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Quarterly Market Letter
Third Quarter 2016
Inside This Issue:
Overview .......................................................................... 1
Domestic Economy .......................................................... 1
Fixed Income Review ....................................................... 2
Equity Review and Outlook
4
Commentary: Election Impact on the Market ................. 5
Overview
Markets were uncharacteristically calm in the third
quarter. The S&P 500 equity index traded in a range of
less than 5%, from 2090 to 2190, and finished with a
moderate gain of 3.3%. For fixed income, the BBCI
(Barclay’s Bloomberg Credit Index) traded in a range of
less than 2%, and had a 3rd quarter return of just .2%.
These quarterly returns, when added to the first half,
bring us to solid year-to-date returns of 7.8% for stocks
and 4.2% for bonds.
Although some would say that this is the calm before the
election storm, we believe that both equity and fixed
income markets are well supported by strong cash flow
and continuing economic progress. This should contain
the presidential debate to the political arena and dampen
any spill-over into capital markets. The most likely
outcome is a continued stalemate in Washington, with
the President and Congress unable to agree on almost
any major new programs. This would maintain the
status quo, and not produce any surprises that create
undue volatility for the markets. History would support
the notion that Presidential elections are well discounted
by the equity market, and that the outcome is seldom a
big surprise, which might cause a major adjustment in
the markets afterwards.
Domestic Economy
U.S. economic growth continues, albeit at a slower and
slower rate. The 2nd quarter GDP rebound from the very
anemic +.8% in the 1st quarter didn’t quite live up to
expectations. Weak business spending, a widening trade
deficit and higher inventories offset solid consumer
spending. As a result, growth was lackluster at 1.4%.
We do anticipate some pick-up in growth beginning in
the just completed 3rd quarter, but we have reduced our
full year economic outlook to 1.8% which would be the
slowest rate of growth since 2013 and below the 2.0%
average growth of the entire seven year expansion since
the deep recession of 2008 - 2009.
Over the past year, one of the more encouraging signs
for the economy has been the steady growth in
employment.
Employment trends have become
increasingly important to GDP growth since jobs create
income which in turn greatly influences consumer
spending. Consumption has been the major driver for
growth as business and government spending remain
weak. Over the entire span of the recovery, more than
15 million jobs, about 160,000 per month on average,
have been added to the work force underpinning this
steady if slow multi-year expansion. The unemployment
rate has fallen from over 10% in 2009 to 5% last month
as more and more previously out of work Americans reenter the labor market. Another positive sign that the
labor market is strong is the four decade low in jobless
claims. Employers are retaining their workers and
raising wages as skilled labor is becoming increasingly
scarce and expensive. However, the current 2.7% yearover-year increase in average hourly earnings should
undoubtedly help strengthen household finances and
encourage spending, without causing any troublesome
surge in inflation. Inflation in general remains well
contained below the Fed’s targeted rate of 2%, with core
PCE up only 1.7% for the year. Furthermore, while the
driver for continued economic growth is still the
consumer, GDP is expected to have some help from a
moderate improvement in capital spending going
forward. Due to the upturn in oil prices, capital
expenditures from energy companies, most of whom had
significantly reduced their capital expenditures over the
past several years, are expected to improve in 2017.
Also, regardless of the outcome of the presidential
election, we anticipate some form of fiscal stimulus from
the government sector should be forthcoming in 2017.
What the particulars might be, as well as the actual
probability of being approved by a possibly divided
Congress, is hard to assess at this juncture. However
any incremental government initiatives, whether
infrastructure, tax reform, or repatriation of corporate
cash held abroad, would be beneficial to economic
growth.
Our outlook for next year calls for only a slightly higher
GDP growth rate of just 2% with inflation still at or
below the Fed’s targeted 2%. Fiscal stimulus may well
have a growth influence on the economy as
accommodative monetary policies seem to have less and
RNC Genter Capital Management
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2016: Third Quarter Market Letter
less impact. The economy has languished in this slow
growth mode for so long that the sharp slowdown in
growth in the first half of this year has raised the
question of whether or not we are in a mid-cycle
slowdown or, more dramatically, are we about to slip
into a modest recession. While the risks of a recession
may have risen, it is important to note that the U.S.
economy has shaken off any number of disturbing trends
and concerns over the course of the past several years,
including a slowdown in China, Brexit, troubled
European banks, and the U.S. political gridlock. Absent
any policy missteps and with the tailwind of potential
fiscal stimulus next year, the outlook for the economy
remains positive but not particularly robust. The
financial markets seem to be a little apprehensive of
such policy missteps or outside events that would
destabilize an already slow economy. We think the
conclusion of the election will reduce these concerns and
2017 will be another year of modest economic progress.
alpha from the four major components of return (i.e.
duration; curve positioning; sector allocation; credit
selection), the majority of our alpha (66%) was again
attributable to individual credit selection.
