OCTOBER 2014 FOURTH QUARTER OUTLOOK Especially compiled and written for clients of Woodway Financial Advisors Guiding successful Texas families in their asset management since 1982 Third Quarter Market Review Staying the Course, page 3 Implications of a Rising U.S. Dollar, page 5
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Q3 MARKET REVIEW - STAYING THE COURSE FOURTH QUARTER 2014 Positive economic trends continue through the third quarter and into the final months of 2014. Economic activity is picking up, production indicators are positive, and labor markets are slowly but steadily improving. Add to that the Fed s loose monetary policy and low long-term interest rates, and you have a positive environment for equities. Gross Domestic Product rose 4.6% in Q2 after a dismal showing in Q1 that was largely due to weather-related disruptions. In the last Woodway Report we predicted that Q1 would prove to be an outlier and that has certainly come to pass. Output is predicted to rise just under +3% in each of the final two quarters, which would bring 2014 in somewhere around +2.2%. That would roughly mirror the gains seen in 2013. The labor market continues to show signs of improvement. The Unemployment Rate sits at 5.9%, the lowest since July 2008 (at which time it was heading in the wrong direction). Private sector hiring has been robust, averaging more than 200K private sector job additions throughout the year. Underemployment, measured by the number of people working part-time for economic reasons, is still elevated though, which we believe gives Allen Lewis, CFA Vice President & Director of Research the Fed some leeway to keep interest rates lower for a longer period of time. Throughout the year the Federal Reserve has been taking its foot off the gas pedal by slowly winding down its asset purchase program. We anticipate that the FOMC will end this current round of quantitative easing (QE) at its next meeting in October. All focus will then be on when the central bank will begin raising interest rates. The current market expectation is for the first Fed rate hike to occur in mid-2015. Woodway believes this is the earliest that the Fed will tighten. Rate hikes could be delayed if recent trends S&P 500 Sector Performance Summary: Q3 2014 MS EAFE Emerging Markets -3.4% Utilities -4.0% MS EAFE International -5.8% Russell 2000 Small Cap -7.4% Energy -8.6% Industrials -1.1% Health Care 5.5% Technology 4.8% Telecommunications Services 3.1% Alerian MLP Index 2.7% Financials 2.3% Consumer Staples 2.0% S&P 500 1.1% Consumer Discretionary 0.3% Materials 0.2% -10.0% -8.0% -6.0% -4.0% -2.0% 0.0% 2.0% 4.0% 6.0% 8.0% 3
persist, such as elevated underemployment, slowing year-over-year wage gains, and a surging dollar. The S&P 500 Index advanced 1.1% in Q3 to finish at 1972.29. Year-to-date the large cap index is up 8.3%. Health Care stocks led the way with a year-to-date return of 16.6%. Biotechnology and specialty pharmaceutical stocks have soared thanks in part to resurgence in M&A activity in the sector. So-called inversion deals, in which a U.S. firm buys a foreign competitor in order to relocate the combined company overseas for tax purposes, have helped drive these gains. Information Technology has also fared well in 2014, returning 14.1% year-to-date. The biggest gainers in this sector have been semiconductor and semi-equipment firms that make components for mobile devices. Technology companies in general have also benefitted from rising levels of capital expenditures by U.S. companies, especially on personal computers and software. The biggest disappointment in Q3 was certainly Energy. Energy was a laggard in 2012 and 2013, but seemed to gain some momentum in the first half of the year. However, oil prices have taken a beating in recent weeks and commodity-levered names have sold off precipitously. Woodway downgraded Energy to market weight during the first half of the year due to our concerns that a $100 oil price was not sustainable. U.S. and OPEC crude production continues to grow, while global demand is in decline. Asian demand is declining due to a slowing Chinese economy, and at the same time the Eurozone is in danger of falling into a recession. Additionally, we anticipate a divergence in monetary policies in 2015 between the Federal Reserve (tightening) and the rest of the world. The U.S. Dollar has already strengthened significantly in recent months. If this trend continues, all commodities including oil could continue to slump. This is a risk we are closely monitoring. The third quarter was especially painful for U.S. Small Cap and International Stocks. The Russell 2000 Small Cap Index declined 7.4% during Q3. Many investors have begun to prepare for the Federal Reserve s shift in monetary policy by moving money out of small companies and into more liquid large cap names. International stocks also struggled in Q3. The MSCI EAFE International Index fell 5.8% during the quarter. European stocks have lagged as the continent flirts with recession. The European Central Bank has promised targeted asset purchases up to EUR 1 Trillion but that has failed to raise growth expectations. Emerging Markets fared slightly better but were still down on the quarter. Prolonged U.S. dollar strength would continue to challenge emerging