Manning & Napier December letter
The U.S. Economy
The usual flow of monthly information on the domestic economy did not reveal any major surprises over the past few weeks. U.S. retail sales rose 0.3% during October, erasing declines from September that were similar in magnitude. Of the 13 main retail categories tracked by the Department of Commerce, 11 showed growth versus the prior month. Sales at electronics and appliance stores as well as gas stations represented the weak spots. Electronics sales were strong in September coinciding with Apple’s release of new iPhone models so the drop in October likely reflected a waning impact of that recent sales boost. The decline in gas station sales is being driven by the downward trend in global oil prices feeding into lower domestic gasoline prices. The price per barrel of Brent crude oil was down more than 30% from the end of June through late November and the national average price for regular unleaded gasoline fell about one-third during that period as well.
Regarding inflation, lower energy prices are visible in the latest headline consumer price index (CPI) data. Year-over-year growth in the all items index has slowed modestly every month since May. In the year through October, headline inflation rose just under 1.7%. The recent trend in core inflation, which removes energy and food prices, has been flatter. Core prices increased 1.8% over the twelve months through October, slightly faster than the prior month’s 1.7% advance.
Lower gas prices effectively unshackle a portion of consumer spending. This generally has positive near-term implications for economic growth as consumers are likely to allocate resources that would otherwise have been spent on energy to purchases in other categories. However, given a change in the nature of global oil supply over the past few years, specifically the substantial increase in U.S. oil production from shale rock in regions such as the Bakken in North Dakota, market watchers should also consider the potential negative impact declining crude oil prices could have on the domestic economy.
The U.S. unemployment rate dipped below 6% earlier this year for the first time since 2008. Some of the improvement in labor markets since the financial crisis can be attributed to growth in domestic oil production. If oil prices remain weak for too long, energy companies may be forced to shutter production and reduce their workforce. This could create headwinds in other areas of the economy and offset some of the boost to growth that typically comes from lower energy costs.
Importantly, we believe any adverse consequences from lower oil prices would not be enough to meaningfully impair the current slow growth environment, but with the U.S. a more prominent contributor to global oil supply in recent times, investors will want to pay attention to this aspect of the economic growth equation.
On the domestic political front, 2014 has contrasted with the fanfare and fireworks of last year that culminated with a 16 day federal government shutdown. That being said, mid-term election results could spur bickering anew as Republicans now hold majorities in both houses of Congress and a Democrat continues to occupy the White House.
We believe it is unlikely that any major policy moves will be made on hot-button issues such as health care or tax reform prior to the 2016 elections. The president’s veto power contributes to this view. While Republicans control both houses, they lack the two-thirds majority needed to override a presidential veto. Additionally, with Democratic support as weak as it has been recently, Republicans do not stand to gain much by attempting to make significant changes at the moment. Rather, we envision a scenario over the next two years in which the GOP simply works to avoid making major missteps and focuses on repeating their recent election success in the upcoming race for president.
A bevy of recently released third quarter GDP reports confirm that some of the world’s most important economies continue to struggle. The pace of expansion in the 18-member Eurozone quickened relative to the second quarter, but was barely positive in absolute terms. Real GDP rose a meager 0.2% for the July through September period. Examining GDP among individual countries, France’s economy returned to growth after contracting during the second quarter. Real GDP in France advanced 0.3% quarter-over-quarter. Germany also narrowly avoided entering recession as contracting GDP during the second quarter gave way to a modest 0.1% rate of expansion during the third quarter. Meanwhile, Italy’s recession continued. Italian GDP shrank 0.1%. Italy’s economy has now contracted in 12 of the past 13 quarters.
While still weak in an absolute sense, Greece and Spain represented two of the fastest growing European economies during the third quarter. Real GDP in Spain grew 0.5% quarter-over-quarter and Greek GDP increased 0.7%. Encouragingly, after six long years of recession, recently revised data show that Greece emerged from recession earlier this year.
The generally weak global economic news also extended to Japan. Reports show that its economy continued to shrink during the third quarter, still unable to overcome the sales tax hike from April and subsequent blow to consumer spending. Japan is now in recession for the third time since 2010. Real GDP fell 0.4% for the July through September period following a 1.9% decline during the prior three months.
Responding to the weak economic performance, Prime Minister Abe dissolved the lower house of parliament and announced a snap election to take place in mid-December. This maneuver is meant to reaffirm support for the prime minister’s “Abenomics” strategy.
If his ruling Liberal Democratic Party loses its majority in the lower house, it would reflect disapproval of Abe’s economic programs and he would resign. Along with this announcement, Japan said it will also delay until 2017 another planned sales tax increase that was originally scheduled to occur in the fourth quarter of next year.
Stripping out the impact from this year’s sales tax hike, Japanese inflation continues to run below the Bank of Japan’s (BOJ) 2% target. To help combat this, in late October the BOJ announced plans to meaningfully boost its monetary stimulus efforts. Yen weakness was exacerbated by the news, with the currency down 5% relative to the U.S. dollar in a matter of weeks. Overall, while Japan’s economy is still clearly struggling to digest the tax hike and more stimulus is needed, we believe it is unlikely that opposition lawmakers gain enough support to spur Abe’s resignation when voters go to polls in December.
Volatility returned to financial markets during recent months. Concerns about global growth and shifting expectations regarding the way forward for domestic monetary policy underlie these market fluctuations. The volatility provides an opportunity to shift positioning toward areas where we see the most attractive risk/reward dynamics. As the broad U.S. stock market quickly recovered from near-term lows, valuations remain elevated as compared to recent years. That being said, we see little evidence of the types of extremes that typically lead to large and lasting selloffs. While measures of bullishness subsided somewhat, there remain signs of complacency in the market that we are monitoring closely. In this environment discernment and flexibility are critical.
In portfolios geared toward investors that need capital growth, our main focus is on identifying companies that can grow in an otherwise growth-challenged global economy. We are looking for businesses that have control of their own destiny and are taking share in large established markets or are creating new markets on their own. The goal is to identify companies trading at attractive valuations relative to their growth potential. In our view, reinvestment rate risk remains the key challenge facing long-term investors that need capital growth. Investing in companies with good fundamentals and tailwinds at their back should help investors combat this risk.
For fixed income investors and investors with a shorter time horizon or current income needs we continue to focus on opportunities we are seeing in investment-grade corporate bonds. A selective approach to the below investment-grade corporate space is helping us find value there as well, however opportunities are becoming more scarce as investors reach for yield. With regard to government debt, we continue to favor Agencies over Treasuries. In light of absolute rates in today’s fixed income markets, we believe shorter-term maturities offer a better risk/reward trade-off. In our view, short-term and income-oriented investors should also explore equities that display stable fundamentals and are trading at attractive valuations. We believe companies that generate strong, stable cash flows, and pay an attractive dividend could be compelling options for these types of investors in the current environment.
Source: FactSet. Analysis: Manning & Napier Advisors, LLC (Manning & Napier).
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