Fixed Income Review
In general, credit metrics should continue to weaken
from present levels. However, we deem that any credit
spread increase will be muted due to global investors’
search for yield. In addition, with negative interest rates
still a reality for high quality foreign sovereign debt, the
positive yields available in the U.S. market should create
somewhat of a ceiling on interest rate levels for domestic
dollar denominated treasury securities and corporate
obligations. In fact, we believe the corporate bond
sector should remain in high demand since corporates
offer relatively attractive yield levels from a global
perspective. Therefore, we will continue to overweight
this sector in our more diverse taxable fixed income
styles, although we have reduced our exposure at these
lower OAS (Option Adjusted Spread) levels.
As we expected, the level of interest rate volatility
remained high during the quarter. In addition, U.S.
Treasury security yields increased across the maturity
spectrum in a bear flattener as there is a high likelihood
of a +25bp (basis points) increase in the Fed Funds
target range before year-end.
U.S. Treasury Yield:
Quarter End September 30, 2016
Year End December 31, 2015
3mo
2yr
5yr
10yr
Rate
Qtr End
Yr End 2015
0.29%
0.16%
0.77%
1.06%
1.14%
1.76%
1.60%
2.27%
+13
-62
+11
-67
30yr
2.32%
3.01%
bp change
QoQ
YTD
+3
+13
-19
-29
+2
-69
Source: U.S. Department of the Treasury
However, while treasury interest rates were rising, the
yield spread on corporate securities narrowed further
reaching a new low for the year. The OAS (Option
Adjusted Spread) of the BBCI closed the quarter at
+127bp with a year-to-date range of +127bp to +200bp.
Outlook / Strategy
We believe that domestic economic growth, along with
inflation levels, will remain below their normal ranges of
the past six years. Needed fiscal policies from a new
President and Congress to help accelerate the economy
cannot be counted on until the later part of 2017, with
actual stimulus not felt until well into 2018. Due to this
uncertainty, yield volatility should remain elevated,
while interest rates stay near current historically low
levels. As measured by the 10-year Treasury, we project
the yield range for the remainder of the year to be 1.50%
- 2.20%, with a year-end level of 2.00%. Our year-end
level for 2017 is 2.50% with an even broader range of
1.00% - 3.50% to allow for differing election outcomes.
In addition, we will continue to underweight government
agency securities as long as spreads remain tight to
treasury securities. Although we continue to review
TIPS (Treasury Inflation Protected Securities) as an
alternative, we believe they are relatively expensive at a
breakeven of 1.65% given realized and projected CPI
headline inflation levels.
Although yields were higher, broad based fixed income
indices added to their year-to-date positive returns
during the quarter. Essentially, coupon interest more
than offset the marginal loss in bond prices. For our
Taxable Intermediate style, returns were enhanced
further from our strategic overweight of corporate
credits. Furthermore, although we achieved positive
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The Fed
At the 9-27-16 FOMC Board of Governors meeting the
number of dissents increased from one to three. This
was the most since the December 2014 meeting. All the
opposing votes recommended a tightening in the Fed
Funds target rate range to 0.50% - 0.75%.
With needed fiscal policy action possible later next year,
the Fed should be thinking in terms of unwinding some
of its excess accommodation now. Persistently low rates
have increased financial leverage in the system but have
not increased economic growth. This needs to be
reversed, so we believe another 25bp increase in the
range to 0.50% - 0.75% is appropriate in December.
Municipals
Municipal / Taxable Treasury ratios increased during the
quarter and now range from 88% at 5 years to 101% at
20 years. This was the result of record primary issuance
that saw the 30 day visible supply rise to $21.5 billion.
