Download Q3 2015 - MCF Advisors

 MCF Advisors Q3 2015
Financial Insights 2015 THIRD QUARTER COMMENTARY In This Issue: Overview: Growth vs. rate hikes in 2015? Our Concerns Our Views Summary MCF News & Spotlight After a third quarter that found many leading hedge fund managers down over 10%, what is reasonable to expect in the 4th quarter? Positive returns! Yes we are given to optimism but the answer is motivated by probability. 1 2 4 5 6 OVERVIEW: WILL US EVER RAISE RATES IN 2015? We started last quarter with this same title and stated, “Another quarter, another wait for the Federal Reserve to reveal its rate policy plan for the future while other central banks have eased monetary policy.” As long as the FOMC is committed to a data dependent view, we do not expect a rate hike in 2015. By waiting for our peer economies to stabilize and for US inflation to signal a need for higher rates, the Fed should be on hold until 2016. The Fed will wait a long time if they think it can pick the bottom in the global economic cycle and raise rates when global sentiment agrees that the US should lift rates from the zero bound. Had the Fed moved rates higher for policy reasons and said that zero rates promote distortions in markets and investment behavior, we believe they could have communicated this decision and acted upon it much sooner with far less market upheaval. One would think with so many speeches by Reserve Governors, the message would get out. Instead, markets were caught wrong‐footed. Once we move past the rate hike, we will be far more optimistic on the US economy than at present. Rate increases will be later and less than initially feared. This has restrained our markets from the first of the year and may continue to do so. WHERE DO WE STAND? First, both real asset and equity markets found little comfort in the third quarter. U.S. economic growth wanders around a 2% annual growth rate. There is very modest job growth, little or no inflation outside of government mandates, and expectations for inflation over the next 10 years have fallen to less than 2%. If the Fed is data dependent, then data has an addiction problem with the zero rate. Since 1971, the average return of the Wilshire 5000 Market Index has been about 2% per quarter for 44 years. The 3rd quarter, which includes some of the notable September and October drops, averages 3/4ths of 1% return. The 4th quarter has a standout return of nearly 4% quarterly, almost as much as the first three quarters combined. The weaker 3rd quarter gives credence to the “sell in May” maxim which would have worked this year after an absence in recent years. Looking at the data and torturing it more, what does market history say about 4th quarter returns? They are positively more positive. What if the market is up after two quarters in 28 of the 44 years? The 4th quarter is up 21 of the 28 (75%). What if the market is down after two quarters in 16 of 44 years? The 4th quarter is up 11 of those 16 (69%). Ok but what if the market is down for the year after 3 quarters in 12 of the 44 years? It is up six years and down six years in the fourth quarter (50%). The average return is less, only about 1% in the fourth quarter. What if one only looks at the 16 negative third quarters? There were 11 positive 4th quarters (69%). After sorting data, the story remains that statistical expectation is for +1% to +7% returns with an average of about 4%. For year‐end on the S&P 500, this forecast would be between 1930 and 2050 with 1990 as a likely finishing point. That 1990 level on the S&P 500 would be a small 3% loss after a very volatile summer. The US economy is still growing, either moderately or meekly. The healthy trends in car sales and housing have continued since our second quarter report. Car sales are still running at the 16M annual rate. Existing home sales are growing at 5M units and annual growth rates are similar to those before 2008. With the Fed on hold, we expect low rates to support the continued progress in car and home sales. Corporate mergers are another source of added value to the economy and their pace has held up well over the summer. There is debt available to finance deals but the cost of that debt has gone up recently due to growth concerns for the global economy. Job growth has been a concern for all the years since the financial crisis and remains one today. The inflation adjusted earnings of American households is still lower 7 years into the recovery. It could be worse: Iceland still owes 4 times its Page 1 of 7 MCF Advisors Q3 2015
Financial Insights GDP from its banking collapse in 2008. Sentiment has fallen since the summer among consumers and CEOs. Production of US oil and gas fell for the first time since Q1 2009. Crude production fell .5M barrels from the record level due to the effects of lower investment in E&P and the capping of wells by privately financed drillers waiting for higher prices. This should be a positive for crude markets as we enter 2016. CEO sentiment reflects the rising anxiety and falling markets over recent months. From chiefexecutive.net: Energy markets, like most commodity markets, are working off surpluses created either by weaker demand than forecast or predatory national policies that resemble mercantile national competition of the 19th century rather than the 21st. This year each of the three major producers – US, Saudi Arabia, and Russia – broke records of over 10M barrels per day of production. The US is working off its inventory of crude even without a removal of the four decade old ban on exporting petroleum products. Uncertainties over global affairs and growth have pulled European and emerging market returns below US performance to date. If it were a matter of looking at expansionary economic policy in Europe and China vs. constricting policy in the US, then