Download Third Quarter 2014 Review and Outlook

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Third Quarter 2014 Review and Outlook
October 7, 2014
While U.S. financial market valuations did not meaningfully change in Q3 2014, there were developments in the quarter
that could have important long-term implications. In Q3, equity prices advanced for an impressive seventh consecutive
quarter. The S&P 500 was up +0.6% for the quarter (+6.7% YTD) while the Dow Jones Industrial Average gained +1.3%
(+2.81% YTD). Small capitalization stocks underperformed with the Russell 2000 declining -7.65% (-5.23% YTD). Ten year
U.S. Treasury yields were unchanged in the quarter at 2.5%. Commodity prices were down 5.25% as measured by the CRB
commodity index while the dollar rose more than 8% against the euro and yen. Inflation continues to remain subdued
domestically and globally. Financial market volatility increased in Q3 as a result of divergences in global economies and
growing geopolitical worries (Middle East, Ukraine, Hong Kong, Ebola, etc.). Weakening stock market breadth and a
midterm election in November, combined with the potential for a U.S. Federal Reserve policy shift, also contributed to
increased financial market volatility. Merger and acquisition activity continued at a near record pace in both the U.S. and
abroad. Importantly, U.S. corporate capital expenditures have increased at a 16.6% annualized rate since February and
are now exceeding the last two cyclical peaks. U.S. economic data continued to show improvement in Q3. Consumer
confidence, industrial production, purchasing managers surveys, housing, and employment all showed continued
improvement. GDP for Q2 was revised to +4.6%, the fastest pace of growth in the prior 10 quarters. Finally, of note in Q3
were the largest IPO in U.S. history (Alibaba) and the abrupt resignation of Pimco’s founder and CEO, Bill Gross.
Source: FactSet, U.S. Conference Board (as of 9/22/14)
It appears that the Federal Reserve’s monetary policy of Quantitative Easing (QE) will terminate before year-end. This is a
clear signal from the Fed that U.S. economic growth has strengthened. September's employment report demonstrated
robust growth of 248,000 versus expectations for 215,000 net new jobs. In addition, August's number was revised higher
by roughly 40,000. The only disappointments were —once again— a fall in the labor participation rate to a 36-year low
and another month of stagnant wages. Nonetheless, despite the structural headwinds, labor market conditions are
improving. As a result, investors will no longer have the important support of ultra-accommodative monetary policy which
could bring additional volatility to financial markets. While QE may no longer be needed, Fed chairman Janet Yellen
recently indicated that interest rates will stay low for a “considerable time” and that the economy continues to face
”significant underutilization of labor resources”. It is generally anticipated that the Federal Funds Rate will increase by
midyear 2015, provided continued economic improvement. As a result, we would anticipate that interest rates would rise
or "normalize" over time. Conversely, the global economic picture is considerably different. Europe, China, and Japan all
appear to be slowing. The European Central Bank appears destined to embark on a form of large-scale asset purchases
similar to QE. The primary result of the diverging global economic environment has been a strong U.S. dollar and lower
interest rates. The ten-year German Bund yield is less than 1% and the Japanese equivalent is 0.5%. U.S. Treasuries should
continue to attract foreign capital on a comparative yield and currency basis. Lower commodity prices and tepid inflation
statistics are also a consequence of a stronger dollar and weaker economic activity overseas.
