies: populism in Europe, the U.K., and the United States; the refugee crisis; terrorism; and unstable governments. While political risks are difficult to quantify, there is the potential to impact consumer confidence and corporate expenditures. While many investors are optimistic, the market seems to be planning for the worst as there is a struggle between risk on and risk off. Investors are demanding a clear margin of safety. This is understandable given the uncertainty in the capital markets. The world is seeking stronger economies and more effectively coordinated global security.
Many investors select traditional passive indices, such as the S&P 500 Index or the MSCI EAFE Index, perceiving the capitalization weighted investments as an efficient way to gain broad market exposure. Smart beta is an alternative to the traditional index investing, wherefactors otherthan market capitalization based indices are used. Smart beta has become very popular, used by one of every five exchange traded funds (ETF) globally. Many of the alternative factors or rules of smart beta are founded in academic studies. One alternative weighting schemeisthe emphasis on the measure oflow volatility. In the Financial Analysts Journal FAJ, Volume 72, Number 1, January/February 2016 a third study appeared about low volatility. "The Low-Volatility Anomaly: Market Evidence on Systematic Risk vs. Mispricing" by Xi Li, Rodney N. Sullivan, CFA, and Luis Garcia-Feijoo, CFA, CIPM, furthered a study of how a strategy of buying low- volatility stocks and selling previously high-volatility stocks has historically generated substantial abnormal returns in U.S. and international markets. On March 21, 2016 in BloombergNews, Rob Arnott, the Chief Executive Officer of PIMCO's Research Affiliates, LLC andone of the first proponents of smart beta usingthe low volatility anomaly,concludedthat this factor tilt will perform poorly as a consequence of its soaring popularity. He comments that "It's easy to dismiss relative valuation and to chase performance, to chase fads…'Valuation does matter'."
Martin Investment Management, LLC has noted the relevance of the academic studies on the low-volatility anomaly in previous newsletters. The low- volatility anomaly is an important academic finding, but Martin Investment Management, LLC believes for itself, thatlow volatility is a byproduct of the firm's stock selection process rather than a deliberate intent, such as the use of low-volatility with smart beta strategies. The firm recognizes that equity investments represent a very long-term stream of cash flows given to shareholders over time. Many companies that grow at a consistent pace tend to be under investors' radar because they do not attract the most attention relative to fast growing stocks. Many of these companies have a long track record of growth with consistent earnings and stock price increases. Consistency of returns and valuation arevery important factors to the decision process of the firm. The investment process looks for reasonable returns without compromising longer term results. In an exuberant market, the firm may underperform, yet over longer time periods, more stable growth may be achieved.
Martin Investment Management, LLC realizes that the market is very challenging presently. On thepositive side,the returnon capital is still well above the cost of capital for the broad market although the spread between return on capital and cost of capital is narrowing. Companies on average are underinvesting for the future so the firm's stock selection continues to be extremely important. The firm is particularly evaluating companies that efficiently deploy capital and invest in future productivity. The firm remains committed in its disciplined investment process for its domestic, international, and global equity strategies.
Warm wishes for a bright spring season!
The Serious Side Of Investing
The past year proved to be difficult in many ways. Few investments seemed to work, and the world was besieged by increased geopolitical risk and more deflationary headwinds. An endless list of factors, including an Emerging Market slowdown, particularly in China, oil and commodity price routs, domestic terror, Middle Eastern conflicts, and mass migration into Europe has eclipsed global stability. The U.S. economy is growing at approximately 2% of Gross Domestic Product (GDP) and has led the developed world’s growth. European growth improved to 1%, and Japan has come close to a technical recession following two quarters of decline. The current economic expansion has seen continuously negative adjustments, and fewer new innovations than in past economic cycles. Against this backdrop, the Federal Reserve terminated quantitative easing in the fourth quarter of 2015 and raised interest rates by 0.25% for the first time in nearly ten years. The Federal Reserve made a decision based on the U.S. unemployment rate falling to 5.0% and inflation rising little above 1.5% despite global monetary policy remaining very accommodative. Nearly all major U.S. equities, government, and investment grade bonds ended 2015 little changed. On a total return basis, the S&P 500 Index ended slightly up at 1.38% for 2015. The S&P 500 Index has become more expensive recently as earnings fell, and the Index remained unchanged.
For 2016, real GDP growth in the U.S. remains in the 2% to 3% range with equal probabilities for both upward and downward economic surprises. The U.S. may likely benefit from federal, state, and local government spending and tax cuts that may add almost a half of a percentage point to GDP. Although the U.S. monetary policy diverged from the rest of the world this past quarter, there is less likelihood that rates will increase much more given global deflation. The dollar, up 8.4% against a basket of currencies in 2015, is expected to see further gains as the United States diverges from other countries, which are continuing easing monetary policies. If the dollar becomes stronger, the U.S. recovery may unwind, as U.S. corporations no longer remain competitive. Corporate defaults may increase. The markets have already priced in continued lower interest rates based on the plunging commodity prices and the carnage in the junk bond markets. The structural forces in the market place, primarily from the aging demographics in the developed world, high debt levels from both the private and government sectors, and the growing importance of human versus physical capital, are causing subdued economic growth, low inflation, and little investment spending in traditional capital goods. Tax reform and regulatory easing are not changing presently allowing little improved corporate earnings multiples.
Weak corporate earnings are the prominent concern, and slow growth keeps debt burdens high. With the S&P earnings growth projected to be flat in 2015, stocks are already expensive. The market is trading at roughly 19.3 times trailing earnings, well above its 15 times average. Company revenue should grow about 3.9 per cent and increases in costs could keep earnings flat for a second year in a row. If labor costs start moving up a little and interest expense increases, it is going to be hard to keep margins up. Looking at the growth in revenues and earnings on both a nominal dollar and a per share basis suggests that earnings rebounded 200% from the March 9, 2009 lows because of lower interest expense and the ability of corporations to keep labor costs under control.