investors should favor markets outside the US. However, in a world of rising risk aversion, the US Treasury market and the US dollar reign supreme. We thought that after a rate increase, fund managers would gravitate to foreign markets but now that is unlikely to happen. The US still has the best combination of growth and currency stability in the world. A major source of support for foreign markets has been central bank policy of additional QE (quantitative easing) from the central banks of Europe, Japan, and China. Europe did “refi” the Greece household but now the refugee and Middle East instability cloud European forecasts for improvements in growth. Japan has posted lackluster economic data over the summer and will resort to more QE or more currency devaluation. We do not anticipate any near term end to the competitive devaluations of currencies abroad. We do anticipate many currency hedgers will underperform due to the volatility and unpredictable nature of these events. WHAT CONCERNS US? China’s attempts to control the world’s most volatile collection of speculators – their own investors – have been Page 2 of 7 MCF Advisors Q3 2015
Financial Insights both a worry and entertainment for free market economists. We believe China will apply enough QE to stabilize their economy and markets. Given their participation in a global economy, we do not anticipate double digit growth. We have moderate exposure to EM because headwinds still exist. In June, we believed the FOMC would not be able to initiate a rate hike but thought the dollar may trade two points either side of 98 with a hike. Now, there is no rate hike and the dollar is trading 96‐97. The relative strength of the US economy and the stability of the currency have maintained the dollar’s value as other nations have chosen to devalue their currencies. We won’t worry about the dollar in 2015. CEOs will mention it during earnings season but their firms can adapt over time. FactSet Finds Market Down with Earnings, Similar to 2011 Drop speculative grade debt lost 7% in the quarter. Bonds we own, such as intermediate term investment grade and muni debt, have performed well. We have little exposure to foreign corporate credits, dollar hedged or not, which did not perform well. Another area of the income market that did not perform well due to rates moving lower was the floating rate and bank loan securities market. We zeroed out our exposure a while ago and are fortunate to have done so. At some point in the future, we expect long‐term bond returns to be negative as rates normalize; however, we are not at that point in the cycle just yet. Market volatility took out every asset category at one point or another through this year. From Treasury bonds earlier, to gold, to emerging markets and a super‐heated Chinese market, to the real estate market, the energy market, and finally the US equity market which weathered the first seven months well. August and September were uniquely volatile and they finally returned the hot biotech sector to a less lofty valuation. Some of this should be viewed as a healthy realignment of market expectations. However, the volatility needs to fall to normal levels or we will see investors run to the sidelines. Morningstar reported that 41 of the asset classes they track showed losses in the third quarter. No rock to crawl under. S&P 500 Volatility Exceeds Small Cap Volatility: Rare! We approach another earnings season after seeing US indexes rally during July’s earnings results and forward guidance. While earnings estimates have come down slightly, most analysts are still expecting the end of the year to be good for American firms. As of this date, most of the reduction in optimism for firm value comes from debt concerns in the energy sector and growth concerns in China. We may learn that US firms were able to generate acceptable earnings in a very difficult environment again. If so, expect a rally. If not, markets have priced in some of the downside already; maybe the disappointment will not be as bad as feared. However, we don’t expect a tremendous rally so long as the FOMC sword of higher rates menaces overhead. Bonds continue to trade in ranges befitting odds at a horse track. The Fed created the conditions for a bond rally by scaring capital out of the fixed income market in the second quarter. Now capital is wary of risk markets in the third quarter. In June, the US Treasury was down 10% on the year and the high yield bond market was unchanged. Today, the US Treasury is down only 2% YTD after an 8% rally while Emerging markets, commodities, and natural resources found the third quarter more challenging than the previous quarters. While energy and commodities have plunged, private equity funds have raised some of their largest amounts ever dedicated to the asset class. So today’s market may be one of differing investment horizons with the long term presented with a good opportunity while the short term is presented with a loss. Page 3 of 7 MCF Advisors Q3 2015
