Research Director Monthly Commentary: February 2016

What if there is a recession?

 There has been a lot of talk in the financial news media in the past few weeks about increasing probability of a recession in the U.S. Citigroup was out recently with an alarming report that, in their view, the risks of a global recession have increased materially. The primary reason they cite is concern that U.S. economic growth is slowing and because of that, the risk of recession has increased. Another argument for supporting the idea of recession focuses on U.S. corporate earnings growth, which has been negative for the past several quarters, and declining corporate profits have led to recessions in the past.

There is no question that concerns over a recession have added to market volatility this year. Market volatility has been further exacerbated by concerns over slowing growth in China, plummeting oil prices, and a change in Federal Reserve policy. But what is the real risk of a recession actually occurring?

 Recent growth in the U.S. measured by GDP has been slow, to wit Q4-15 real GDP growth of about 1%. We have to remember that the recent decline in oil prices and oil-related activity has had a material impact on the economy. Also, the theory that negative corporate profit growth will lead to recession also has to be put into context: if one excludes the energy sector from S&P500, corporate profit growth was a reasonable 5% in 2015 and is expected to be about that level in 2016. Employment in the U.S. remains stable and reasonably healthy and unemployment claims continue to decline. Housing remains strong and growth in consumer spending is also expected to remain healthy in 2016 at about 3%. The point is there is very little evidence aside from earnings, that the U.S. is on the verge of recession. The concern over the strength of the Chinese economy also appears to be misplaced: U.S. exports to China represent a very small 1% of GDP; and Barron’s magazine recently cited economist Michael Lewis who found that not a single recession in the post-World War 2 economy could be traced to foreign economic woes.

 
So what is the point of all this? 1) We think concerns over a U.S. recession are overblown; and 2) even if there is a recession, we know that that are ways to position portfolios to reduce the impact of a recession. What are some of those ways? Diversification by asset class can help to reduce portfolio volatility because of differing correlations of returns. For older clients who cannot withstand higher volatility, allocations can be more skewed towards fixed income investments which have a low or negative correlation with stocks. Through tactical asset strategies, investment managers can reduce overall equity exposure in a client portfolio or increase holdings in sectors with lower volatility (such as utilities or consumer staples).  In other words, there are ways to mitigate the risk of recession through proactive risk management, with the classic strategy in this regard being asset class diversification, and maintaining a financial plan that not only includes an appropriate investment strategy but also reduces the temptation to time the market by imparting investment discipline. Clients will be better positioned to weather a potential recession if their portfolios are properly positioned in accordance with a sound financial plan.

 

Research Director Monthly Commentary: January 2016

Deep Powder

 

Over New Year’s I was skiing with my family in the Washington Cascades in some of the best snow conditions I can ever remember: 170 inches of deep, soft powder….so deep you could stick your ski pole into the snow and it would not stop going down…down. As you might imagine, ski conditions were fantastic.  

We did some off trail skiing into what some might refer to as “backcountry”. To get there, we had to traverse through forested areas with cliffs, shelfs, and drop offs. One thing that occurred me trekking out in this was the “problem” one might have if one “slid” off the trail and head-planted into this deep, deep powder…..it could be potentially deadly because it would be so hard to get out of on your own.

So what does this have to do with financial planning? Two words: “risk management”.  Just as in investing, off-trail skiing has certain risks you don’t find when skiing the “groomers”. Risks include getting lost, getting injured far from help, hidden obstacles under the snow like rocks and fallen trees, or ironically, snow that is SO beautiful it has a seductive charm that can lead to a problem, such as a deep fall from which extraction is quite difficult.

We can take precautions to manage risk while skiing in the backcountry that improve our odds of success: don’t ski alone; carry a GPS device; carry safety equipment that may help you “dig out”; if you don’t know the area, go with someone who does; and most of all, know your limitations and abilities.  

Just as in backcountry skiing, there are precautions we can take to manage personal financial risk through financial planning.  One element of this involves preparation. Preparation comes in the form of information gathering, organizing one’s financial affairs, and setting goals as part of a plan. A good financial plan provides discipline which helps reduce risk by adhering to the goals of the plan, such as budgeting or savings goals, tax or estate goals, and discipline in investing. A formal investment plan, and the discipline to stick with the plan for the long term, can significantly improve the likelihood of achieving your financial goals.

