Second Quarter Investment Commentary 2013

Transcription

1 Second Quarter Investment Commentary 2013 Summertime And the livin is easy. Fish are jumpin. and the cotton is high. One of these mornings, you're going to rise up singing. Then you'll spread your wings and you'll take to the sky. But until that morning, there's a' nothing can harm you With your daddy Ben Bernanke standing by.... A little economic lullaby for your comfort, So hush little baby, don t you cry. The U.S. stock market, as measured by the S&P 500 Index, finished the second quarter with a return of just under 3%. Since the end of the quarter, the stock market has broken out to all-time new highs in the month of July. Meanwhile the data have just shown modest improvement in the economy. The employment picture has improved ever so slightly with initial claims dropping in June, although the headline unemployment rate stayed fixed at 7.6%. Recent manufacturing data have improved in some important regions, specifically in the New York and Philadelphia regions. These reports highlighted a pickup in automobile and home sales. The trends nationwide are also positive. Of course this slight improvement in data does not come cheap, as the Federal Reserve continues to pump $85 billion per month into the economy. The Federal Reserve s balance sheet stands at $3.58 trillion, and climbing, as of July 17 th. So just how long can the stock market continue to make new highs? My guess is that stocks will continue to rise until the Fed decides that it no longer needs to maintain this $85 billion per month of artificial demand and begins to taper their unprecedented additional liquidity. In the meanwhile, Chairman Bernanke has tried to reassure the markets that the massive easing will continue for as long as it is necessary. Not to worry he says. If more liquidity is needed, the Federal Reserve is ready to supply it.

2 Leading Economic Indicators The index of leading economic indicators was unchanged in June, which was weaker than the 0.02% increase that had been forecasted and suggests that the outlook for the next three to six months has begun to deteriorate. The Index was helped most by a persistently accommodative interest rate spread. Fewer people than projected filing for jobless benefits also contributed to the Index. Also a slight uptick in Consumer expectations helped to round out the plus side of the data. In total, five of the ten indicators in the leading Index contributed to the reading, while one was unchanged and four measures declined. A negative reading for Building Permits was the largest drag on the Index for June. The Index also indicated a decline in orders to U.S. factories. Following is a table of the data for the entire second quarter: June May April Leading Economic Index The ten components: Interest Rate Spread 0.24 % 0.20 % 0.18 % Leading Credit index 0.13 % 0.12 % 0.10 % Jobless Claims 0.07 % % 0.12 % Consumer Expectations 0.02 % % % Consumer Goods Orders 0.01 % 0.05 % 0.15 % Average Workweek 0.00 % 0.00 % 0.00 % Orders non-def. Cap. Goods % 0.06 % 0.04 % Stock Prices % 0.17 % 0.05 % ISM New Orders % % % Building Permits % % 0.38 % Manufacturing Pick Ups Manufacturing in the New York region expanded at the fastest pace in five months. The Federal Reserve Bank of New York s Empire State Index posted a reading of +9.5 in July, the highest since February. Readings above zero signal expansion in manufacturing in the region that covers New York, Northern New Jersey and southern Connecticut. The Philadelphia Fed Manufacturing Index increased to 19.8, the highest level since March of The Philadelphia Fed covers eastern Pennsylvania, southern New Jersey and Delaware.