Corporate debt issuance has a strong relationship with share repurchase that does not help long-term investors as much as it helps corporate management. Dividend payouts, instead, are an extremely important part of the total return of equities for investors, especially when real interest rates are negative for long periods of time. Remarkably, dividends were the only return from stocks in the 1930s and in the 2000s.
The proliferation of the Exchange Traded Funds (ETFs) to over $3 trillion has greatly increased the volatility of the market. Greater and greater amounts of money are chasing fewer opportunities. The exceptionally large gap between the pricing of certain ETFs and their underlying securities is noteworthy for market stability and investor confidence. Although ETF providers counter that they make the market more liquid, what is less clear is the structure of ETFs and their contribution to financial stability. The breadth of the market has narrowed with very few stocks contributing to market advances. There are a “number of crowded trades” suggesting the likelihood of a surprise. An acronym of FANG (Facebook, Amazon, Netflix, and Google) became very popular in 2015 representing major equity investments, yet not all these stock investments are based on solid fundamentals. For example, Amazon (AMZN), a dominant player of ecommerce with over 50% of retail market share, has a price earnings multiple of 50.4x forward earnings and a trailing 12 month price earnings multiple of 975.2x, Return on Equity (ROE) of 2.9%, and trailing twelve months of $5.4 billion free cash flow for the period ending September 30, 2015. Its earnings over the last 3.75 years totaled $108 million or $28.8 million annualized. If one compares Amazon’s numbers to the current multiple of about 20x for most stocks in the S&P 500 Index, one may conclude that Amazon is expensively priced. Amazon has a wonderful story, but its equity price seems to be mispriced on the high side based on extremely high earnings growth expectations. Roger Ibbotson and Thomas Idzorek published “Dimensions of Popularity” in the 40th Anniversary Issue of The Journal of Portfolio Management 2014, explaining how popularity can temporarily misprice stocks about which the market has become overly enthused.
Martin Investment Management, LLC’s response to the present market is to be nimble about the long-term changes in the marketplace while responding to investors’ wealth preservation. We believe in the quality products and services offered in our equity holdings. Although the present market is challenging, there always exists some bright spots to help the world prosper and thrive. Apple, Inc. has developed a complex combination of technologies on Apple Pay to make purchases on the phone easier and safer, addressing cyber security concerns. Because Apple Pay encrypts a string of data on a device account number that stands in for the credit card, it eliminates the exposure of the credit card number in its process. The unique code is used to approve or reject the transaction, and the merchant never sees the actual credit card. In Project Loon, billions of people could get online for the first time because of helium balloons that Alphabet Inc. (formerly Google), will launch soon to reach many places that do not have cell towers. Alphabet Inc. is commenting that the balloons can deliver widespread economic and social benefits by bringing Internet access to the 60 per cent of world population that do not have it. Although the Health Care sector growth may slow since the Affordable Care Act is normalizing, several companies will continue to thrive from their pipeline of groundbreaking drugs. Gilead Sciences, Inc. developed the first pill that can cure most cases of hepatitis C. The U.S. remains a dynamic economy and has the deepest and most liquid equity market, offering exposure to a full range of sectors and styles. Internationally, the major driver is quantitative easing from the European Central Bank (ECB) and Bank of Japan, which helps equities. Additionally, the European and Japanese equities have a low valuation relative to many markets. Global growth will remain slow but European companies are well placed to take advantage of growth.
Benjamin R. Auer and Frank Schumacher in the Financial Analysts Journal Volume 76 Number 6, “Liquid Betting against Beta in Dow Jones Industrial Average Stocks,” further expand the beta anomaly initially discussed by Baker, Bradley, and Wurgler in 2011. The latter authors conclude that high beta stocks significantly underperformed low beta stocks over a century. According to Baker (2011), the presence of the low beta anomaly has a pervasive global effect in all asset classes and challenges the basic notion of risk and return. The persistence of the anomaly is strongly related to distortions introduced by benchmarking. Auer and Schumacher also found the existence of the low beta anomaly by trading the most efficiently priced Dow Jones Industrial Average (DJIA) stocks. Simple strategies that bet against beta generate a significant positive abnormal performance that cannot be explained by the exposure to standard asset pricing factors. Rising betas indicate an inverted risk-return relationship even in the most efficiently priced stocks traded in the DJIA. Exploiting the beta anomaly appears to be possible even within a universe of highly liquid stocks. Auer and Schumacher’s finding were found in all market types from 1926 to 2013 and confirm that the beta anomaly can be exploited.
Martin Investment Management, LLC will continue to base our equity research on sound academic studies that can contribute to overall insight to the market place. We also seek opportunities with companies that can enhance the world’s ability to prosper and thrive while addressing the structural transformation in the global economies. We believe there are huge unmet global needs that can ignite growth.
Our wishes for a healthy 2016!
Patience and Persistence in a Complex Marketplace
The S&P 500 Index declined 6.44% in the third quarter of 2015, marking the first back to back quarter decline since 2011. September’s markets performed similarly to the August markets, which responded to macro factors of the U.S. interest rate policy, China, and lower energy prices. For the third quarter of 2015, the U.S. Gross Domestic Product (GDP) estimate has been revised downward to 1.8%. The unemployment rate remained stable at 5.1%, but the participation rate fell to 62.4% in September, the lowest rate since 1977. This downward participation rate is likely to continue for the next decade as more and more baby boomers begin to retire. Auto sales continue to surprise on the upside, and consumer confidence is rising despite global uncertainty.
