My experience composing this quarter’s Portfolio Commentary is no doubt similar to what our clients and colleagues have noticed in recent years. I’m on a United flight that is stuffed to the gills – not one empty seat. The flight departed from a humming and antiquated Washington-Dulles with its low-ceilings and vintage layout of long, narrow corridors. Our plane is a Boeing 767-300 that was manufactured in 1988 — nearly 30 years ago. Reflecting back on the first quarter of 2014, in which the best-performing sector of the market was airlines (up nearly 25%), it all seemed a fitting analog for the post-2009 recovery. Profits are up, way up. Corporations have pricing power. Yet companies, consumers, and even governments remain lean, wary of capital spending or expansion, and suspicious that the whole recovery may lose steam at any moment.
Although you’d never guess it from reading the mainstream media, the US, Europe, Japan, and the emerging world are all now growing concurrently. Yet similar to United, companies and countries have clawed their current footing out with unconventional measures whether they be bailouts, cost cutting, downsizing, QE, ZIRP or austerity. United’s quandary is akin to the conundrum currently facing virtually all businesses, companies, and countries these days: Do we believe in this recovery? Or this market? Can we trust in it? Is it enough to make a bet on the future with the equivalent of new planes, hiring, and expansion? In other words, is it time to actually grow again? We would argue yes, for reasons discussed below.
The first quarter of 2014 ended without much to show for it, with the S&P 500 and the MSCI ACWI both basically flat for the year despite some pronounced volatility. During the quarter, momentum and high-beta trades got crushed, such as biotech (down 13%), Tesla (down 13%), and Netflix (down 20%); while boring and passé bonds surged upwards 8% — an outcome few would have predicted.
Reminiscent of prior years, defensive and yield-driven sectors like utilities, telecom, and health care advanced, while growth sectors like technology and cyclicals declined. Domestic and foreign developed markets outperformed emerging markets; Europe slightly outperformed the US, and both outperformed Japan, which fell by 8%.
Outlook & Positioning:
Looking ahead, we believe that domestic and international growth will manifest itself in 2014. US growth was primarily impacted by winter storms and polar vortices, which kept many consumers at home. But the underlying forces driving corporate profitability over the past several years have reached the end of their effectiveness and are likely now creating impediments. As such, companies will soon need to unleash their cash hoards on new capital equipment, technology, and productivity-enhancements – and will in turn also push wages higher (the third leg of the recovery). Internationally, markets were unnerved by the Russian invasion and annexation of Ukrainian Crimea. We believe that investor anxiety from both winter weather and Russian expansionism factors were overreactions that will be short-lived.
With regard to Russia specifically, more than half of the nation’s budget runs off of energy export revenue and, as such, Russian President Putin will stop short of impairing Russia’s broader economic interests — he’s certainly a dictator, but he’s not foolish.
Meanwhile European growth rates have been revised further upwards, with positive surprises now in Germany, Spain and the UK. With Europe still 20% off its 2007 highs, we believe that an earnings-driven expansion is both possible and probable – and we remain quite bullish on international small cap.
Emerging markets may also have finally a found valuation-based footing, as their entrenched attributes of better demographics and easier productivity gains stand in stark contrast to their developed market peers. India will soon anoint a vastly more pro-business government and China will settle into a “new normal” of 5% to 7% growth as President Xi Jinping’s political house-cleaning has been accomplished and full attention can be turned to domestic consumption and environmental improvements.
Corporations have reached the end of the road with regard to the cost-cutting measures and productivity gains that have propelled their earnings off of 2009’s market lows. Although stock-buybacks and other financially creative uses of shareholder capital may continue, we believe that consumers and corporations around the world are finally regaining their animal spirits and that further economic and market gains based on capital spending and investment are probable. With all three legs of the global economic stool (the US, EAFE, and EM) finally achieving synchronous expansion, we remain confident in our 2014 outlook for continued economic growth and modest equity gains. If you have any questions we can address, please contact your Advisor. As always, we are happy to help.
David Wolf, Chief Investment Officer