3 Sweltering Currently the Federal Reserve is purchasing $85 billion of mortgage backed securities and Treasuries every month. That amounts to $1.02 trillion in annual purchases that they plan to make each year, for as long as it takes, until the economy can gain enough traction and the employment picture improves more substantially. The Federal Open Market Committee (FOMC) has said it will keep overnight rates near zero and continue with these purchases as long as the jobless rate remains above 6.5% and inflation is 2.5% or less. According to a release from the central bank on July 17 th, the Fed s balance sheet has now ballooned to more than $3.58 trillion. That s up nearly 10% from the $3.25 trillion at the beginning of the second quarter. That equates to an increase of Three Hundred and Thirty billion dollars. For a little historical perspective, the Fed added $2.3 trillion to the financial system during the first two rounds of Quantitative Easing, from December 2008 to March 2010 and from November 2010 through June How much will QE3 ultimately add to the total? Only time will tell. Meanwhile, back at the ranch, Federal Reserve Bank of Philadelphia President Charles Plosser said in an interview in Jackson Hole, Wyoming that he thought that the central bank should begin tapering its $85 billion in monthly bond buying in September and should end it all together by the end of the year. I don t want to do it all at once, but I think we should begin to taper very soon That would be a healthy thing for the economy. We can do it gradually. In another interview on July 15th, with Michael McKee of Bloomberg News, President Plosser said, We don t want to create another housing boom and we have to be careful of the unintended consequences of our policies. Plosser is not alone in his desire to bring an end to QE3. In an interview on Bloomberg Television with Peter Cook, Richmond Federal Reserve Bank President Jeffrey Lacker said he would be, fine with us tapering it off right now. In fact, minutes of the June 18 th and 19 th meeting of the Federal Open Market Committee (FOMC) show that about half of the FOMC participants want to halt bond buying by the Fed by year-end. Driven to Bankruptcy On July 18th, the city of Detroit filed the biggest U.S. municipal bankruptcy in our nation s history. Decades of declines in population and chronic municipal mismanagement has reduced this city, which was once a symbol of American industry and innovation into a cautionary tale of how lost manufacturing jobs and excessive

4 pension obligations combined can go horribly wrong. While it was once the nation s fourth largest city, and still remains the largest city in Michigan, Detroit has lost a quarter of its population since the year According to the Census Bureau, more than a 35% of those who remain are living below the poverty line. Median household income is less than $28,000. Manufacturing jobs fell from about 296,000 in 1950 to fewer than 27,000 in At least 78,000 buildings are vacant, including 38,000 deemed potentially dangerous, according to Kevyn Orr, Detroit s Emergency Fiscal Manager. The situation is so dire that it is literally lights-out, with an estimated 40% of the city s street lights being out of service. The city faces about $18.5 billion in total debt that it must restructure. The city owes more than $8 billion in bond debt and municipal bond insurers are mostly on the hook here. The city has $1.13 billion in general obligation bonds, and while a portion of that is covered by city assets, about $651 million of it is only secured by the city s ability to raise taxes. This portion is the most at risk in the eyes of the bond insurers as the base of taxation in Detroit has little to offer in the way of new revenue. In particular, Federal Guaranty Insurance Co., Ambac Financial, Assured Guaranty Ltd. and National Public Finance Guarantee Corp. have all retained council in anticipation of suits against the city for anticipated losses. In addition to the general obligation bonds, Detroit owes nearly $6 billion in revenue bonds, mostly in water and sewer projects. Beyond its outright bond debt, the city faces a crippling pension liability, both in current benefits being paid as well as in future obligations. Detroit s pension funds are currently underfunded by $3.5 billion. Detroit s general retirement system is the city s largest unsecured creditor, with about $2.04 billion in unfunded liabilities. The pension plan for retired police and firefighters is also owed an additional $1.44 billion. On top of these current debts, the city also owes $5.7 billion in unfunded future healthcare and benefit obligations. The city has about 20,100 retirees which is about twice the number of active employees. Beware of Bond Funds Long-term declines in interest rates over the last two decades have provided an engine for reliable and relatively safe returns in our fixed income marketplace. Normally bonds are thought of as safe investments, unfortunately the tide appears to have turned. Massive redemptions in the largest fixed income funds in the second quarter have sent up a big red flag. U.S. bond mutual funds and fixed income Exchange Trade Funds (ETFs) posted record monthly redemptions of $61.7 billion through June 24 th, according to TrimTabs Investment Research. Estimates from the Investment Company Institute also support that investors pulled approximately $60 billion from