Financial Insights Of the different alternative asset classes, real estate and REITs performed well after a difficult second quarter. Currency trades, in separate funds or in bond funds, were largely unsuccessful given the volatile swings between days and weeks. The energy MLPs gyrated down well beyond any sensible measure of value but fortunately have started the new quarter with healthy gains. Gold (the metal, not the miners) had little of the volatility that equity markets saw in August and September and gained some investor interest as a result. Keynes opined on market irrationality and the ability to trade against it and we concur. We remain conservative long term investors and seekers of a fair return on capital as well as a return of capital. WHAT’S OUR VIEW? In equities, we still like the US over Europe. We like developed markets over emerging. We have preferred large cap growth such as the Nasdaq 100 and midcaps over small caps. Portfolios reflect these choices and have done so for almost two years. Changes, we anticipate or will consider if markets permit us to make, are to increase small cap exposure if the economic growth expands in the fourth quarter. We would also favor a little more asset exposure to Europe. Americans have traveled there in droves now that the Euro is 30% cheaper and we think their economies will benefit from increased exports and an expansionary European Central Bank. To do this, we will look at reducing US large cap and US midcap weights within equity allocations. Growth has outperformed value too easily and with the recent headwinds for biotech and other knowledge based industries, it may be time to examine the case for value in this stage of our low growth recovery. We have waited an eternity for a sustainable growth trend in emerging markets and have a modest allocation that we don’t intend to change at present. Similar to the Euro‐land growth story, should China fix itself, we would like to add weight to EM indexes correlated to the higher growth regions of the world. We have not carried much weight in emerging markets due to the fact that we did not like the prices others have paid for growth that did not materialize. We also would like to see more reforms in Latin America as a catalyst to growth. While, income securities have traveled to great extremes and back, we have greeted their prodigal returns warmly. We have minimized credit risk across the income portfolio and have avoided significant losses in the credit space. The Barclays Aggregate Bond Index has outperformed over 2/3rds of active managers and we’ve been pleased with our allocation to it. Another area of relative calm has been the investment grade municipal bond market. It is outperforming many peers and we still like it even as the FOMC approaches a rate hike. Muni bonds are far less volatile than similar Treasury or corporate bonds. We have held a larger position in short term high quality securities than we would prefer due to global uncertainties – this has control portfolio volatility, but at the expense of income. If the FOMC normalizes rates via a small hike, we will need to lower short‐term security exposure accordingly as the medium‐ to short‐term bonds will likely feel the effects of FOMC policy most directly. If rates are rising dramatically, we will consider either very short‐term structures to minimize volatility or consider floating rate securities to maximize the increased income of rising short term yields. We view longer term Treasuries dimly for now due to their large interest rate risks. High yield or speculative debt has moved back to fair value and is now more attractive after yields and returns reached record lows in the last year. We have avoided HY for almost two years as a result of its previous inadequate compensation for risk. If the economic picture remains intact at year end, we will examine the case for HY corporate and HY municipal bonds. Both have improved in terms of a risk and reward calculus over the last year. Defaults are very low. Even with the pressure in the energy sector, high yield indexes are poised to deliver reasonable returns next year. In the alternative income, real return, and diversifying strategy space, we have many ideas to consider. After selling our US REITs at an excellent price earlier, we have been looking at re‐entering the space at a lower price. We didn’t commit capital at the extreme low before July 4th and have examined the investment merits over the summer. No matter how damaged Chinese investors are in their home markets, they have great demand for US commercial and residential real estate. US real estate (in most areas) is still a bargain compared to other foreign centers of wealth and so the ability to develop, finance, and exit real estate investments has fared well over the turbulent summer. Yes, US banks have tightened some lending but credit is available and buyers are willing. Commercial real estate may benefit from rent escalation clauses negotiated a few years ago when inflation rates were much higher than today’s, thus locking in rising cash flows as Page 4 of 7 MCF Advisors Q3 2015
Financial Insights the cost to finance drops. That is a winner over the long term. The most common real asset other than a REIT in many portfolios is a Treasury Inflation Protected Security (TIPS). They require inflation to gain more than expectation if investors are going to make a decent return. We have no direct holdings and very low indirect holdings due to the sub‐
par inflation rates over recent years. The recent activity of gold bugs suggests that we may need to investigate inflation linked investments next year. However, gold may trade higher independent of any catalyst, including inflation. At present, we have not found TIPs compelling or rewarding. We hold positions in energy MLPs and they have been disappointing. We believe in the long term investment opportunity, but have not been pleased with the volatility – whether from the industry’s misfortune or investor irrationality. The asset class now, even after a rebound from unreasonable lows, offers a compelling return relative to even HY bonds and we still like the category. However, we are examining broader diversification – one, by finding an appropriate time to buy US REITs again, and two, by considering other alternative income producing assets. The reason we are looking at alternatives is that rising rates, should the rises be rapid, will hurt traditional bond investments that we prefer. By finding quality income streams with less correlation to interest rate risk, we can assure appropriate long term returns are earned. The MLP