The year-to-date level of new issuance increased to $348
billion, 4.5% greater than 2015, on track to meet our
expectation of over $400 billion for this year.
Unfortunately, this caused underperformance of
municipals relative to their taxable counterparts. High
grade municipal yields either rose more than or in lockstep to treasury securities across the maturity spectrum.
However, strong demand from crossover investors and
the continued positive inflows to municipal bond mutual
funds supported the marketplace and muted the
downside risk.
Fortunately, this year’s presidential election has both
candidates agreeing on one important issue, supporting
the need for infrastructure spending. We view this
support as a positive for the marketplace, since
municipal bond issuance finances approximately two
thirds of domestic infrastructure projects. Essentially,
this fact reduces the near-term threat of any legislation to
cap the tax-exempt income benefit for municipals. We
have noted previously that any cap on municipal interest
would increase the cost to the State or local issuer and
even threaten the potential viability of a given project.
Furthermore, well-planned infrastructure projects should
provide an improved jobs picture that could potentially
benefit the respective State and local governments with
increased tax revenues. Presently, we do not feel that
the possible reduction in marginal tax rates, assuming a
Republican victory, is an issue given that munis ratios
far exceed the breakeven ratios of any possible
modification to the brackets.
We expect supply to be manageable through year-end,
with demand from the sources previously outlined
remaining robust, due to attractive Municipal / Treasury
ratios. We continue to see value in several segments of
the market with pre-funded securities topping the list.
Their secondary supply has risen given the abundance of
refundings to-date due to refinancing of the higher net
interest cost of older issues. This aberration in supply
has caused these top-tier structures to trade at relatively
attractive levels to their historic norm. As a result, we
continue to emphasize pre-refunded / escrowed bonds
with a targeted 15% for intermediate portfolios and 25%
in the shorter maturity style.
Currently, we find the new issue market attractive given
that underwritings are being priced with considerably
higher yield differentials to the secondary market. We
expect that yield spread to remain in place for the
foreseeable future as broker/dealers are unwilling to
accumulate inventory due to increased regulatory capital
requirements. Furthermore, we still see value in “A”
rated issuers, especially for select airport, public power
and port facility revenue bonds. We feel these credits
have less exposure to the escalating pension problems
facing State and local governments.
Given our continued view that the Fed will not be
increasing rates in a stair-step fashion, as in past cycles,
the curve should remain positively sloped. As a result,
measured risk roll-down strategies will continue to
accrue positive results. At this point in time, we believe
the 5-10yr maturity range provides the best relative
value. Therefore, we have modified our maturity
distribution by increasing our weight in that area of the
curve.
We have updated our view and have continuing concerns
about Public Pension Funds. In the eight years since the
recession, the S&P 500 is up more than 200% and broad
based investment grade bond indices have produced
solid positive results. Given how well these asset classes
have performed, one might conclude that State pension
funds should be closer to fully funded. Unfortunately,
many of the pension funds have instead seen an increase
in their unfunded levels due to a variety of factors
including the unintended consequences of an extremely
accommodative Fed.
Furthermore, while benefit
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requirements have increased, investment returns have
been well-short of their expected target returns.
As an example, the California State Teachers’
Retirement System reported that for the third
consecutive year the Fund will miss its annual return
target of 7.5%. For the fiscal year ending June 30th
2016, the Fund returned only a scant 1.4% and for 2015
it was 4.8%. Another example, according to Bloomberg,
the California Public Employees’ Retirement System,
the largest U.S. pension fund, has missed its 7.5% target
for five of the last ten fiscal years. While CALPERS has
averaged 7.8% over twenty years, it has returned only
6.2% over the ten years ending June 30th 2015.
Finally, a more troubling statistic was provided by the
Wilshire Trust Universe Comparison Service, showing
that public plans had a median increase of only 1% for
the year ended June 30th 2016.
Most pension managers think the low returns over the
last ten years are cyclical and sooner or later the
domestic economy will return to a higher growth path
with moderate inflation. That expected combination of
factors should result in a higher interest rate
environment. However, in the meantime, only a few
pension funds have started lowering their return
expectations.