economies, which rely on foreigners to fund capital investment. Despite some recent bumpy market action, we remain positive on equities. Both the manufacturing and services sectors continue to post healthy gains, and private sector job growth is supportive of continued consumer spending. As we move into 2015, we are keenly aware that the current economic cycle is maturing and that defensive portfolio shifts may be necessary. Fixed income portfolios continue to suffer from low coupon yields and limited capital improvement. While threatening Fed monetary tightening would suggest a higher yield environment, the timing of such a move remains elusive and we could be mired with limited income opportunities for quite some time. Woodway therefore remains concentrated in the middle of the yield curve (5-7 year maturities) where absolute yields are enough to warrant holding a hedge position in U.S. investment grade debt instruments. The key objective for maintaining fixed income allocations is to hedge against any potentially significant downturn in equity markets. 4
IMPLICATIONS OF A RISING U.S. DOLLAR The strongest performing asset class in Q3 was by far the U.S. dollar, rising 7.68% in the three month period, reaching a high last seen in 2010. Global currency levels trade relative to one another and are typically based on differentials in economic and interest rate prospects for their underlying markets. The current surge in the dollar is being driven by stronger U.S. economic trends against still weak and weakening European and Japanese conditions, our two key trading partners. While the U.S. Federal Reserve is winding down quantitative easing programs (QE3) and is expected to begin raising federal lending rates mid next year, European and Japanese monetary authorities are stepping up easing programs and promise continued low or lower interest rates over the coming months. Currency rates chase stronger economic growth and higher interest rates and therefore the U.S. dollar is expected to continue to trend higher until market differentials begin to equalize. A strong U.S. currency seems like an admirable position and certainly makes good political rhetoric but we must be careful Rick Morales, CFA Executive Vice President, Vice Chairman of the Board & Chief Investment Officer for what we wish for. The most immediate negative impact can be seen in commodity markets, whereas underlying commodities are priced in dollars. The S&P Goldman Sachs Commodity Index plummeted 12.8% in Q3 and gold gave up nearly all of its first half gains. Crude prices, a major influence on our local economy, fell 13.5% during the Historic Yield Perspective (Monthly Data 1/31/1919-9/30/2014) 5
quarter, all on the back of the rising greenback. Woodway cut our overweight position in energy stocks during Q1 of this year based largely on the currency dynamic. Trade conditions will favor foreign goods sold in the U.S. and negatively impact U.S. goods shipped abroad. This could force domestic manufacturers to cut prices to maintain market share and therefore squeeze profit margins. A strong dollar is also typically associated with weak emerging market performance but this relationship may not necessarily present itself in the current cycle. Emerging market currencies have historically been indexed to the dollar, forcing their central banks to raise rates alongside the Federal Reserve to maintain the currency regime. In many cases these emerging market economies were not strong enough to withstand such artificial monetary policy and were crushed under the pressure. However, many emerging market currency regimes have been loosened substantially, reducing such pressures to equalize monetary policy with the U.S. In addition, relative strength of emerging market economic trends remain quite favorable whereas European and Japanese markets find themselves in the higher risk strata among global markets. A strong domestic currency cannot be all bad and the benefits can be driven by the same downside effects. Lower commodity prices, such as oil and gasoline, as well as lower prices for foreign imports improves consumer confidence levels and therefore spending patterns, a big plus for domestic retailers. U.S. Dollar vs. Reuters Continuous Commodity Index 6
A strong dollar will also promote foreign investment into the U.S. market, although this can become a political issue as we have experienced so many times in the past. Before we become overly concerned by a rising dollar we must place it all in perspective. Although the near term rate of change in the dollar has been quite noticeable, on an historical basis, the trade weighted dollar remains quite subdued. The negative impact of a strong dollar may actually prevent the Fed from being too aggressive in their tightening measures. Not only can it be detrimental to economic growth but a rising dollar will drive already non-existent inflationary trends lower, making it more difficult for the Fed to fight disinflationary pressures. This could limit the Fed s ability to significantly tighten policy. Woodway will continue to monitor currency rates, among many other macro factors, with regards to their economic and investment implications and will adjust our asset allocation decisions accordingly. Trade Weighted U.S. Dollar 7