space does not need $70 oil but its performance would benefit from $60 oil in 2016. SUMMARY We do not believe that markets should see a US rate hike in 2015. Bonds do not provide as safe an alternative to equity allocations as they normally should. Thus, bond investors should carry lower expectations into 2016. Since we expect the US stock market to grow slowly over the next few quarters, we are seeking opportunities to diversify from an inept Federal Reserve. We continue to minimize our risk to dramatic rate increases and screen for opportunities in alternatives to traditional bonds. We continue to review alternative income sources to complement our portfolio. We still believe jobs and job growth remain a concern for investors and the real economy. We see signs of progress and yet the progress is disappointing compared with previous recoveries. We find China’s byzantine systems of economic control to be counter‐productive and only delay any transition to the wisdom of free enterprise. There are few good things to discuss in the chaos that is the Middle East. Yet, we remain optimistic and believe at some point even Latin America will align to promote growth and free market economics when the failure of socialist interventions become unsustainable. It is ironic that since the Fed Chair Janet Yellen has reinforced the desire of the Fed to follow the data to initiate a rate hike, the data has trailed expectations and remains weaker than forecasts. As we said before, we have been consistently disappointed in the dovish Fed’s ability to communicate and the market’s ability to listen. Productivity needs to improve for many sectors of the economy. But corporate growth is expected to resume and profits too. We expect a better fourth quarter for stocks. We know investors become more ebullient at the end of the year. We know liquidity for risk assets improves. We’ll be mindful of the risks but the US remains as compelling as it did when the year started. There are many positive reasons to expect long term growth in the US and abroad. It is the natural course of events when economies can function freely to allocate capital to the best ideas. We hope that a quarter that has a holiday called Thanksgiving provides returns to be thankful for as it has done 75% of the time. We wish you a great fall season. Page 5 of 7 MCF Advisors Q3 2015
Financial Insights MCF NEWS & SPOTLIGHT
MCF Adds Two Financial Consultants We are excited to welcome Hunter Nighbert and Scott Downing to the MCF team! Each joins MCF as a Financial Consultant, located in our Lexington office. Hunter has been serving clients in an advisory capacity across Kentucky for over five years. He has developed an intensive understanding of the financial needs of physicians and other medical professionals and works with many clients in those fields. Hunter is active in a number of local non‐profit organizations and enjoys coaching youth sports, golf and other outdoor activities. Scott has leveraged his operational background in financial services into a very a promising future serving families, business owners, and executives as a trusted advisor. Scott comes to MCF excited to access our team and resources, enabling him to better serve his existing clients and focus on helping additional families along the way. Scott is active in his church and in a number of local non‐profit organizations and enjoys golf, Kentucky sports, and a good bourbon in his spare time. A native of Maysville, Kentucky, Scott and his wife, Allison, reside in Lexington with their twins Wells and Elinor. Cash Sweep Feature for Schwab Accounts If your account is held at Schwab, you may see some changes to the cash feature on your account in the coming months. Schwab has increased the minimum household balance on their taxable and tax‐exempt Sweep Money Funds (Money Market Mutual Funds) to $500,000. Accounts with household balances below this minimum will have the cash feature changed to the Schwab Bank Sweep feature in Q4 2015. Accounts with household balances above $500,000 will not be affected. New accounts opened since October 1, 2014 already have the Schwab Bank Sweep cash feature. Although this will not operationally affect your account, we wanted to provide a notice in advance of the change. You may also receive a notice in the mail from Schwab regarding the change. If you have questions regarding the change, please contact your Financial Consultant. Important Disclosures Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product (including the investments and/or investment strategies recommended or undertaken by MCF Advisors, LLC), or any non‐investment related content, made reference to directly or indirectly in this newsletter will be profitable, equal any corresponding indicated historical performance level(s), be suitable for your portfolio or individual situation, or prove successful. Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from MCF Advisors, LLC. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. MCF Advisors, LLC is neither a law firm nor a certified public accounting firm and no portion of the newsletter content should be construed as legal or accounting advice. A copy of the MCF Advisors, LLC’s current written disclosure statement discussing our advisory services and fees is available upon request.
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Financial Insights “The best – perhaps even the only – way to predict the future is to create it.” ‐ Peter Drucker www.mcfadvisors.com Institutional Investment Group (IIG) Private Client Group (PCG) Retirement Plan Advisory Group (RPAG) Wealth Builders Group (WBG) Northern KY / Cincinnati Office Lexington Office 50 East RiverCenter Blvd. 333 West Vine Street Suite 300 Suite 1740 Covington, KY 41011 Lexington, KY 40507 859‐392‐8600 859‐967‐0999 Page 7 of 7