USD/EUR
Source: OANDA Corp
Source: Charles Schwab, Bloomberg data
Y/Y Eurozone GDP (left), IFO Germany Business Expectations Survey (right)
On balance, an improving U.S. economy, low interest rates, low inflation, and a strong dollar should continue to favor U.S.
equities. Further, if the economy gains strength, capital spending will continue to rise. With almost $2 trillion on balance
sheets, U.S. corporations deploying capital would certainly boost economic activity and buoy investor confidence. The
economic improvement should lead to higher corporate revenues and higher stock prices. Q2 S&P 500 profits rose 11.7%
while revenue per share jumped 6%. Q3 profits are expected to grow 6-8%. Consensus estimates for earnings growth in
2015 is currently +8.1%. Today, the S&P 500 trades for 15.5 times analyst’s consensus earnings-per-share estimates for
the next 12 months. Today's S&P 500 P/E is slightly above the long-term average forward PE of 15.0, but below the P/E at
previous peaks. U.S. equities appear to be cheap relative to U.S. Treasury bonds and fixed income investments. Nearly half
of S&P 500 stocks yield more than the five-year U.S. Treasury bond. Impressive common stock dividend growth (12.37%)
coupled with record low dividend payout ratios suggests equities continue to look attractive versus fixed income
alternatives. Small capitalization equities seem particularly attractive with today's backdrop of an expanding economy and
a strong dollar, particularly in light of their 2014 underperformance. Merrill Lynch recently published research that
evidenced strong stock market performance in midterm incumbent election cycles. Interestingly, regardless of the
outcome, equity markets historically perform quite well from September in the midterm election year through July the
following year. Given the low risk of an economic recession in the near term, a bear market in U.S. equities seem unlikely.
Stocks should continue to outperform bonds, commodities and cash.
Our current conclusions mirror earlier conclusions from this year’s prior letters to investors and serve as a good score card
as well. To reiterate earlier summaries and offer final conclusions:
Q1 2014
“In conclusion, U.S. capital market performance in 2014 has the potential to mirror the trends that began in 2013.
Continued gradual economic improvement, easy monetary policy, low inflation and improved corporate profits seem
likely. Equities have the potential to outperform bonds. Long-term interest rates should gradually increase over the next
two or three years and fixed income returns could become increasingly challenging. Convertible bonds continue to look
very attractive given these conclusions, on an absolute and relative basis. Sonora Investment Management favors equity
ownership in businesses with meaningful competitive advantages, good balance sheets, strong free cash flow generation,
and compelling business models.”
Q2 2014
“Sonora Investment Management continues to strongly favor convertible bonds. While bonds tend to lose value when
interest rates rise, convertible bonds have tended to more closely reflect equity returns than bond returns when interest
rates rise. Typically, convertible bonds are more influenced by price movements of their underlying stocks then by interest
rate fluctuations. If the impetus for interest rates increasing is that the domestic economy is improving, then this bodes
well for the companies that comprise the domestic economy and their associated common equity. The case for strategic
convertible bond allocations remains strong. We favor equity ownership in businesses with meaningful competitive
advantages, good balance sheets, dividend growth, strong free cash flow generation, and compelling business models.”
Q3 2014
As the ongoing U.S. economic recovery continues, financial markets will be met with increased volatility primarily due to
the lack of monetary accommodation from the Federal Reserve. Additionally, the threat of higher interest rates associated
with economic recovery and changing Fed policy can ultimately present risks to both equities and fixed income
investments. Continued economic growth and the associated lift to corporate earnings should be the primary impetus for
appreciation in U.S. equities. Geopolitical risks remain an ongoing menace to financial markets and exacerbate volatility.
Global economic disparities should make dollar denominated assets more attractive to foreign investors and challenge
those U.S. businesses with international currency exposure. Further, strength in the U.S. dollar should put downward
pressure on commodity prices. Consumer spending in the U.S. could benefit from a drop in commodity prices, particularly
energy. Finally, convertible bonds should not only benefit from an improving domestic economy, but also from an
improvement in the relative performance of small-mid capitalization equities that have greater leverage in an accelerating
economy.
As always, thank you for your support.
Sonora Investment Management
4720 E. Cholla St., Suite 100, Phoenix, AZ 85028 | 480-474-4188 | 877-468-6468
2343 E. Broadway Blvd., Suite 116, Tucson, AZ 85719 | 520-624-4554 | www.invmgmt.com |[email protected]