In July of this year, the State Employees' Retirement
System of Illinois lowered its assumed investment return
to 7.0% from 7.25%. Likewise, in 2015, New York State
and Local Retirement System has lowered its assumed
rate to 7.0% from 7.5%. Lowering this assumption is a
more conservative path, but it does potentially increase
the yearly funding requirements. We view a low
growth, low return environment as normal and believe
that a majority of large pension funds should be reducing
their expected rate of returns further. Since most
pension funds are currently assuming a return
expectation in the 7.50% to 7.75% range, they have a
considerable way to go.
According to the Federal Reserve, state and local public
pension plans were underfunded by $1.9 trillion as of
June 30th 2016. Furthermore, the Rockefeller Institute of
Government reported that unfunded pension liabilities as
a percentage of GDP was at 9.9% as of Jan. 1, 2016, up
from 1.3% in April 2007. The ratio had touched a high
of 12% in July 2011 but was overfunded 5.50 in January
2000, just prior to the dot.com bust.
Unfunded Liabilities as a Percentage of GDP
Source: Rockefeller Institute
According to Rockefeller Institute, because of high
exposure to equity related investments, larger swings in
the ratio are now expected to be the norm.
Equity Review and Outlook
There was little change to the tone of the equity market
over the summer. Earnings reports continue to be
lackluster for most companies and sectors, except energy
companies’ where sharp drops caused a slight decline in
the EPS (earnings per share) of the S&P 500 as a whole.
With oil now trending back up, and above $50/barrel,
the energy sector comparisons are less negative and the
S&P EPS should show increases in the fourth quarter
and into 2017.
The economy seems to be stuck in second gear, unable
to accelerate. Even though U.S. economic cycles seem
to be getting more prolonged, the current cycle is now
over seven years old, well past the average for the last 50
years. But cycles usually end because some segment
gets overheated. In the current cycle, with a low overall
growth rate averaging below 2% versus a more normal
3%, no segment has gotten even mildly extended. While
current auto production of 17 million units has almost
doubled from the low point in 2009, it has not broken the
prior record level of 18 million back in 2007. Current
new housing starts of 1.1 million are not even enough to
accommodate the increase in population. Prior cycle
highs were over 2.0 million per year. So the bad news is
that the economy continues to slog along at a
disappointing growth rate. The good news is the
economy is not overheating, a precursor to recession.
With that in mind we have been resisting the urge to buy
stock in companies that should do much better when the
economy improves.
Instead we are looking for
companies that can consistently build even in a slow
growth environment. This has the added benefit that if
the economy were to somehow slip into a recession, our
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companies would be less subject to disappointments.
Nowhere is this more apparent than in Health Care.
With the Democratic Party push to control drug prices,
the stocks have been under pressure for most of the year.
This means they are cheap now at the same time that we
expect the pressure should abate after the election. A
split Congress will be unable to move effectively in
2017 to restrict the pricing flexibility of the industry.
While there are plenty of individual examples of large
price increases, the average price increase for all drugs
runs about 5%. And in 2017-18 several large launches
of generic replacements for high priced proprietary
drugs should lower that rate even further. So Teva
Pharmaceutical Industries Ltd. (TEVA), the world’s
largest generic drug manufacturer, is one of our largest
holdings. They consistently lower their prices as they
achieve manufacturing economies of scale. We expect
to find additional opportunities in this sector, companies
with consistent growth that can withstand the economic
cycle effects.
As was pointed out in our fixed income section, we are
seeing corporate balance sheets start to degrade. This is
our signal to make sure we do not get sucked into
owning companies that are increasing leverage in order
to maintain growth. Buying back stock has been very
popular in the last five years and is now often
responsible for a significant part of the reported growth
of many companies. We have nothing against this, and
indeed are happy if management does this with excess
cash. But if the cash is from borrowing from the banks
or selling bonds, then this is a red flag for us. We expect
the quality of our portfolio to improve in the coming
quarters as a way to lessen our risk if the market were to
deteriorate.
We look forward to 2017, when election rhetoric dies
down and corporate earnings are once again positive.
We maintain a glass half empty viewpoint in order to
catch early signs that the economy is starting to roll
over. But in the intermediate term that still seems
unlikely to us, and we expect earnings, dividends and
market returns from equities to all grow close to their
long term average of 5 - 7% over the next 12 months.
Commentary: Election Impact on the Market
With the Presidential Election less than four weeks
away, market pundits are falling over themselves to
bring additional insight into play.
