October 2014 Newsletter
We are pleased to provide you with a quarterly perspective featuring the status of our investment class weightings, our interpretation of recent data, an outlook for the future and watch items for the coming months. If you have any questions about any topic, we hope you will not hesitate to contact us.
Status of our Investment Class Weightings
Changes from our July 2014 Quarterly Perspective are noted in italic.
US Large Cap Sectors – No changes; consider Consumer Discretionary for downgrade and Financials for upgrade.
No Weighting - Utilities
Underweight – None
Neutral – Consumer Staples, Energy, Financials and Healthcare
Overweight – Consumer Discretionary, Industrials, Technology and Materials
US Mid and Small Cap – Maintain mid cap and consider small cap for downgrade.
International Developed Markets – Maintain all weightings.
Emerging Markets – Maintain all weightings.
Alternative Strategies – Maintain weightings in multi-asset funds and REITs.
Multi-sector Bond Funds – Close low duration funds. Look to lengthen duration above 5 years.
Investment Grade US Corporate Bonds – Open new or add to established positions.
High Yield US Corporate Bonds – Reduce positions.
Floating Rate Bank Loans – Close positions.
Convertible Bonds – Maintain positions.
Investment Grade Municipal Bonds – Underweight.
Data – The 3rd quarter of 2014 was the worst quarter for equities since the last quarter of 2012. During the quarter, US Large Caps rose slightly at +0.61%, while US Small Caps fell a disappointing -7.65%. For 2014, the small cap benchmark Russell 2000 Index is -5.34%. International equities (as measured by ACWX) fell -5.28% during the quarter. Fixed income investors fared no better as the Barclays US Aggregate Bond Index fell -0.44% during the quarter. The disappointing stock market performance is in some conflict with domestic economic data that was mostly positive during the quarter. GDP growth for the 2nd quarter came in at a strong +4.6% and many analysts predict continued solid growth for the 3rd quarter. Consumer confidence remains high (even though it dipped in August) and the September Business Outlook Survey by the Federal Reserve Bank of Philadelphia showed optimism in the manufacturing sector. The national unemployment rate now stands at 6.1%, even though non farm payroll growth slowed in August. Weekly unemployment claims averaged a low 299,000 during the quarter. Inflation remains tame as shown in the August CPI reading which reported a 12-month increase of just 1.7%, well below the Fed target. Durable goods and factory orders were quite strong in July, only to fall in August. New home sales jumped +18.0% in August while housing starts rose in July (+15.7%) only to fall back during August (-14.4%). Earnings season for the S&P 500 will begin next week with an estimated earnings growth rate for Q3 2014 of 4.7%. We should note that on June 30th the estimated earnings growth rate for the same Q3 2014 was 8.9%. The only sector expected to report a Q3 year-over-year decline in earnings is consumer discretionary.
Outlook – All eyes will remain on the Federal Reserve as a path to interest rate normalization begins to take shape. At her news conference on September 17th, following the two-day policy meeting of the FOMC, Fed Chairwoman Janet Yellen again suggested that the Fed does not plan on raising the target range for overnight interest rates for a considerable time. This suggestion defied the expectations of many economists who thought this policy meeting was the proper forum to clarify or dial back such language in preparation for monetary policy tightening in 2015. Rates will continue to stay low, but, when they do rise the trajectory of change may be somewhat steeper than previously anticipated. In June, the median estimate among Fed officials for the Fed’s target rate at the end of 2016 was 2.5%. The latest and most current estimate for the end of 2016 is now between 2.75% and 3%. As expected, the unprecedented bond buying program, know as QE, is coming to an end in October. Left in the wake of this massive program is the management and eventual reduction of a now bloated inventory of more than $4 trillion in mortgage and US Treasury bonds. The Fed will allow the bond holdings to gradually shrink by allowing bonds to mature without consideration to reinvestment. Chairwoman Yellen has suggested that the portfolio of bonds, held by the Fed, could remain large until the end of the decade.
The most recent GDP data suggests that we should expect to see rising interest rates accompanied by economic expansion. It is common to experience some volatility and initial market pullbacks as we move within 6 months of the initial rate hike. (October 2014 is for many analysts within an arbitrary 6 month window leading up to an initial rate hike in early 2015.) Liz Ann Sonders, of Charles Schwab, recently suggested that “in looking at the past five rate hikes, the average pullback – nearly always having concluded before the actual hike – was less than 6%, therefore not even qualifying as a correction. It is important to note that overall, the stock market fares pretty well in the six months before and after the initial hike. Her article referenced a study by BCA Research, Inc. that suggested that in the six months immediately following the initial rate hike the market climbed, on average, 10.6%.”
Watch Items - On the domestic front, we have an expected course for Fed monetary policy, GDP expansion, falling unemployment and growing corporate earnings. The picture for much of the developed world ex-US is not as good. The Eurozone is still fighting deflationary pressures and high unemployment, both of which are factors in an economic outlook that is weaker today, than at the start of 2014. A recent QE-like plan could spur growth, at least in the short term. In China, we continue to see some risk in a slowing of economic growth, but, as usual what we see is not always the complete story as the Chinese government works hard behind-the-scenes to prop up its economy. The combination of a slower growing China and a tightening US Fed could make the path to longer term economic growth for much of the emerging world a more difficult one in 2015. Lastly, the fears of intensifying conflict in Syria, Iraq and Ukraine may hamper markets in the coming months. Geopolitical events are seemingly common occurrences in the world we live in today. So long as these events do not turn into broader, long term wars or other types of “world changing events”, the financial markets should be able to work through the impacts of these and future crises.