5 bond funds in the month of June, the biggest monthly redemption in their records going back to Vanguard Group, the largest U.S. mutual fund firm had its first net monthly redemption in almost twenty years as bond fund investors went running for the door. Investors pulled $9.7 billion from the company s bond offerings in the month of June. Pacific Investment Management Co. (PIMCO) is the world s largest active fixed income manager. Their flagship fund is the PIMCO Total Return Fund (PTRRX), managed by noted investor Bill Gross. PIMCO Total Return Fund is the largest fixed income fund in the world. For the month of June, this one fund saw net redemptions of a staggering $9.9 billion, or approximately 3.5% of the total asset under management in the fund at the end of May. Are we setting ourselves up for higher interest rates and persistently negative returns for fixed income investments? Perhaps this is the beginning. Is there a higher risk to holding shares of a bond fund today? You bet there is. What s Behind a Note? The last time that Congress had a battle over raising the debt limit, one solution that was proposed was to mint a $1 trillion platinum coin. The coin would then be used to fund the government s commitments until a more permanent solution could be found. The $1 trillion platinum coin never materialized. As we know, in the end, Congress just kicked the debt-limit can down the road to deal with at a later date, which is now fast approaching. As we begin to grapple with the debt ceiling limit again, I thought it would be interesting to take a look at what big currency actually exists, both in and out of circulation. The $500 bill. A portrait of William McKinley graces the front of the $500 bill. McKinley was our 25th President and served from 1897 until 1901, when he was assassinated in his second term by a deranged anarchist. There are still 280,000 of these bills in circulation. Although they are no longer being printed, they are still legal tender and can be used to settle debt. The $1,000 bill. A portrait of Grover Cleveland adorns the $1,000 bill. Cleveland was the only President to leave the White House and return for a second term four years later, serving as both our 22 nd and 24 th president. During his second term Cleveland faced an acute depression. He obtained repeal of the mildly inflationary Sherman Silver Purchase Act and, with the aid of Wall Street, maintained the Treasury's gold reserve. Ultimately his party abandoned him.

6 The $5,000 bill. A portrait of James Madison is on the front of the $5,000 bill. Madison was our 4 th president and is known as the Father of the Constitution. On his watch he asked Congress to declare war on the British on June 1, Our young nation was ill prepared for war. The British entered Washington and set fire to the White House and the Capitol. There are only 353 of these bills still in circulation, according to the Bureau of Engraving and Printing. The $10,000 bill. On the front of this bill is a portrait of Salmon P. Chase. Chase was the 6 th Chief Justice of the United States, served as a Senator and Governor of Ohio and also as our Treasury Secretary under Abraham Lincoln. As Secretary of the Treasury, Chase developed the establishment of a national banking system and the issue of paper currency. The first U.S. federal currency, the greenback demand note, was printed in , during Chase's tenure as Secretary of the Treasury. It was Chase's responsibility to design the notes. In an effort to further his political career, he put his own face on the $1 bill so that the people would recognize him. This $10,000 bill, which was printed from 1928 to 1946, is the largest denomination bill that the Treasury ever issued for circulation in the general public. There are only 346 of them known to be in circulation today. The $100,000 bill. On the front of this bill is the portrait of Woodrow Wilson, our 28 th president. Under Wilson s tenure, we had the passage of the Federal Reserve Act, which provided the Nation with a more elastic money supply. Wilson was re-elected under the slogan He kept us out of war. After getting re-elected, on April 2nd, 1917, he asked Congress for a declaration of war on Germany. This is the largest denomination bill ever printed by the federal government. (So far.) Backed by gold bullion, these bills were issued only to Federal Reserve Banks for making large transactions with one another. This bill can not be held, legally, by collectors. If Congress gets back around to considering the minting of a $1 trillion coin to take care of our debts, whose face do you think should be chosen to adorn it? McKim Williams, Jr. Chief Investment Officer July 20th, 2013 The opinions contained herein are those of McKim Williams, Jr. as of the date of publication and are subject to change without notice. The contents have been compiled or derived from sources believed reliable. Old Point Trust makes no representation or warranty, express or implied, in respect thereof, takes no responsibility for any errors and omissions which may be contained herein and accepts no liability whatsoever for any loss arising from any use of or reliance on this report or its contents. Old Point Trust, its affiliates and/or their respective officers, directors or employees may from time to time acquire, hold or sell securities mentioned herein.