Download EGA US Market Commentary Q1 16

Market Review and Outlook
Q1 2016
EGA U.S. Equity
From the EGA Portfolio Management Team
The markets exhibited a risk-off environment during the first half of the first quarter marked by a high correlation between equities, bonds and crude oil. However, upbeat reports on retail sales and employment, along with
indications of easing oversupply in crude oil, drove a risk-on rally in the second half of the quarter. The S&P 500
Index returned +1.35% in the quarter while international equity markets, represented by the MSCI EAFE Index,
declined -3.01%. Interest rates generally declined in the quarter, leading to positive returns in fixed income.
Economy: Underlying domestic economy remains solid
Q4 2015 real GDP was revised up to a 1.4% annual rate from a previous estimate of 1.0%. The stronger reading
stemmed from an upward revision to personal consumption expenditures (PCE), which rose at a 2.4% annual
rate versus 2.0% in the previous estimate. In Q1, the manufacturing sector showed signs of stabilization. The
ISM Manufacturing Index rose 2.3 points in March, the most since August 2014, to 51.8, above the break-even
level of 50 for the first time in seven months. It has been under downward pressure from a strong U.S. Dollar,
weak global demand, and the shrinking mining sector at home. A pullback in the dollar and a rally in oil prices
have set a positive backdrop for manufacturing over the months ahead.
Sources S&P / Case-Shiller, U.S. Census Bureau
The S&P/Case-Shiller U.S. National Home Price Index rose 0.5% in January, and is up 5.4% from a year ago. The
sustained increase in existing home prices is supporting growth in household wealth. Housing starts rebounded
5.2% in February to a 1.178 million unit annual rate. Single-family starts, which account for about 70% of total
starts, increased 7.2% to an 822,000 unit annual rate, the highest level since November 2007. The upward trend
in single-family housing forms a strong argument for the sustainability of the ongoing housing market recovery.
The Conference Board’s Consumer Confidence Index rebounded 2.2 points to 96.2 in March. Additionally, the
previous month was revised up by 1.8 points to 94.0. The financial market volatility, which weighed on
confidence in February, has now mostly abated. The increase in March was due entirely to a 4.8 point gain in
consumer expectations, as the outlook for business conditions and the jobs market improved.
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Q1 2016
The labor market continued to make steady progress as nonfarm payrolls increased by 215,000 in March.
An improved labor market drew more people into the labor force, which led to an uptick in the unemployment rate to 5.0% from 4.9%. Over the past 12 months, the labor force has expanded 1.4%, the
most since October 2008. Despite these improvements, the unemployment rate including workers
working part-time but still looking for full-time work, (the red line in the graph below), remains elevated
compared to history. The number of workers that have dropped out of the labor force also remains
higher than usual, although the aging of the population and increased retirement explains part of this rise.
These factors imply that despite the low headline unemployment rate, there may still be significant
underutilization of labor resources in the economy.
Source: Bureau of Labor Statistics
Oil: Stabilizing
Oil prices rebounded during the quarter after Russia and Saudi Arabia announced a preliminary agreement on a temporary production freeze. Additionally, U.S. field production of crude oil showed that U.S.
oil producers had finally begun cutting back output. Whether or not OPEC would cut production was a
debate all quarter and it remains to be seen, but the aforementioned reports gave crude oil prices and
the energy sector a lift.
Source: U.S. Energy Information Administration
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Inflation: Ticking up
Q1 2016
The Consumer Price Index (CPI) rose 1.0% in February over the prior year. Excluding food and energy,
prices were up 2.3% of which prices for services were up 3.1%, the most since 2008, indicating a
possible upturn of inflation pressures. Inflation has been subdued mainly due to lower energy prices and
a strong dollar. However, the impact of those two factors is now reversing as oil prices have stabilized
and the dollar has started weakening.
Source: Bureau of Labor Statistics
Subdued wage growth may keep a lid on inflation. While many labor market indicators point to an
economy near full employment, a notable exception is the sluggish rise of wages. This slow wage
growth reflects a mix of cyclical and secular factors. The cyclical factor is the underutilization of labor
resources, mentioned above. The secular factor is driven by retiring higher-wage baby boomers, who
are being replaced by lower-wage workers sidelined during the recession.
Corporate Profits: Profits hit a pot hole
According to Starmine “Smart Estimates”, earnings for the S&P 500 Index will contract by 6.9% in the
first quarter of 2016 versus the prior year, largely due to a projected earnings decline of 104.8% in the
energy sector. Excluding the energy sector, S&P 500 Index earnings are projected to decline by 2.2%.
Growth in earnings from Consumer Discretionary, Telecom Services and Health Care sectors are
projected to be the strongest while earnings from Energy, Materials and Financials are forecasted to lag.
With the S&P 500 Index currently near 2059, the Price-to-Earnings Ratio of the market is around 16.6
times forward 12-month estimates (compiled by Factset), a level which is slightly above the long-term
average. According to Factset, earnings growth for 2016 is currently forecasted to be 2.2%, an improvement from the 3.6% decline that the S&P 500 Index posted for 2015. Earnings headwind from a strong
dollar in 2015 may become a tailwind in 2016 if the dollar stabilizes here or continues to weaken.