Having a sound financial plan is like skiing on a trail you know is secure, it provides a rational roadmap to keep you on course with your financial and life goals and reduces the risk of a “headplant”. It’s also about knowing what you don’t know….if you are skiing backcountry, it is important to know about snow conditions, terrain, or how to find your way back down safely. The analogy to financial planning is guessing or not knowing if your financial plan is appropriate can increase personal financial risks and cause one to fall short of his/her goals. And it is important to be honest with yourself: if you truly do not understand your financial roadmap or how your investments can work better for you, seek the counsel of an advisor you trust.

Bob Toomey

Research Director

S.R. Schill & Associates

Summary of our 1Q-16 Investment Strategy Meeting

We held our first quarter investment strategy meeting on December 22, 2015. From a longer-term perspective, we continue to believe the U.S. stock market remains in a secular bull market. That said, within secular bull markets there will inevitably be periods of volatility, corrections and cyclical bear markets. Our strategy of investing your capital in a diversified portfolio helps to mitigate exposure to market volatility.

While the stock market delivered  (up to now) a flat performance in 2015, we think a number of the issues contributing to that performance, such as the decline in oil prices, weaker nominal earnings, and uncertainty over Federal Reserve policy, are being resolved. The Federal Reserve finally raised its benchmark Fed funds rate on December 16. This action removes an element of uncertainty which overhung the market for many months. Also U.S. corporate profits declined in 2015 due to low oil prices, weaker exports, and the strong dollar. With the U.S. economy on firm footing (we expect real GDP growth of around 2.5% in 2016), and oil prices most likely in a bottoming process, this should contribute to improved corporate earnings visibility in 2016.
 

There are lingering issues in 2016, such as the strong dollar and slower growth in China and emerging markets, that will act as a drag on both global GDP and U.S. earnings; however, with the U.S. economy now delivering the strongest growth of developed world economies, we believe U.S. stocks will continue to be viewed as attractive. We also believe the pace of future rate increases by the Fed will be very gradual. This combined with moderate improvement in corporate earnings growth should help support stock valuations as we move through 2016. As we’ve said before, we believe stock market returns going forward will be lower than the mid-teens growth experienced over the past 5-6 years largely due to maturation of the economic cycle and slow global growth. We expect U.S. stock market returns going forward will more likely be in the 5-10% range.

With respect to significant changes in your portfolio following our meeting, we continued to increase our weighting in U.S. large and mid-cap growth stocks. We believe growth stocks that deliver higher earnings and cash flow growth will garner higher valuations in a slow or moderate growth environment. We also slightly reduced our exposure to international equities due to lower expected growth compared to the U.S. Within fixed income we slightly raised both long end and short end exposure. While we expect long rates to remain relatively flat even with the Fed gradually raising rates, long bonds provide a higher level of income in your portfolio. We expect short debt exposure can benefit more from a gradual rise in short-term rates thereby providing potential for growth in portfolio income.

 

 

Fourth Quarter Investment Strategy Highlights

We held our Q4 investment policy meeting on September 21, 2015. There were some meaningful changes in our policy following this meeting, which will be reflected in your portfolios.

One of more significant considerations at our meeting was the recent decision by the Federal Reserve to postpone its long-anticipated increase in its Fed funds target range, a decision which has numerous implications. The primary reason for the Fed’s “non-move” was concern over the pace of global growth, which does appear to be slowing due to the slowdown in the Chinese economy. The implication of this is that both interest rates and inflation may remain lower for a longer period than we and other investors expected. In its deliberations, the Fed also reduced its forecast for inflation, estimated global growth rates, and pace of future interest rate increases. All of this implies further continuation of what some have dubbed the “new normal”, a euphemism for an extended period of low growth and low inflation. Other key considerations in our meeting revolved around relative exposure to “growth” versus “value” sectors of the market as well as U.S. versus international exposure.