To place the current downward marketplace in context, the first deflationary wave resulted from the bursting of the U.S. housing bubble in 2008. The second deflationary wave in 2011 was caused by the European financial crisis. The present, third deflationary wave is happening from the slowdown in China and the emerging markets. In 2015 equity market volatility has also been somewhat grounded in a tentative rate hike from the Federal Reserve, which has been warning markets that it is on the verge of raising interest rates for the first time since 2006. The announcement by the Federal Reserve to an increase in rates began in the spring of 2014. The rate hike would occur at a time when, in particular, the developed world was in the middle of new monetary accommodation. Although there was no actual rate hike in 2014 or yet in 2015, the U.S. dollar began to strengthen and commodity prices began to decline. These prices often fall when the dollar strengthens.
Energy prices had the most significant decline of the commodity sector, primarily hurting energy producing nations. The strengthening U.S. dollar, to which China’s currency is quasi-pegged, caused the Yuan to strengthen on an inflation adjusted basis at a time when its economy was weakening. China recognized this problem, and the People’s Bank of China (PBOC) decided to devalue the Yuan on August 10, 2015, aiming to bolster its exports. The Federal Reserve complicated the situation for the markets with its ambivalent language over the health of the global economy on September 18, 2015, postponing any interest rate increase. Their comments weighed heavily on the final days of the third quarter of 2015 resulting in the worst quarterly performance for the S&P 500 Index since 2011.
While political maneuvers may have an impact on short-term equity prices, over the long term free-floating currencies do not generate real returns. In a recent book, The Dollar Trap: How the U.S. Dollar Tightened Its Grip on Global Finance, Eswar Prasad focuses on the dollar as a reserve currency. According to his work, the dollar’s dominance is not a trade or economic issue but rather a political one. Its dominance is driven by capital flows and the growing demand for a global safe asset, especially from emerging market countries, who use it as a reserve and buffer against financial crises. The huge dollar reserves held by foreign central banks make it all but impossible for the dollar to decline without causing significant losses on the borrowers’ balance sheets. More integrated global capital markets have also created great capital flow volatility. The Dollar Trap demonstrates how, especially after the recent financial crisis, U.S. policies and a dysfunctional monetary system have paradoxically strengthened the dollar’s importance.
For investors, volatility and risk have increased in the short term from monetary easing policies. In “Deep Undercuts,” an article in the September/October 2015 CFA Institute Magazine, John Rubino advises that if current monetary policies in the U.S., Europe, Japan, and China do not produce growth and normalize interest rates, more extraordinary experiments may need to be tried such as a “war on cash” (charging extra fees for people who transact with cash) and “helicopter money” (where printed money is dispensed freely). In 2015 the Bank of International Settlements stated that low interest rates “run the risk of entrenching instability and chronic weakness.” While present worldwide currency changes are deflationary due to demographic changes of an aging population in the developed world and the impact of debt burdens, the uncertain implications of monetary easing policies needs to be addressed because the markets have moved so significantly on the mere prospect of a Federal Reserve rate hike and a depreciation of the Chinese Yuan.
The energy sector is on a downward trajectory due to overproduction and weak demand from a global economic slowdown. Global oil production has continued to rise worldwide exacerbating the supply glut. The impending return of Iranian and Iraqi crude oil to global markets and the easing of shale production continue. Geopolitical risks are a worry for the Middle East, but the U.S. has little continued interest in this area. American geopolitical deleveraging from the Middle East has created disequilibrium: Iran vs. Saudi Arabia for regional hegemony. OPEC is no longer a functional cartel as each Middle Eastern country is working to support its own interest. Apart from oversupply, U.S. refiners are finding it more difficult to gain global market share because of the strong U.S. dollar. Domestic inventories continue to build, which will push down refining margins. In addition, U.S. shale oil producers are spending more than 80% of operating cash flow on debt servicing.
The U.S. corporate sector is adjusting to the effects of deflation abroad, the decline of global trade, increasing multipolarity, lower energy prices, and the rise of the U.S. dollar. Martin Investment Management, LLC is positive, remaining constructive on equities for the long term. With the Federal Reserve no longer adding financial liquidity into the U.S. financial system, shrinking as a percentage of U.S. GDP, investors need to focus on economic growth and a company’s cash flows when making an investment decision. In April 2015, a recent academic study, “The Behavior of Aggregate Corporate Investment”, by S.P. Kothari, Jonathan Lewellen, and Jerold B. Warner reviewed aggregate corporate investment behavior from 1952 to 2010. Their conclusion stated that expected investment growth is connected to recent profit growth and stock returns but only weakly related to changes in interest rates, stock volatility, and the default spreads. There was no evidence that investment growth slows after a rise in short and long term interest rates, contrary to the idea that Federal Reserve driven movements in interest rates has a primary impact on corporate investments. The link between investment and prior corporate performance reflects the impact of fundamentals on investment.
Martin Investment Management, LLC believes consistent earnings growth is the primary driver of intrinsic value and long-term stock appreciation. Our efforts focus on identifying and investing in concentrated portfolios of mid to large capitalization companies, which we believe are capable of delivering sustainable, above average earnings growth. We seek to invest in U.S., international, and global businesses with exceptional earnings growth, driven by a sustainable competitive advantage, solid financial strength, and distinct products/services. Earnings stability and financial strength serve to make the portfolio less volatile during declining markets such as the recent third quarter of 2015. Our goal is to invest in 25 to 30 high quality growth businesses, which we can buy and hold to preserve and compound a client’s wealth over time. We use the same investment criteria for all holdings across regions of the world, industries, and market cycles. We limit our opportunity set to those businesses we expect to hold over time.