We thought we would take a step back from the actual
battle taking place now and take a longer term
perspective ( as we usually do).
While this election is being advertised as a race of two
unpopular candidates, the fact is that it has been a long
time since two popular candidates ran against each other
and the outcome was not seen as divisive. To us, the
cries of “this time is different” ring hollow, and we think
that this will be no more than a bump in the road for the
stock market. By their intrinsic nature, stocks have
several major inputs that are impacted by the election.
The first is the future earnings and cash flows from a
company. If the election signals a change in corporate
tax rates or any substantive policy affecting the stream
of corporate cash flow and dividends, either pre-tax or
after tax, then this would have a durable impact on
valuation and stock prices. The second piece of the
puzzle is the certainty of receiving value from these
flows. Uncertainty about policy, tax rates, depreciation
schedules, inflation, etc. all reduces the value of the
expected cash flow stream. Thus even if cash flows are
reduced by a policy action, if these lower cash flows are
now viewed as being 100% certain instead of just
possible or likely, then the market may evaluate this
trade off as a net positive.
With this in mind, we hazard the following comments
about the election and its impact on the stock market.
While there is something in the headlines every day
about the election, this will soon pass. We will go back
to focusing on a broader set of developments around the
world, providing a more diversified, even keel for the
domestic and international economy. Even after the
election is decided, most of the impact of any policy
change will take a year or more to implement. The
policy statements will have to be translated into a legal
document, submitted to the appropriate authorities here
or abroad, debated extensively and then finally passed,
potentially with an even later implementation date. This
delay gives all parties time to adjust to the new playing
field. Corporations can change their offerings to
conform to and perhaps even take advantage of the new
rules. As was the case with Obamacare, it was not as
bad as many health care companies thought it would be,
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2016: Third Quarter Market Letter
and some even prospered. So we do not expect any
large change in the general market level due to the
election outcome. The market is an efficient discounting
mechanism for uncertainty. Currently it expects a
Clinton victory and is comfortable with this because it
also expects the House to remain Republican. This will
neutralize her ability to create any major policy change.
Thus, this outcome extends the status quo and allows
business to go forward without any disruptions, a
favorable outcome that is reflected in year-to-date stock
market performance.
A Trump victory would be a surprise to the markets, but
his policy pronouncements to date have on balance been
more pro-business than Clinton’s. His commitments to
lower taxes and fewer regulations would offset the
uncertainty caused in other areas like foreign trade,
where his opposition to many current trade treaties
would require many years to sort out. As the large cap
indices are dominated by 50-100 companies with broad
international exposure, this would have a substantive
impact on the stock market averages. But a huge
number of smaller domestic oriented companies would
benefit from his tax policy without the drawback of
more difficult foreign trade. This might not show up as
strongly in the broad stock market averages because
many of these companies are private, but it would still
help GDP growth significantly.
While every election is different, market action, both
leading up to and afterwards, has not been. Looking at
the post war period since 1952, October and November
historical volatility in election years is only slightly
higher than non-election years. And if you exclude the
17% drop in October 2008, then October becomes the
least volatile month of the year. Additionally, October
and November are part of the 4th quarter, which has been
the best quarter of the year on average for the markets
over the last 65 years. Both months have had positive
performance more than 60% of the time. So statistically
speaking, elections are a minor blip to the market and
one that often has a net favorable impact.
So unless we have a “hanging chad” style controversy
that prolongs the election uncertainty (November, 2000
market was down 8% largely as a result), we think that
the all-consuming nature of a Presidential election will
soon fade and we will get back to business as usual with
only a few modest changes.
Also to be noted, both candidates are proposing policies
that would shift the playing field for certain industries
and sectors. A Trump win would help oil and gas
companies find more domestic oil, but would hurt the
previously mentioned international export oriented
companies. So there might be significant moves in
various parts of the market, but not much change in the
broad averages. Surprisingly, our current analysis would
suggest that while many would expect health care
companies to benefit from a Trump win and the potential
repeal of Obamacare, we think there would be a
prolonged period of uncertainty around any replacement
system. We cannot go back to a system that would drop
close to 10 million people from coverage, so it would
take time to reach a solution that would increase choice
and lower costs. We expect this would set up Health
Care stocks for disappointment in the near to
intermediate term.
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