2015 First Quarter Review – Reality Sets In - Domestic equity markets struggled during the quarter
KLS Professional Advisors Group
Description
PROFESSIONAL ADVISORS GROUP, LLC
Complete Financial Management
Reality Sets In
Volatility and Uncertainty
Domestic equity markets struggled during the quarter – down in January, recovering and surging
ahead in February only to once again lose ground in March. The S&P 500 finished the quarter up
.95%. As anticipated, the strength of the dollar and the resulting currency translation losses weighed
heavily on earnings of multinational corporations. Slowing productivity and perhaps the beginning of
some hourly wage gains also generated concerns over margin contraction restraining earnings
growth.
The outlook for annual GDP growth remains guarded with consensus estimates at 2.5-3%. Durable goods orders and capital expenditures were unimpressive and may have been held back by the surging dollar, although the U.S. economy is not highly dependent on export activity. Employment data continued to slowly improve. Finally, recent core inflation data reflected price gains approaching Federal Reserve target rates.
Oil and other commodity prices, however, held overall inflation well below the Fed target. The Federal Reserve, fatigued by finely parsing its words, has communicated that it will take the data and all competing considerations into account in its determination as to the timing of interest rate increases and will likely move slowly in small increments. At the same time, the bond market will make its own judgements as to the rate of interest required to attract capital – inflation outlook and credit risk being two principal factors. With the European Central Bank embarking on its own quantitative easing program, European interest rates are at historic lows and in some cases at negative rates. As foreign capital has flowed to U.S.
debt in search of higher yield (and currency gains as the Euro weakened against the dollar) U.S. rates have remained low, benefitting from the currency induced interest rate ceiling and divergent monetary policies of the Federal Reserve and the European Central Bank. European equity markets gained in anticipation of quantitative easing and early signs of economic improvements (focused on Germany). Given continued structural issues in Europe, we expect the recovery to be gradual. China continues to disappoint.
Government policies easing lending and increasing infrastructure spending have not produced the increased levels of economic activity desired by the government. In the domestic equity markets, shares of midsize and small companies outperformed the large companies, and shares of growth oriented companies outperformed value companies. European and Japanese equities outperformed domestic shares, although for unhedged U.S. investors, gains on Euro denominated shares were markedly reduced by currency conversion losses.
The yen/dollar relationship was by contrast fairly stable during the quarter. Consumer discretionary and healthcare stocks outperformed during the period while utilities, energy and financial companies declined. Each sector seemingly focused on differing individual macro and policy driven data points and market forces, including anticipated interest rate moves, ECB quantitative easing, the geopolitics impacting oil prices, healthcare sector merger activity, and employment and inflation data. 1325 Avenue of the Americas, 14th floor ï‚·New York, NY 10019 t 212.355.0346 f 212.355.0413 www.klsadvisors.com . For the quarter, the Dow Jones Industrial Average gained .33%; the S&P 500 and Russell 1000 Indices gained .95% and 1.59%, respectively; while the Wilshire 5000 returned 1.61%. The MSCI EM Index increased 2.24%. The Russell 2000 Small Cap Index and the S&P 400 Mid Cap Index increased 4.32% and 5.31%, respectively. The MSCI EAFE Index gained 4.88%.
The MSCI All Country World Index returned 2.31%, and the European Equity Index gained 3.45% net of currency losses. Portfolio Construction The price-earnings ratio for the S&P 500 is approximately 17.44x 2015 estimated EPS. Mid- and small-cap shares are valued at approximately 21x 2015 estimated EPS, with much greater anticipated growth in 2015 EPS. We continue to maintain our allocation to mid- and small-cap companies in most client portfolios; modestly underweight large-cap shares and modestly overweight mid- and small-cap shares. With long-term Baa corporate bonds yielding approximately 4.54%, the implied PE ratio for equities is 22x.
While PE expansion is possible, it is more likely that interest rates will rise thus lowering the implied equity multiple. We continue to believe that the drivers of share price increase going forward will be growth in EPS rather than multiple expansion. As discussed above, we anticipate this growth to be modest and gradual. Most client portfolios emphasize domestic equities and are underweight foreign equities.
Much of our foreign equity exposure is hedged back to the U.S. dollar to mitigate the impact of currency conversion on client portfolios. Although the first economic indications from Europe are encouraging, we anticipate slow going for the near future.