We hope you have a lovely fall season!
Navigating The Present While Honoring The Past
The global macroeconomic backdrop, emerging out of the relatively soft start to the year, looks broadly positive with reasonable growth rates, but not all markets look the same or face the same challenges. Monetary policy has diverged. The U.S. interest rates may no longer remain historically low while other parts of the world will continue to fuel liquidity with easy monetary policies. The S&P 500 Index rose 0.28% for the second quarter of 2015 and 1.23% for the first half of 2015. The Greek credit turmoil in late June of 2015 negatively impacted the final performance of the global equity markets.
The decline in U.S. economic activity during the first quarter of 2015 was greater than earlier estimates, and it appears to have weakened business sentiment in other parts of the world. Most of the fall in U.S. aggregate output was due to temporary factors such as adverse weather and port disruptions that delayed export shipments. The strong dollar also reduced the earnings growth of large U.S. corporations with multi national exposure. While U.S. economic growth is widely expected to recover in the coming months, investors have been disappointed by the slower than expected consumer response to lower oil prices.
The tepid pace of current economic expansion in the U.S. combined with intermittent economic growth in Europe and Japan, and a decelerating economy in China has maintained the threat of global deflation. A period of secular stagnation occurs from lingering debt overhangs, persistent demographic shifts in saving preferences, and increased efficiency of capital. These longer run trends, which are powerful and long lasting, will impact the economic outlook for many years. Debt servicing diverts capital from productive investments. Economic growth, inflationary pressures, and interest rates may remain at historically low levels for several years.
For markets to generate a higher level of return in the future requires substantially higher levels of real growth. A 3% U.S. growth rate has been the average over the past 50 years and is based on contributions from consumer spending, business capital spending, and housing. Expecting a present 3% U.S. growth rate for 2015 is likely difficult since the U.S. economy has averaged a 2.2% growth rate since the financial crisis. Despite the U.S. economy's meager growth, it is entering the seventh year of expansion. Since the end of the inflationary 1970s, the U.S. economy has transformed from a domestically focused, manufacturing economy to a more import heavy, service based knowledge economy. The last three expansions, which began in 1982, 1991, and 2001, respectively, lasted an average of 95 months, or roughly eight years. By that measure, the current economic expansion still has room to build on the progress made so far.
The first quarter of 2015 was unique and will likely not repeat itself. The U.S. shale producers saw their world turn upside down temporarily, but the majority of the U.S. economy is a huge consumer of oil, and the lower oil prices are going to be a very positive tailwind to U.S. growth in those industries dependent on energy, which saw their costs cut in half. Additionally, the U.S. consumer is benefiting from a functional tax cut as a result of lower oil prices. Overall lower oil prices are providing a tailwind for the U.S. at the same time labor markets are improving. The U.S. economic recovery continues to be more robust compared to other world economies.
Suppressed interest rates are no longer consistent with the observed U.S. macro data. While the Federal Reserve is not expected to increase interest rates until the fall of 2015, most Federal Reserve officials appear to favor very gradual increases after the first hike. The overall policy backdrop continues to be supportive of economic growth, keeping U.S. borrowing costs low and supporting consumer demand. A form of monetary tightening is already occurring this year due to the strong dollar, which acts to reduce domestic inflation. The inflation outlook is an important component of the secular view of the economy, where the reflationary monetary policies of the central banks support economic growth with a 2% inflation target. The main drivers of inflation will be both service and goods contributing to higher prices.
The European Central Banks's (ECB's) quantitative easing (QE) program is less about increased liquidity into the banking system and more about the weakening of the euro, which is important because Germany drives half of European growth with its export-oriented economy. The weakening euro appears to be the strongest policy tool to re-engineer growth in Europe. The further the euro depreciates, the greater the rate of export growth. The European Central Bank's (ECB's) monetary measures have helped revive business and consumer confidence. The ECB expects the euro region to expand 1.5% in 2015 and 1.9% in 2016. The risk of deflation that worried investors and policymakers in the euro zone for the last few years has faded as core inflation moved close to one percent this year. To bring inflation closer to the target of 2%, the ECB believes the current quantitative easing measures need to be sustained through most of 2016. The tailwinds of a cheaper currency and oil prices will be more short term. In the medium to longer term, there are huge structural imbalances in parts of the Eurozone, including a lack of full labor flexibility, a lack of fiscal consolidation and coordination, and lack of political coordination. According to Mohamed El-Erian in his June 26, 2015 article, "Shelter from The Storm In Europe", Europe must confront three challenges simultaneously: the Greek crisis, Russia's incursion in Ukraine, and the rise of populist political parties.
Japan appears to have broken a period of deflation, as the Japanese economy grew at a healthy 2.4% annualized during the first quarter of 2015. The low exchange rate has been leading some Japanese companies to re-locate production back to Japan, a net long-term positive. Unemployment is 3.3%. Inflation is less than a half of a percentage point. Household spending has recovered from last year's steep fall while the Japanese are also turning more positive on housing with low interest rates and rising wages. The quantitative easing had two meaningful impacts. Real interest rates were lowered, which boosted asset prices (equity and real estate markets), and pension funds have begun to buy equities. When the pension funds are buying equities over bonds and foreign investors are not investing in Japanese zero yielding bonds, the only bond buyer left becomes the Bank of Japan (BOJ). The bonds are being financed through debt monetization, and the BOJ is fully funding the government's deficit. Contrarily, in the U.S. and Europe, quantitative easing was about liquidity injections and currency manipulation.
