The volatility we saw in 2015 has continued into 2016 driven by commodity prices, negative interest rates in Europe and Japan, concerns over China, and a concern that the global economic slowdown could spread to the U.S. economy. Layer on to those concerns the ramping up of Presidential election rhetoric and it is not surprising that volatility in the investment markets continues.
During this period, we have maintained strong cash positions and are taking advantage of bargains as they present themselves. While the stock market as a whole remains expensive, there are pockets that we believe represent excellent multi-year opportunities for investors. On the fixed-income front, the bond markets are being driven by the actions of “Foreign Central Bankers” and a U.S. Federal Reserve that seems to vacillate with each new data point.
U.S. ECONOMY and FIXED INCOME INVESTING
In her most recent speech on March 29th entitled “The Outlook, Uncertainty, and Monetary Policy” Janet L. Yellen, Chair of the U.S. Federal Reserve stated:
…the FOMC’s ability to use conventional monetary policy to respond to economic disturbances is asymmetric. If economic conditions were to strengthen considerably…the FOMC could readily raise its target range for the federal funds rate to stabilize the economy. By contrast, if the expansion was to falter or if inflation was to remain stubbornly low, the FOMC would be able to provide only a modest degree of additional stimulus by cutting the federal funds rate back to near zero.
One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment. Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could…put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities. While these tools may entail some risks…we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.
Chairwoman Yellen essentially stated that the Federal Reserve does not have the monetary tools available to them to mitigate a serious shock to the U.S. economy. What they do have is the ability to put downward pressure on interest rates through giving speeches i.e. “forward guidance” or further quantitative easing. According to recent studies by the Federal Reserve, these approaches had only marginal success in promoting economic growth over the past seven years.
The Federal Reserve is out of bullets and its Chair is increasingly cautious. Perhaps, not all is as well with the U.S. economic backdrop as the headlines would suggest.
Over the past several years, a boom in energy production, a surge in automobile demand and an improving housing market has supported the U.S. economy. In 2015, the U.S. Energy Complex went from boom to bust. Recently, automobile demand flattened out. However, the housing market seems to be holding its own. Consequently, U.S. economic growth seems to be coming in a bit more lethargic than it had been over the last few years. In fact, the Atlanta Fed’s estimate for U.S. economic growth in the First Quarter of 2016 is 0.4%–not exactly “knocking it out of the park.”
While the employment number has been holding up, the type of job creation we are seeing is a bit concerning. The March, 2016 U.S. Jobs Report showed continued improvement with the addition of 215,000 new jobs. However, less than 38% of those jobs were full time private sector jobs. This trend has been going on for some time as job growth occurs primarily in part-time service related sectors such as hospitality, leisure and healthcare, while manufacturing continues to decline.
We are seeing some other cracks in the U.S. employment picture. For example, The Conference Board’s Help Wanted Online Data Series shows that while employer job demand was flat for most of 2015, more recently and through this past quarter, online “help wanted” ads were down and this may be an indication that future demand is also softening. On top of this, we have seen a significant decline in the demand for temporary workers. Temporary workers are a great gage for both job demand and economic growth. As companies sense an increase in demand for their goods and services they would turn to contract or temporary labor to fill that need as the quickest and cheapest way to ramp up labor. Conversely, as employers see a slowdown in demand for their goods or services the quickest way to reduce costs is through the temporary labor force. The slowdown in “help wanted” ads and in the demand for temporary workers does not bode well for future jobs or economic growth.
With U.S. economic growth slowing, the Federal Reserve is unlikely to move quickly to increase short-term rates. Further, with the Presidential Election season upon us, there is zero possibility of any change in Fiscal Policy coming from Washington. Therefore, it is likely that the Federal Reserve will keep short-term interest rates lower longer even if we see economic data improve.
With signs of a slowing economy as a background, it is likely that fixed-income investors and savers will have to continue to deal with a low rate environment. We continue to recommend a laddered approach in High Quality Municipal Bonds, Investment-Grade Corporate Bonds, and Treasury Inflation Protected Bonds (TIPs). This approach will allow fixed-income investors to add bonds with higher rates once economic conditions change and the Federal Reserve moves rates higher.