Investors also continue to watch as the Greek-Eurozone developments unfold, mindful of the implications for other Eurozone countries of lesser economic strength. We continue to have modest duration exposure in most fixed income portfolios. We are not likely to extend maturities as the Fed has signaled that tightening (or raising interest rates) may commence in mid-2015. Our fixed income portfolios have generally benefitted from the increase in bond values attributable to the decline in interest rates.
We continue to invest in high quality municipal bonds held as a risk mitigator in most client portfolios, and anticipate that the Fed will be cautious in raising rates so as not to upset the trend of improving economic conditions. Hourly wage gains remain modest, not presently fueling pressures to raise interest rates. 2 . Background and Expectations Oil prices are likely to remain low as the demand/supply balance continues to calibrate. During the quarter, prices initially declined, firming again as armed conflict in the Middle East escalated, yet the markets remained mindful of the additional supply that could result from lifting of Iranian sanctions should a nuclear deal come to fruition. The decline in oil prices has significantly reduced aggregate corporate earnings thereby elevating the PE ratio of the equity market. Investors, however, still await the arrival of the “oil dividend” that would support corporate profits of non-energy industry companies and increase free cash available for spending by consumers as their energy costs decline. Rather than spending at higher rates that would elevate GDP growth, consumer savings rates have increased. Although consumer confidence remains strong, apart from auto loans, consumers having recently de-levered their personal balance sheets, have apparently not increased borrowings for consumption.
Corporations, by contrast, continue to borrow, financing share buybacks to enhance growth in earnings per share while locking in low interest rates. Covenant light loans to non-investment grade borrowers have also returned in full force. Financial engineering is alive and well. The path to economic equilibrium is a protracted one as the worldwide economy, currency relationships, energy prices and interest rates adjust.
Investors should anticipate continued volatility and a challenging earnings growth environment for the balance of the year. Although surges in share price may occur from time to time, we expect growth based on earnings and economic fundamentals to be modest and anticipate equity returns consistent with this. Nevertheless, diversified domestic equities represent a competitive investment on a relative risk/reward basis as compared to other asset classes. We continue to maintain exposure to both growth and value equities and to both passive and active styles of management in most client portfolios. The above commentary represents the economic and market views of our firm.
We remind you, however, that each client’s portfolio is managed individually. Please speak with your KLS advisor with respect to your personal circumstances and individual portfolio performance. March 31, 2015 3 . .
The outlook for annual GDP growth remains guarded with consensus estimates at 2.5-3%. Durable goods orders and capital expenditures were unimpressive and may have been held back by the surging dollar, although the U.S. economy is not highly dependent on export activity. Employment data continued to slowly improve. Finally, recent core inflation data reflected price gains approaching Federal Reserve target rates.
Oil and other commodity prices, however, held overall inflation well below the Fed target. The Federal Reserve, fatigued by finely parsing its words, has communicated that it will take the data and all competing considerations into account in its determination as to the timing of interest rate increases and will likely move slowly in small increments. At the same time, the bond market will make its own judgements as to the rate of interest required to attract capital – inflation outlook and credit risk being two principal factors. With the European Central Bank embarking on its own quantitative easing program, European interest rates are at historic lows and in some cases at negative rates. As foreign capital has flowed to U.S.
debt in search of higher yield (and currency gains as the Euro weakened against the dollar) U.S. rates have remained low, benefitting from the currency induced interest rate ceiling and divergent monetary policies of the Federal Reserve and the European Central Bank. European equity markets gained in anticipation of quantitative easing and early signs of economic improvements (focused on Germany). Given continued structural issues in Europe, we expect the recovery to be gradual. China continues to disappoint.
Government policies easing lending and increasing infrastructure spending have not produced the increased levels of economic activity desired by the government. In the domestic equity markets, shares of midsize and small companies outperformed the large companies, and shares of growth oriented companies outperformed value companies. European and Japanese equities outperformed domestic shares, although for unhedged U.S. investors, gains on Euro denominated shares were markedly reduced by currency conversion losses.