In China, parts of the economy are in recession, particularly manufacturing and commodity related areas, which now have overcapacity issues. Typically, a cyclical downturn would lead to a rise in unemployment and a collapse in growth. This is not happening, as presently the labor market is tightening in China, and its Gross Domestic Product (GDP) growth rate is stable near 6.5% to 7.0%. China has increasing labor shortages because of the "One Child Policy" that was put in place decades ago and the current resistance by workers to relocate for work in metropolitan locations. Because wages have started to increase significantly, consumption as a percent of GDP has started to increase. Wages are often underestimated officially in China as individuals report less income to avoid paying taxes. The challenge in China is that the whole economy is going in opposite directions, where rural and manufacturing areas are suffering. The central bank of China has been very aggressively easing to maintain a targeted growth rate. Other emerging economies have been negatively impacted by the stronger dollar.
Although the global economy is struggling and the U.S. has experienced a weak recovery, the U.S. equity market has set a new all time high. The equity markets have advanced since 2009, despite slow economic growth. This market cycle is unlike most of the past because of the historic low interest rates, unprecedented government regulation and involvement in the economy, and the record levels of cash generated by corporations from foreign operations that remain untaxed. Even with multiyear market advances, equity investors remain cautious and have not flooded into the markets. The growth in equity assets is primarily accounted for by rising stock prices. Future gains in the stock market during the second half of 2015 will require investors to overcome the fear of interest rate increases, global crises, and a weak recovery. Although there will be some volatility around the first Federal Reserve rate hike, corporate America may be able to maintain lofty profit margins, supported by operational efficiency, reasonable borrowing costs, continued low commodity prices, and modest wage pressures.
The Federal Reserve prepares to increase interest rates for the first time in almost a decade, beginning the end of an era of stimulus that pushed $1.1 trillion of investor cash into the bond market according to data from the Investment Company Institute. An effort is being made by the regulators to maximize safety for investors and promote the functioning of deep and liquid capital markets. A big fear is that investors will sell their holdings simultaneously into a deteriorating market with few firms available to quickly buy the debt. New regulations designed to discourage excessive risk taking have made it harder for banks and securities firms to trade for their own profit and market for other investors. This has drained liquidity from the market and remains a problem for the Federal Reserve unwinding their present monetary policy.
In response to a low rate environment, investors have taken on high risk from leveraged bets to make money. Managed futures strategies had gained $1.4 billion in the first two months of 2015. Many strategies, like managed futures, are opaque, expensive, and unproven. Illiquid securities have been sold in the marketplace that promise investors immediate liquidity when they want their cash back. U.S. Secretary of Treasury, Jacob J. Lew, wants "high risk highly leveraged investments to become harder to trade." Because a longer period of time is involved to trade less liquid stocks, the transaction costs tend to be higher. While low expense ratios make index funds appealing, they can incur meaningful transaction costs that are often overlooked. Changes in an index's constituents force the funds that track it to buy and sell the affected securities around the same time. Additionally, the equity holding period in the U.S. is down to seven months on average, due to the growth of exchange traded funds (ETFs) and high frequency traders (HFT) who account for 70% percent of daily trading activity. Excessive trading occurs too often on the short side and costs the portfolio in total return.
Because of economic uncertainty, short-term investment behavior has increased since 2009. The behaviors of company management, shareholders, and investors appear to be following the same short-term horizon. Corporations have bypassed additional R&D expenditures, fixed capital spending, and human capital investment in education for skilled employees in favor of short-term goals of share buybacks, profit margins, and CEO stock option remuneration. Corporate management bypasses more costly R&D and capital expenditures that do not boost their remuneration. Short-term behavior has significant investment implications acting as a drag on domestic demand growth according to Jeremy Grantham of Grantham Mayo van Otterloo (GMO). BCA Research's May issue 2015, Vol. 66, No. 11, addressed the growing inequality in society as a result of inadequate long-term planning to enhance human capital formation. On a portfolio level, a longer-term view does not eliminate risk out of the investment equation or address technological destruction, but an entirely short term focus creates a herding mentality, where everyone buys or sells the same assets simultaneously driving prices from equilibrium. According to David Donoho in the article, "Is Patience a Virtue? The Unsentimental Case for the Long View in Evaluating Returns," The Journal of Portfolio Management, 2010, a manager's track record takes about 25 years to assume statistical significance.
Productivity growth has remained very low over the past several years, yet there is a positive correlation between capex growth and labor productivity growth two years later. Capex has been a laggard in the current recovery. The current recovery has been led mostly by the continuation of the shale boom, which has had narrow implications for growth, capital, and labor across most industries. As a result, capex has not been a source of productivity growth in the current expansion. Capital growth should strengthen as unit labor costs rise, creating an incentive for companies to substitute more capital for labor. Operational efficiency is much greater in high skilled labor industries because of the knowledge effect. Steven Vannelli, CFA, and Eric Bush, CFA published an article this June on a new market anomaly, "The Knowledge Effect: Excess Returns of Highly Innovative Companies." They discuss how conservative accounting practices since 1974 have led to an information deficiency of companies investing significantly in knowledge. This leads investors to make a systematic error reflected in a persistent risk premium or excess return for these companies. This inefficiency has led highly innovative companies to deliver persistently positive abnormal returns in the stock market.