On the equity side, all of the major markets across the globe remain in downtrends—from Europe to Asia to Emerging Markets and Commodities. Over the last 12 months, we have seen equity market decline around the Globe:
- Germany’s DAX is down -23%;
- Japan’s NIKKEI is down -28%;
- China’s Shanghai is down -41%;
- India’s Sensex is down -17%; and
- Canada’s TSX is down -14%.
During this same time period, the S&P 500 has been in a trading range between roughly 1800 on the downside and 2150 on the upside.
Unfortunately, while the U.S. markets have moved sideways for over a year now, valuations for the markets as a whole remain at or near historic highs. For example at the end of 2015 the median price to earnings ratio was 22, today it has risen to 22.6. (On average, the normal price to earnings on the S&P 500 is 16). The rise in this valuation was not driven by stock prices increasing, but rather because earnings for U.S. companies have been declining. We have now surpassed the valuation peak of 2007.
Even though the overall market may be expensive, we are finding opportunities in beaten down sub-sectors that we believe represent excellent long-term value—in particular, pharmaceuticals/biotech (BioPharma) and energy pipeline.
While BioPharma companies have recently been the target of Presidential politics, there are several factors that make investment in this area attractive—not the least of which is we are all still getting older. In fact, the fastest growing demographic cohort in the United States is the number of people living past the age of 100. People are living longer, healthier and are increasingly focused on the quality of their lives. As we age, we take more pills, have more medical procedures, and get more replacement parts. Finally, we are now entering a golden age for drug discovery and development. The unlocking of the human genome combined with sophisticated computer algorithms has accelerated the process of drug discovery tenfold. This confluence of an aging population and innovation will create a tailwind to this industry for years to come. Many of these companies are selling at discounts to the market, the overall Health Care Sector, and their own growth rates. We believe this is an opportunity to lock in great and growing companies at significantly discounted pricing.
This is not the first time we have seen this industry caught up in politics. However, current valuations combined with superior long term growth prospects makes these companies exceptionally compelling for long-term investors.
Another area of opportunity is the energy pipeline industry. While many of these stocks come with the burden of having to deal with K-1s during tax season, they represent a historical value opportunity. Because of the selloff in energy over the last two years, we have seen pipeline company stock prices pull back significantly and are now selling at valuations approaching levels last seen in 2009.
Think of these companies as toll both operators. While the oil and natural gas prices may move up and down, you still need to move product from wellhead to refiner and eventually to end user. The cheapest and most efficient way to do this is through a pipeline. The pipeline companies collect a toll for that movement generating huge levels of excess cash flow and paying this cash flow out to shareholders in the form of dividends and/or partnership distributions. Currently, many of these companies pay out two to three times the income that one could receive from the bond market. We believe this area represent an excellent way to generate both high current income and long-term capital appreciation.
ONE FINAL NOTE
Presidential election years without an incumbent are always periods of high uncertainty. The angst of the election is often reflected in an uptick in stock market volatility. While volatility can be difficult in the short-term, it often creates some of the best long-term investment opportunities. We will continue to keep higher levels of cash in your portfolios to allow you to pick up good long-term investments at discounted pricing. We have seen some good opportunities in the pharmaceutical and biotechnology space as well as the energy pipeline space and have added to those positions when appropriate. It would not be surprising to us to see more volatility this summer. As the winner of the U.S. Presidential Election becomes more apparent, the market should respond favorably to that clarity. In the meantime, we will use your strong cash positions to add good investments at a discount born from near term volatility and we will continue to use cash to dampen the effects of market volatility on your portfolio.
Please remember that past performance may not be indicative of future results. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment, investment strategy, or product made reference to directly or indirectly in this newsletter, will be profitable, equal any corresponding indicated historical performance level(s), or be suitable for your portfolio. Due to various factors, including changing market conditions, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this newsletter serves as the receipt of, or as a substitute for, personalized investment advice from Riggs Asset Management Company, Inc. To the extent that a reader has any questions regarding the applicability of any specific issue discussed above to his/her individual situation, he/she is encouraged to consult with the professional advisor of his/her choosing. A copy of our current written disclosure statement discussing our advisory services and fees is available for review upon request.