The yen/dollar relationship was by contrast fairly stable during the quarter. Consumer discretionary and healthcare stocks outperformed during the period while utilities, energy and financial companies declined. Each sector seemingly focused on differing individual macro and policy driven data points and market forces, including anticipated interest rate moves, ECB quantitative easing, the geopolitics impacting oil prices, healthcare sector merger activity, and employment and inflation data. 1325 Avenue of the Americas, 14th floor ï‚·New York, NY 10019 t 212.355.0346 f 212.355.0413 www.klsadvisors.com . For the quarter, the Dow Jones Industrial Average gained .33%; the S&P 500 and Russell 1000 Indices gained .95% and 1.59%, respectively; while the Wilshire 5000 returned 1.61%. The MSCI EM Index increased 2.24%. The Russell 2000 Small Cap Index and the S&P 400 Mid Cap Index increased 4.32% and 5.31%, respectively. The MSCI EAFE Index gained 4.88%.
The MSCI All Country World Index returned 2.31%, and the European Equity Index gained 3.45% net of currency losses. Portfolio Construction The price-earnings ratio for the S&P 500 is approximately 17.44x 2015 estimated EPS. Mid- and small-cap shares are valued at approximately 21x 2015 estimated EPS, with much greater anticipated growth in 2015 EPS. We continue to maintain our allocation to mid- and small-cap companies in most client portfolios; modestly underweight large-cap shares and modestly overweight mid- and small-cap shares. With long-term Baa corporate bonds yielding approximately 4.54%, the implied PE ratio for equities is 22x.
While PE expansion is possible, it is more likely that interest rates will rise thus lowering the implied equity multiple. We continue to believe that the drivers of share price increase going forward will be growth in EPS rather than multiple expansion. As discussed above, we anticipate this growth to be modest and gradual. Most client portfolios emphasize domestic equities and are underweight foreign equities.
Much of our foreign equity exposure is hedged back to the U.S. dollar to mitigate the impact of currency conversion on client portfolios. Although the first economic indications from Europe are encouraging, we anticipate slow going for the near future.
Investors also continue to watch as the Greek-Eurozone developments unfold, mindful of the implications for other Eurozone countries of lesser economic strength. We continue to have modest duration exposure in most fixed income portfolios. We are not likely to extend maturities as the Fed has signaled that tightening (or raising interest rates) may commence in mid-2015. Our fixed income portfolios have generally benefitted from the increase in bond values attributable to the decline in interest rates.
We continue to invest in high quality municipal bonds held as a risk mitigator in most client portfolios, and anticipate that the Fed will be cautious in raising rates so as not to upset the trend of improving economic conditions. Hourly wage gains remain modest, not presently fueling pressures to raise interest rates. 2 . Background and Expectations Oil prices are likely to remain low as the demand/supply balance continues to calibrate. During the quarter, prices initially declined, firming again as armed conflict in the Middle East escalated, yet the markets remained mindful of the additional supply that could result from lifting of Iranian sanctions should a nuclear deal come to fruition. The decline in oil prices has significantly reduced aggregate corporate earnings thereby elevating the PE ratio of the equity market. Investors, however, still await the arrival of the “oil dividend” that would support corporate profits of non-energy industry companies and increase free cash available for spending by consumers as their energy costs decline. Rather than spending at higher rates that would elevate GDP growth, consumer savings rates have increased. Although consumer confidence remains strong, apart from auto loans, consumers having recently de-levered their personal balance sheets, have apparently not increased borrowings for consumption.
Corporations, by contrast, continue to borrow, financing share buybacks to enhance growth in earnings per share while locking in low interest rates. Covenant light loans to non-investment grade borrowers have also returned in full force. Financial engineering is alive and well. The path to economic equilibrium is a protracted one as the worldwide economy, currency relationships, energy prices and interest rates adjust.
Investors should anticipate continued volatility and a challenging earnings growth environment for the balance of the year. Although surges in share price may occur from time to time, we expect growth based on earnings and economic fundamentals to be modest and anticipate equity returns consistent with this. Nevertheless, diversified domestic equities represent a competitive investment on a relative risk/reward basis as compared to other asset classes. We continue to maintain exposure to both growth and value equities and to both passive and active styles of management in most client portfolios. The above commentary represents the economic and market views of our firm.
We remind you, however, that each client’s portfolio is managed individually. Please speak with your KLS advisor with respect to your personal circumstances and individual portfolio performance. March 31, 2015 3 . .