Martin Investment Management, LLC believes optimism has served investors better than pessimism as bad times are often only temporary. The firm finds a positive correlation between capex growth and labor productivity growth. We continue to look for opportunities in companies that advocate productivity increases. Additionally, we favor companies that have reasonable yields and can grow dividends, as they provide an objective measure of a company's health, value, and profitability. Some of the most attractive equity opportunities are tied to several compelling trends that are likely to persist over the coming years in technology, health care, and the consumer sectors. Over the long-term, strong, well-managed companies with exposure to these areas are likely to exhibit better than market growth, and their equities have greater prospects for capital appreciation. The long term trends of new products and services of connected cars and homes, secure payments, portables and wearables, digital advertising, ecommerce, organic food, pharmaceutical consumption, and biotech research to address aging, cancer, and multiple diseases are not fully appreciated to most investors. Over the long-term, Martin Investment Management, LLC believes that strong bottom-up fundamentals and well-managed companies with exposure to these areas are likely to exhibit better than market growth and have potential for capital appreciation.
We hope you have a relaxing summer!
Investing Challenges As Market Dynamics Change
The first quarter of 2015 continues major trends that began in 2014. Global disinflation worries, decoupled monetary policies of central banks, deflationary oil prices, and a strong dollar are shifting investor sentiment, which is in a risk adverse mode. The U.S. economic data continues to be mixed in the first quarter of 2015. Another winter of severe weather and a West Coast dock strike probably exacerbated an existing economic slowdown. For first quarter of 2015, the S&P 500 Index increased a mere 0.95% on a total return basis, and the Federal Reserve’s forecast for real Gross Domestic Product (GDP) is less than 0.1%.
For the U.S., the main short-term, negative impact of lower oil prices is in the sharp cutbacks, actual and potential, in shale fracking. This reverses the recent growth in capital expenditures (capex). The immediate effect is to cut capital spending on new shale projects, which have a short productive life and require frequent renewal. In the three years to 2014 third quarter, real GDP growth averaging 2.6% was driven by an increase in real business investment of 5.2%, twice GDP’s growth pace. The capex growth rate fell to 1.9% in the fourth quarter of 2014, contributing to the GDP slowdown. The capex slowdown and the dollar’s rise of 12%-13% have taken away much of the incentive to develop new shale oil production in the U.S. with oil in the $50 per barrel range.
One of the biggest threats to the U.S. and global recovery is the soaring dollar. The dollar is up 15% in real terms from its 2014 average and 20% from its undervalued level of 2011 to 2013. One of the main reasons for the rapid dollar increase is the behavior of economies with surplus savings, specifically Japan and the euro zone, which are buying U.S. dollar denominated assets. U.S. Treasuries appear a good value compared with ultra low yielding Japanese and European bonds in depreciating currencies. The surge in the dollar hurts the short term profits of U.S. exporters, who have a choice of maintaining their price in terms of foreign currency by cutting their revenues in U.S. dollars or raising their price in foreign currency to preserve their margins. The dollar appreciation is difficult for “carry trades” in the emerging markets, where loans made in an undervalued U.S. dollars in 2009 need to be repaid in greatly appreciated U.S. currency. The emerging market share of loans, particularly Asia, has doubled to $4.5 trillion since the beginning of the financial crisis in 2008. The overvalued dollar was a major cause of unsustainable global imbalances from 2003 to 2007 as foreign investors poured into U.S. dollar denominated investments, particularly securitized housing loans.
Like the misplaced analysis in 2008 that the world was running out of oil, the current surge in the U.S. dollar may be ignoring the possibility that the U.S. currency dominance, begun in 1944 with the Bretton Woods Agreement, could change. At the end of 2014, China and India led 19 other Asian and Middle Eastern nations in the formation of the Asian Infrastructure Investment Bank (AIIB), which competes with the existing Asian Development Bank (ADB), founded in the 1960s to promote Asian interests with the U.S. and Japan as the dominant forces. The AIIB will primarily support China’s political interests by controlling the flow of infrastructure financing for the developing world. This past March 2015, the U.K., Germany, France, and Italy also agreed to join the AIIB, further accommodating China’s rise to power. The loss of the U.S. dollar’s position as the only international reserve currency would be a direct threat to U.S. monetary dominance.
The combined effects of deflationary wages, an aging population spending less, the rising student debt burdens due to the soaring cost of education, which is dragging on consumption and home-buying, and the structural development of the economy eliminating many middle-income jobs, continue to slow the economy. Recent hourly wage inflation of less than 2% compares with hourly productivity gains of 1.5% in non-farm business. This suggests that labor costs are rising at less than 0.5% rate versus core inflation of 1.25% to 1.5%. There also continues to be 5% to 6% of the workforce that is no longer counted as part of the labor force. Structural trends of technological innovation and globalization also have negatively influenced the jobless rate. Eventually, falling unit labor costs in the U.S. will help to stimulate job creation. Until the market shifts back to rapid job growth and falling unemployment, the rapid acceleration of wages will be difficult.
Although first quarter consumption will struggle to reach a 2% growth rate, not all data supports weak growth. The fundamentals for consumers are extremely favorable. Cheaper gasoline has an important psychological influence on U.S. consumers. Most of the windfall gains in real income rising from falling oil prices have initially been saved, so that the savings rate in January of 2015 rose to 5.5%. Consumers are initially cautious, particularly with wage restraint. However, the recent consumer sentiment and confidence figures are impressive. Since gasoline accounts for nearly 4% of consumer spending, the drop in price adds about 1.5% to real income. The current savings rate could begin to fall for the remainder of 2015 and into 2016 as the 5% growth rate of real personal income feeds through into stronger real consumer spending. The U.S. economy is changing to consumer led growth from an economy based on an investment led growth, notably a reduction in capex for shale fracking and the decline in the repatriation of production that had been transferred from cheap offshore labor.