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Q1 2016
Interest Rates: The Fed hits the pause button
The Federal Open Market Committee (FOMC) voted to keep interest rates unchanged and reduced
their projections for future rate hikes. Instead of four rate hikes expected earlier this year, the Fed is
now projecting just two rate hikes through December. The FOMC will continue to monitor economic
data as well as international events before raising rates again. Chairperson Yellen downplayed the
recent pickup in core inflation, citing unusually high readings in “volatile” categories. However, core
inflation has been led higher by rent and health care, both of which are not particularly volatile
categories. Also, the FOMC slightly downgraded longer run projections for the unemployment rate,
indicating that the members believe the economy can tolerate lower unemployment before we see
inflation pressures.
The 10-year U.S. government interest rate declined from 2.30% at the end of December to 1.77% at
the end of March. Interest rates on 10-year government bonds have declined significantly in Europe and
have turned negative in Japan, following the Bank of Japan’s surprise decision to adopt negative interest
rates in late January. The U.S. corporate bond (investment grade and junk) interest rate spreads rose
sharply by the middle of the quarter, but ended the quarter largely unchanged.
International: The economic recovery is uneven across the world
The global manufacturing Purchasing Manager’s Index (PMI) decreased 0.2 points to 50.5 in March from
50.7 in December, indicating a modest expansion in global manufacturing activity. The new orders
index, a leading indicator for future output, rose to 51.2, which is above its 12-month average, suggesting the worst may be behind us. Developed markets continue to show strength relative to emerging
markets. Eurozone PMI weakened from 53.2 in December to 51.6 in March and remained in expansionary territory throughout the quarter. Excluding Greece and France, all countries in the Eurozone
reported expansion. Japan was the true disappointment, with its PMI slumping to 49.1 from 52.6 in
December. Weak overseas demand was largely to blame, prompted by slower global growth and a
stronger yen, which sent the export orders index down to its lowest level since January 2013. China,
however, presented a nice upside surprise, as its Markit PMI rebounded to 49.7 in March from 48.2 in
December. Although this still represents a contraction in manufacturing activity, it was the smallest
decline since February 2015. The jump in China’s PMIs was led by the new orders index, suggesting that
fiscal and monetary stimulus is helping boost future demand.
Having lowered its growth outlook repeatedly in 2015, The International Monetary Fund (IMF) again
lowered its growth projections for 2016 and 2017 by 0.2% to 3.4% and 3.6% respectively. The downward revisions largely reflected a more pessimistic view of some countries in the emerging world and
a cut in forecasts for Russia and Saudi Arabia. However, the sharp rally in oil and emerging market
equities, along with stabilization of the dollar, indicate a possibility of a positive surprise in those
regions. In its annual session, China’s National People’s Congress (NPC) spelled out the country’s key
social and economic goals from 2016 to 2020. The government’s 2016 work plan is a pro-growth and
slow reform plan, indicating new measures to stimulate growth even if they delay long-term reform
plans.
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Investment Strategy
International Equity: International equities decline
The international developed equity markets declined this quarter as measured by the MSCI EAFE Index.
Eagle International portfolios slightly trailed the index returns primarily due to stock selection in
Consumer Staples and Telecommunication sectors. Sector allocation was negative with an underweight
in the Materials sectors, and country allocation was affected by an underweight to Australia. We
increased the portfolio’s exposure to Telecommunication Services, Consumer Discretionary and
Consumer Staples while decreasing exposure to Financials and Information Technology. Top performers: Magna International and Orange. Disappointments: Shire, Fuji Heavy and KBC Groupe. New buys/
additions during the quarter: Nippon Telegraph & Telephone and Ono Pharmaceutical. New sells/ trims:
NXP Semiconductors.
Fixed Income: Rates down but volatility in risk premiums
The unexpected decision by the Fed to delay rate increases naturally prompted Treasury rates to fall
and bond prices to rise. However, concern about the economic outlook in China and the weakness in
oil prices at the beginning of the quarter, prompted a sell-off in corporate bonds, especially in lowerrated issuers. With the reversal in the oil price and reduced concerns about the economic outlook,
spreads tightened in the second half of the quarter to almost where they began. As we have reduced
the maturities in our portfolios and positioned them for higher rates, our portfolios lagged the broader
bond markets. Still our high quality emphasis stood us in good stead when the market got spooked and
sold off the lower rated issuers. We expect that rates will rise eventually and maintain our current
duration and exposure to corporates.
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Q1 2016
Domestic Equity: U.S. equities decline
Eagle domestic equity portfolios trailed the return of the S&P 500 Index. Individual portfolio returns
may differ due to cash flows, tax management, and other factors. Sector allocation, primarily underweights to Telecoms and Utilities, drove the underperformance. Good stock selection in Health Care
was undercut by poor selection in Consumer Discretionary and Financials. Our largest overweight
remains in Health Care, Consumer Discretionary and Industrials. Consumer Staples and Information
technology are the largest underweights. During the quarter we increased our exposure to Industrials,
Telecommunication Services and Consumer Staples while reducing our exposure to Financials,
Consumer Discretionary, Health Care and Materials. Top performers for the quarter: Visteon and
Honeywell. Disappointments for the quarter: SunTrust Banks, AIG and Celgene. New buys/additions
during the quarter: Dow Chemicals, Verizon, McKesson and Microsoft. New sells/trims: St. Jude
Medical, Enbridge Energy and Voya Financial.