We now expect an increased level of volatility in the equity markets over the near term primarily due to heightened concerns over global growth, risk of associated slowing in corporate profit growth, and lingering uncertainty over Federal Reserve policy. We believe these factors have increased the near-term risk of some further downside in the stock market and we have taken action to address this risk, discussed below. We continue to remain positive about the long-term outlook for the U.S. economy and stock market and we do not believe this derails the secular bull thesis; however, we felt it prudent to make these adjustments in managing risk in your portfolios.

With respect to changes in your portfolio, we reduced equity exposure by about 5%, on average, reflected in a lower allocation to all equity sectors, both domestic and international. Within equities we raised our allocation to growth stocks versus value stocks because we believe growth companies can maintain stronger relative earnings growth in a slower economy and maintain a higher relative valuation. Our real estate and commodity/natural resource exposures were also reduced slightly; however within natural resources we increased exposure to energy (primarily oil) as we believe it offers good relative value. We maintained exposure to health care, financials, and home builders as we believe they still represent attractive secular growth opportunities. Within the fixed income sector, we slightly increased our overall exposure while increasing our effective duration (time-weighted average maturity). As we now believe rates will stay lower for a longer period than we previously expected, we believe this implies better returns for longer-maturity bonds than we previously expected warranting some lengthening of duration. 

Q3 Outlook and Meeting Summary……”Transition Period”

We held our third quarter investment strategy meeting on June 26. We see the financial markets in a transition period as we move into a new phase of Federal Reserve policy. A new regime of rising interest rates, when that occurs, would change the investment landscape somewhat. Based on the history of previous rate cycles, we believe stocks can continue to rise in an environment of rising interest rate.

Uncertainty over the timing of the Fed rate increase and a slowing in corporate earnings growth have kept a lid on the stock market so far this year. As of this writing (June 29), the stock market as measured by the S&P500, is flat year-to-date on a price basis. As we have mentioned previously, we expect stock market returns going forward will be lower than the past 5-6 years largely due to lower expansion in equity valuations. A resumption of corporate profit growth later this year and in 2016 should support higher stock prices despite less tailwind from valuation expansion.

A big question now is what would a Fed rate increase mean for stock and bond prices? Based on history, stocks should do OK, in our view. Looking back on five previous Fed tightening cycles, stocks outperformed bonds. Stocks rose on average by 14% during the first year of the cycle and 16% over the entire cycle. We believe a gradual tightening should not be an impediment to further rise in stock prices assuming reasonable earnings growth and continued moderate inflation. Bonds typically underperform in a rising interest rate environment.

In term of meeting outcomes, we have maintained an overweight exposure to stocks in all major categories. One significant change in the large-cap sector was the sale of technology stocks (XLK) and replacing them with a position in financial stocks (XLF, primarily large banks and insurance companies), which we believe offer attractive relative value. Within the developing equity sector, we added a position in U.S. homebuilder stocks (ITB) as we believe the sector is poised to show above average growth over the next several years. Within fixed income, our allocations remain essentially unchanged (underweighting long bonds), however we introduced a position in the PIMCO Total Return actively managed bond ETF.

A note on Greece: As of today, it appears negotiations on Greek debt payments (to meet a June 30 deadline) have failed, and it now appears Greece will default on its debt. Greece represents a very small portion of the developed world debt and economy and, therefore, we do not believe a Greek default would have significant repercussions in other larger economies. The greater concern is that Greece could pull out of the Eurozone and set a precedent that could be repeated by other Euro area countries. As of now, we believe the probability of both a Greek exit (from the Eurozone) and that event being repeated by other Euro are countries is very low. Therefore, as of now, we have not taken specific steps to hedge an event such as this. We believe the situation with Greece will eventually be settled and as of now, we do not see sustaining ramifications that would cause us to materially alter our strategy.

June 29, 2015

 

 

Q2 Investment Strategy Meeting

We held our second quarter 2015 investment strategy meeting on March 24. The most notable changes following the meeting were an increase in exposure to European stocks and modifications to our fixed income strategy.