The Federal Reserve’s quantitative easing persisted to a degree until late 2014 by which time the Bank of Japan and European Central Bank began to ease. In the first quarter of 2015 the breadth and degree of monetary policy easing globally, particularly in Asia, was noteworthy. The central banks of India, Singapore, Australia, China, and Indonesia provided policy accommodation to start the year. China continues to address the lack of domestic demand, the slow-down in its property sector, and the deleveraging in the shadowbanking system. Japan is expected to recover from last year’s technical recession by a delay in the next value-added tax (VAT) hike and the increase in the Bank of Japan’s easing program. The European Central Bank (ECB) has now increased the growth rate for the Eurozone economy from 1.0% to 1.5% for 2015 through their quantitative easing. The easing will be marginally net positive for regional growth and inflation.
While there is an expected further climb in market volatility, as measured by the VIX, because of the dollar’s rise, the price decline of oil, and the Federal Reserve’s ambivalence on interest rate hikes, the outlook for corporate earnings is reasonable and does not imply a major equity correction. Stronger domestic consumption and rising sales along with low long-term interest rates should offset weaker profit margins, particularly for U.S. exporters. Global exports account for a modest share of U.S. Gross National Product (GNP). However, foreign earnings account for a third of total U.S. corporate profits, which is double the economy’s export exposure in terms of GNP. Stocks can shrug off a slowdown in profits, especially if domestic consumption becomes stronger, and revenues are increasing. Large U.S. companies are able to hedge their currency risk. While the S&P 500 Index ended the first quarter of 2015 on a soft note, the breadth of declining stock was not widely distributed. The energy sector, representing about 8% of the S&P 500 Index, appears to be stretched. Global oil producers have not fully adjusted their output to reflect slowing global economic trends and oil supply excesses.
In the May/June 2012 issue of the CFA Institute’s article, “Market Drivers: Fundamentals vs. Technicals,” Tom Biwer, CFA, Brian Jacobsen, CFA, and Adam Kurkiewicz, CFA quantify the differences in buying and selling equities based on company fundamentals, technical market factors, or a mix of both. The authors review the real time expected changes in fundamentals and their historical relationships with actual prices to calculate a “fundamental price” at each point in time. The difference between the fundamental price and the actual price comes from the impact of technical, or non-fundamental factors. Their conclusion is that over time, the market tends to trade primarily based on expected changes in fundamentals. Market prices in the long term reflect fundamentals. Although there can be short-term aberrations in the market such as in February 2009 where technical factors drove prices below a level consistent with historical fundamental relationships, market prices quickly reversed a few month later. Fear and panic from macroeconomic or geopolitical events can distract investors from a focus on fundamentals.
Martin Investment Management, LLC agrees with the authors of this article and believes that deviations from technical factors are often more short lived. Current events such as the strong appreciation in the U.S. dollar and the rapid plunge in oil prices have driven investors to respond to technical market factors and momentum rather than focus on companies’ fundamentals. The price of oil can quickly reverse from geopolitical risks, and the strong dollar is dependent on the Federal Reserve’s perceived statement of the U.S. economy. Since oil prices and the dollar are inversely correlated, their present valuations could precipitously change. In a complex environment, Martin Investment Management, LLC believes that investors can reach widely disparate conclusion, but this firm believes that fundamentals of individual companies eventually change market dynamics. Equity ownership of businesses, which can reasonably look forward to gains in profits from above trend growth, rising capacity utilization from technological advances, and positive operating leverage from low interest rates, can create wealth for their shareholders over time.
Friendly wishes for a bright spring season!
Investing In A World of U.S. Assets and Global Paucity Points of Difference
The U.S. had the best performing major equity market in 2014 as the S&P 500 Index rose 13.7% for the calendar year and 4.9 % for the fourth quarter of 2014. The continued strength in the U.S. highlights the closed nature of its economy, insulated from economic slowdowns in Europe, Japan, Russia, and the Middle East. The strength of the S&P 500 masks what occurred within the U.S. stock market. The leadership of the S&P 500 was extremely narrow with the top 10 stocks representing 31.3% of the S&P 500 Index gain in the first half of 2014 and 43.9% in the second half of 2014. Moreover large market capitalization stocks as represented by the S&P 500 outperformed small capitalization stocks (the Russell 2000 Index™) by about ten percentage points.
This divergence within the U.S. stock market was also seen on an international scale. Since 2009 to mid 2014, there had been an increasing correlation between like-investments. This scenario has been changing the last six months of 2014 as the U.S. dollar and U.S. economy strengthened, oil prices declined, inflation remained low, and global expansion slowed. The combination of slowing global growth, a large savings glut, and tighter fiscal policy in the U.S. places downward pressure on safe haven borrowing yields. Taking a long-term view, the U.S. dollar has withstood its previous devaluation quite well, and presently appears to be benefiting from the upswing in the U.S. economy and its energy renaissance.
The loss of economic momentum outside the U.S. is broad-based, and will require aggressive policy action to spur a turnaround. The change in leadership is reflective of the low chances of a reacceleration of global growth, especially without new monetary liquidity injections or looser fiscal policy. Global deflationary pressures remain acute, consistent with a flight to safety to U.S. assets. Japan is reliant on successive currency devaluations for growth. In the present deflationary environment, the European Central Bank (ECB) has few options except to shock the economy into growth with a new monetary policy change. China is responding to a less robust economy by discounting its yuan. Going forward, the decoupled U.S. and global economies eventually will respond to each other, whether the result is a global rebound sparked by the U.S. or a falling U.S. economy from global deflation.
