We believe that investors should reduce risk in their portfolios. We believe that the bull market in equities is winding down, interest rates have nowhere to go but up and growth in emerging markets is decelerating. Although we believe that the United States economy is performing below its potential, we do not see any positive catalysts that will move it towards achieving its potential during the next couple of years. We do not see an economic recovery around the corner at this moment in time. We also see governmental and political policy risk resulting in potential headwinds for the U.S. economy due to following recent events:
- The recent partial shutdown of the federal government,
- The upcoming debt limit fight
- New draconian regulations on America’s cheapest, most abundant energy source (coal)
- Execution risk associated with the launch of ObamaCare
- High-profile municipal elections in major U.S. cities like New York City, Minneapolis, Detroit, Atlanta, Boston, Pittsburgh, Seattle, Cincinnati, Cleveland, Miami and Houston
In 2012, we were a little more optimistic about the economy in general and the U.S. economy in particular. We scoffed at PIMCO CEO Mohamed El-Erian’s New Normal thesis because it relied on the heavy hand of government intervention in the U.S. economy. Based on electoral developments that took place from 2009 to 2011, we saw that Americans were steadily rejecting expansive government regulation and intervention at the ballot box in favor of more free market oriented candidates and policies. Such candidates and policies would serve as potential positive economic catalysts. We compared PIMCO’s New Normal thesis with BlackRock’s “Investing for a New World” investment strategy message and we concluded that BlackRock’s message was more appropriate for investors at the time. However, our enthusiasm waned since then due to these observations:
- The governmental and political policy risk headwinds previously mentioned
- The results of the 2012 U.S. elections
- Our concerns that the Federal Reserve’s monetary printing program is creating a potential stock and bond market bubble
- Decelerating economic growth
- Decelerating EPS Growth across all 10 of the S&P GICS Sectors
- Waning growth from emerging markets
Although the U.S. GDP growth rate of 2.5% in Q2 2013 was higher than the 1.1% achieved in Q1 2013, it is still weak by historical comparisons. Economic expansion following the 2008 recession has been the weakest of the post-second world war era. Furthermore, the Q2 2013 growth rate was below economists’ forecasts. We can see that the Thomson Reuters/University of Michigan Consumer Sentiment Index fell to 77.5 in September from 82.1 in August and was the lowest final reading since April. Other gauges also hit their lowest final reading since April: the gauge of consumer expectations, at 67.8, and the index of current conditions, at 92.6. We disagree with University of Michigan Economist and Survey Director Dr. Richard Curtin’s observations that few consumers expected a federal shutdown but agree with him prospects for job growth has diminished. At the same time, the expected one-year inflation rose to 3.3% from 3%. We at Saibus Research believe that the U.S. economy will grow at 1-2% annualized from H2 2013 through FY 2014 in the absence of any positive and unexpected catalysts.
We are not relying on emerging markets to continue the blistering rate of growth achieved last decade. Growth in India (around 5%), Brazil and Russia (around 2.5%) is barely half of what it was at the height of the boom. China’s projected 2013 growth of 7.5% is less than the double-digit rates achieved in the 2000s. Although we do not expect the emerging markets countries to suffer through an economic bust, future growth will be more gradual and measured. Investors should also realize that many once-in-a-lifetime factors helped drive the hyper-growth in the emerging markets in general and especially the BRICs (Brazil, Russia, India and China):
- Russia’s economic growth was due to surging energy prices
- China benefitted from its ability to offer cheap labor for multinational corporations who engaged in offshore outsourcing
- India also benefitted from its ability to offer cheap labor for multinational corporations who engaged in offshore outsourcing as well as economic liberalization reforms implemented in the 1990s
- Brazil’s economy grew by the decade-long commodities boom as well as growth in domestic credit and the continuation of economic reforms implemented by Fernando Henrique Cardoso which strengthened its currency and public finances
We recently devoted a report in which we analyzed and evaluated the bond market. Interest rates in the G7 countries bottomed out on May 2 and have been increasing ever since. We believe that this is due to the oversupply of government debt in those countries. We believe that investors are starting to demand higher interest rates as the central banks and governments in those countries are essentially monetizing their debt. The Federal Reserve’s easy money policies during the last decade helped push down the 10-Year U.S. Treasury rate from 6.58% at the beginning of 2000 to 1.66% as of May 2013. However, interest rates have increased throughout the G7 countries since May and the ever-present specter of rising government debt has contributed to the 10-Year U.S. Treasury rate increasing from 1.66% in May to 2.64% in September. Corporate borrowers have stepped into the bond market in order to take advantage of historically low interest rates and issued an all-time record for monthly corporate bond issuance ($193.7 Billion) in September 2013. We reiterate that investors that are interested or obligated to invest in debt securities should focus on high quality, short-duration securities.
In 2011, we were very enthusiastic about the stock market in general and many of our stock holdings in particular. The S&P 500 had increased by 9% from January 2011 to May 2011 but gave up its gains and racked up a net loss of 10% as of the end of September 2011. The S&P 500 trailing 12 month PE as of the end of September 2011 was 12.5X and we concluded that the market overreacted to the debt ceiling debate and resolution in 2011. With the S&P 500 TTM PE now at 19.3X, we believe that the stock market does not offer as much potential as it did in 2011. In 2011, we were more optimistic about the economy, earnings growth was stronger in 2011 versus 2013 and PE ratios were lower. Now that PEs are higher, earnings growth is sagging, revenue growth is anemic and we’re less optimistic about the economy in general, we believe that equity investors should look to take their profits whenever possible.
In conclusion, we have a downbeat outlook on the global economy in general and the U.S. economy in particular. We reiterate that investors should get more defensive with their investment portfolios. We are aware that the U.S. economy is not performing at a level reflecting its potential capabilities. At the same time, we are aware of many structural roadblocks that need elimination in order to enable the U.S. economy to perform at its potential. For those that are expecting emerging markets to pick up the slack from the developing markets, those countries are facing slower growth environments. Investors will be facing slower worldwide and have to deal with rising interest rates. This will provide two sets of headwinds for stock market investors. This combination is more than enough to turn us away from our previous bullishness on the economy and the stock market.
Past performance is not necessarily indicative of future results. All investments involve risk including the loss of principal. This report is confidential and may not be distributed without the express written consent of the original author and does not constitute a recommendation, an offer to sell or a solicitation of an offer to purchase any security or investment product. Any such offer or solicitation may only be made by means of delivery of an approved confidential private offering memorandum.
Investments may currently or in the future buy, sell, cover or otherwise change the form of its investment in the companies discussed in this letter for any reason. The author hereby disclaims any duty to provide any updates or changes to the information contained here including, without limitation, the manner or type of any of the investments.
All of the views expressed in this research report accurately reflect the research analysts’ personal views regarding any and all of the subject securities or issuers. The research analyst is not registered with FINRA, and may not be subject to FINRA rule 2711 restrictions on: communicating with the subject company, public appearances, and trading securities held in the research analysts’ account. No part of the analysts’ compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report. The analyst responsible for the production of this report certifies that the views expressed herein reflect his or her accurate personal and technical judgment at the moment of publication.
Under no circumstances must this document be considered an offer to buy, sell, subscribe for or trade securities or other instruments.
Disclosure: Analyst(s) publishing this report is short the TLT.
Copyright © 2013 Saibus Research. All rights reserved. This report or any portion hereof may not be reprinted, sold or redistributed without the written consent of Saibus Research.