We remain constructive on the outlook for U.S. stocks but recognize volatility has increased in 2015 and we expect volatility will most likely remain elevated in the near term for a number of reasons. The reasons for the increased volatility so far this year include heightened uncertainty over Federal Reserve policy, a temporary slowdown in corporate earnings growth, and uncertainty over the health of the global economy. Going forward, we think returns on U.S. stocks could be more moderate (mid to high single digits) compared to the 15% annualized returns experienced over the past five years.

U.S. economic fundamentals remain constructive. We expect another year of moderate 2.5-3% real GDP growth in 2015 with continued moderate inflation. With improving job growth, lower oil/gas prices and strong dollar, we believe U.S. consumers are in a stronger position to increase spending, which should support economic growth and an acceleration in U.S. corporate profits in 2H-15.

Investors were highly focused on the March FOMC meeting for indications of future direction of Federal Reserve policy. In our view, the meeting supported continuation of the Fed’s gradualistic policy and it now appears any rate increase by the Fed may be pushed out. We expect the Fed will attempt at least one rate increase in 2015, most likely in the fall; however we do not expect this rate increase to have a lasting impact on stocks as it is highly anticipated and, historically, the first few rate increases in a tightening cycle have not derailed a cyclical bull market.

The primary change to your portfolio this quarter was a slight increase in allocation to equities through increased exposure to international stocks. We introduced a holding in large European stocks as we believe Europe is undergoing an improvement in economic and monetary conditions, both of which should support higher valuations for quality European stocks.

Our macro allocation to bonds remained essentially unchanged. Our current strategy in bonds is to underweight long-maturity bonds and overweight short-maturity. We believe it is prudent to position your portfolios for the eventual rise in interest rates which, typically causes more volatility in long bond prices, thus our underweight in this sector. Our overweight in short bonds reflects the fact that short bonds tend to be less sensitive to rising rates and currently present an opportunity to capture a rising income stream as maturing bonds get rolled into higher yielding bonds once interest rates begin to rise.

 

3/27/2015

Summary of our 1Q-15 Investment Committee Meeting

We held our first quarter 2015 investment committee meeting on December 18. We continue to “stay the course” in maintaining a fairly full exposure to stocks. We believe U.S. stocks continue to offer the most attractive risk/reward among global markets. This is based on our positive outlook for the U.S. economy and corporate earnings and continued low inflation. Growth of the U.S. economy remains the strongest of the developed world economies. We expect U.S. real GDP growth in 2015 of about 3%, compared to virtually zero growth in the Eurozone. Both China and many emerging markets are experiencing slowing in growth. Relative growth of U.S. corporate earnings should remain a positive factor in 2015.

The Federal Reserve continues to remain accommodative of economic growth. While we expect the Fed to begin raising interest rates in 2015, we expect this increase will be a) later in the year and b) gradual and well telegraphed. We do not share the concerns of some that a change in Fed policy will cause a significant upset to financial markets,  particularly if inflation remains low and corporate profit growth remains sound, both of which we expect as of now.

With respect to recent stock market volatility, we note that volatility is a normal element of all financial markets. The mid-December pullback in the stock market was about 5% and well within the normal range of day-to-day, week-to-week volatility going back many years. It seemed worse because of the coincident plunge in oil prices. That said, we think the cyclical bull market is maturing and we do not expect stock market returns going forward to be as strong as the past 5-6 years. Valuation, for one thing, is now above the long-term average and will not be the tailwind it has been for the past six years. We expect market growth going forward will mostly be driven by earnings.

We spent more time this quarter in deliberating our bond investment strategy. As we’ve explained previously, the conundrum (balancing act) facing bond investors is maintaining income in a very low rate environment while protecting against capital risk associated with rising interest rates. We have implemented a structure that underweights the long end of the curve and overweights shorter duration while also holding bonds or bond substitutes (such as utility stocks) that support portfolio income. With respect to equity investments, within U.S. exposure, we increased our weightings to large and mid-cap value (higher dividend-paying) stocks and also increased exposure to real estate. We slightly reduced aggregate exposure to international stocks and held steady our exposure to commodities, primarily in the areas of energy and forest products.