The present U.S. inflation looks stable. Interest rates are low, and there is a more accommodative credit environment as the consumer deleveraging appears over. The U.S. wage growth is increasing slowly, and the unemployment rate is coming down. Core equipment capex spending is reigniting. Lower energy prices are a boost to the U.S. consumer. Although the U.S. labor market is healing, there are some mixed signs in the economy. Mortgage applications for home purchases remain close to recession lows despite falling mortgage rates, while home equity lines of credit have continued to dwindle even in the face of falling rates, which should help housing at the margin. Housing costs for renters rose by $20.6 billion in 2014. Motor vehicle sales, which accounted for onethird of consumer durable purchases, have slowed noticeably at the end of 2014. Business confidence has varied. While the Federal Reserve is likely to stop increasing the size of its balance sheet, no policymakers are talking about tightening monetary policy soon, especially after recent market volatility.
The energy industry in North America has been another asset with rapid technological changes over the last five years. New technologies have made the shale revolution possible and the U.S. able to be energy independent for the first time since the 1950s. Companies producing technological expertise have seen strong growth in revenue and net income during this period. The oil and gas sector now accounts for 10% of non-residential capital spending and nearly 40% of the S&P 500 Capex. The steep drop in oil prices over the last six months of 2014 was severe and unexpected. Fundamentally, the current drop in oil prices reflects a positive supply imbalance and weak demand. The increase in production in the U.S. was widely anticipated in 2014. However, OPEC shocked global oil producers with their November decision to keep production at current levels, leading to oversupply and driving down prices of oil. In addition, unexpected oil production from countries, such as Iraq and Libya, increased supply sources. The market's panic reaction to this news and slowing economic growth in China and emerging economies pushed prices into a free fall.
In the long term oil prices will correct just as they did after the 2008-2009 drop. Producers will cut back on production, and new projects, that are not economical at current price levels, will be postponed. Oil is an important product and a necessary input for economic growth. As emerging economies develop, their demand for oil increases proportionately. At the same time lower prices will be good for U.S. consumers and a net positive for global growth. Present oil prices are deflationary, and central banks may need to be more accommodative to avoid financial stress from countries and producers defaulting from the declining oil prices. Since oil is traded in U.S. dollars, the exchange rate for emerging energy economies is more challenged. Countries dependent on oil production for their economy, such as Venezuela and Nigeria, are harmed by lower oil prices. Countries such as China are attempting to defuse the instability of a rising U.S. dollar through its monetary policy of renminbi internationalization, which is now used for approximately twenty-five percent of all Chinese trade.
In 2014, U.S. short-term yields rose slightly, but long term bond yields were well below expectations. The 10 year yield dropped 85 basis points since late July of 2014 with most of the drop coming from declining inflation expectations. The curve flattened also because of the Federal Reserve's comments to hike rates six months after the completion of tapering and the flight to quality as global setbacks increased. The Federal Reserve's lift off timing for rate increases oscillated greatly during the second half of 2014, and this volatility increased the flattening of the yield curve. Due to the historically low yields today, bonds have the potential for large losses should interest rates move materially higher as bond prices and interest rates are inversely related. Given the asymmetric risk/return relationship within bonds presently, investors are shifting to shorter duration bonds or to investing in equities.
Investors continued to flow into U.S. assets in 2014, in which they have more confidence, as their greatest worry continued to be insufficient global growth. Wealth flowed out of the local currency as investors sold domestic assets and bought into U.S. dollar assets. Although the U.S. 10 year Treasury yield continues to remain very low, relative to history, the U.S. became a safer investment choice to other parts of the world from its more robust growth, stronger dollar, improved budget deficits from rising receipts, and lower balance of payments from its energy independence. For the S&P 500 Index long-term earnings expectations and price growth trends are largely on track for earnings per share of U.S. corporations. Placing the current bull market in context, the S&P 500 In-dex is up nearly 205% since its March 9, 2009 bottom and has lasted seventy months versus the average 165% gain and 57 months duration for a bull market. The S&P 500 Index valuation is 18.3 P/E for the trailing twelve months (TTM) and 16.6 P/E for the next twelve months (NTM) versus the average over the last 55-years of 18.9 P/E (TTM) and 16.6 P/E (NTM) for the Index. Additionally, the average bond, based on the 10 year Treasury yield, currently has a P/E of 46.0 for the decade and the average house, based on U.S. Median Home Price/Median Rent, is currently a P/E of 18.9 for the decade. Publically trade equities are not comparatively overvalued than other asset classes.
Looking ahead to 2015, Martin Investment Management, LLC remains constructive on the U.S. economy and reasonably valued equity markets, being mindful of concerns related to the decoupling of central bank policies, global deflation, and corporate growth forecasts for 2015. With artificially low interest rates across the yield curve, what worked in the past may very well be inadequate in the future if interest rates rise. Credit expansion helped fuel economic growth in recent decades, and many investors recognize they have come to rely on investments linked to favorable interest rate conditions. While interest rates might very well continue to edge lower, rates are also near their absolute limits. Timing is always an uncertainty, but this asymmetry is profound. After 30 years of declining interest rates, many investors are searching for answers for whatever environment might be next.
Long-term corporate earnings performance tends to drive results for stock prices. The strategies with a rigorous process to identify and harness recurrent earnings of quality corporations may lead to an opportunity to outperform the market over time. Understanding the interrelationship of equities over economic and business cycles is as important as the conviction to employ portfolio exposures proportionate to the investor's framework for risk. Martin Investment Management, LLC believes that reasonably valued equities of profitable companies will continue to be a solid investment choice whether inflation remains low, or monetary policy is accommodative. We also believe that the central banks of Japan and Europe will engage in more aggressive monetary policy, which should support their equity markets. While achieving significant returns is difficult in the current environment of low interest rates, which shifts wealth to borrowers from savers, Martin Investment Management, LLC will consistently attempt to understand the marketplace, to discover companies with solid fundamentals, and to buy quality equities at reasonable valuations.
Warm wishes for a very rewarding 2015!