Manning & Napier letter
The U.S. Economy
The U.S. economy expanded faster than originally thought during the third quarter 2014 according to the most recent GDP growth estimate from the Bureau of Economic Analysis. Domestic output adjusted for inflation rose at a 5% annualized rate from July through September. This upward revision from the prior 3.9% growth estimate was due to larger increases in business and consumer spending. Occurring on the heels of the second quarter’s solid 4.6% annualized growth pace, the U.S. economy has not grown this strongly in consecutive quarters since 2003.
There was also some good news on Capitol Hill during recent weeks. Although the process offered glimpses of the deep ideological divide that exists between Democrats and Republicans today, elected officials were still able to come to agreement on a $1.1 trillion budget plan for the U.S. federal government that should fund operations through September 2015. As the spending bill made its way through Congress there was concern that some lawmakers might dig in their heels and provoke a government shutdown situation reminiscent of 2013. In the end, the process occurred somewhat quickly and with relatively little political wrangling. This should move contentious fiscal debates closer to the bottom of the list of potential 2015 developments investors might worry about.
Regarding monetary policy, once again market watchers anxiously awaited the official statement from the Federal Open Market Committee (FOMC) following its December 2014 meeting. The main question was whether the Committee would continue to include “considerable time” language in reference to how long it will be between the end of quantitative easing and the first hike in policy interest rates. Indeed, the Fed did modify its description of timing by stating that “it can be patient in beginning to normalize the stance of monetary policy,” but then quickly noted that this was consistent with prior guidance calling for “considerable time.” As such, despite all the market attention the FOMC’s message was little changed as compared to recent meetings. Investors should expect the Committee to adjust monetary policy only when incoming economic data justifies doing so. The market consensus continues to anticipate an interest rate increase in mid-2015.
Consumers’ financial health remains a focal point in the current economic cycle and other data reflected ongoing progress in this area. Nonfarm payrolls surged during November with 321,000 jobs added to the U.S. economy. This represents the best month of domestic job creation since January 2012 and was only the fifth occasion in the post-recession environment with payroll additions exceeding 300,000 in a single month.
November’s job growth was broad-based. Professional and business services experienced the largest monthly gain as 86,000 new positions were added in those sectors. Arguably more important than the headline job creation figure was information within the report pertaining to wage growth. Average hourly earnings rose 0.4% month-over-month in November, marking the strongest one-month increase in 2014 as of December. On a year-over-year basis, growth in hourly earnings accelerated slightly to 2.1% from 2% the prior month.
Rising wages and cheaper fuel costs helped lift consumer sentiment to levels not seen since before the financial crisis. Having risen nearly 10 points during the fourth quarter, the University of Michigan’s Consumer Sentiment Index stood at 93.6 in December. The last time this measure of consumers’ feelings toward the economy and their financial wellbeing exceeded the 90 level was 2007.
While the domestic economy has experienced a number of distinct positives in recent months, we believe it is important to remind readers that we continue to expect a slow growth environment in the U.S. during 2015. The modest acceleration in wage growth we have seen of late is encouraging (particularly given that it has coincided with strong job growth suggesting that slack in the labor market is slowly diminishing), but further improvement would be required to maintain a GDP growth pace similar to that of recent quarters.
Global Economy
The People’s Bank of China (PBOC) unexpectedly reduced important policy interest rates during late November in response to recent indications that the pace of expansion in the world’s second largest economy is slowing. For the first time since the summer of 2012, the PBOC lowered its one-year lending rate, which dropped to 5.6% from 6%. The central bank also trimmed benchmark one-year deposit rates to 2.75% from 3%.
Beneath the ebb and flow of information on China’s growth trajectory over the past few years is the transition away from investment being the primary economic engine. As consumption slowly becomes the key driver of growth in China, a number of policy changes are expected to help facilitate the shift. A recently announced plan to implement bank deposit insurance is one such adjustment. Recall that “shadow banking” (a system where unregulated non-bank entities provide financial services similar to those offered by regulated banks) has long been a source of concern in China due to poor information on fund flows and credit quality.
We believe the creation of deposit insurance should reduce the prevalence of shadow banking and thereby limit the potential for harmful consequences to the financial sector and economy in a default scenario. The program is similar to the Federal Deposit Insurance Corporation (FDIC) in the U.S. insofar as it will guarantee deposits up to a certain amount (500,000 yuan or about $80,000) and banks will be required to pay a small premium to participate. While adjustments to the banking landscape in China such as this are unlikely to meaningfully improve the near-term economic growth outlook, to the extent that deposit insurance lifts confidence in China’s formal banking sector, the overall financial system should be stronger for it. The move is also a necessary step in deregulating interest rates on savings and is likely to boost competition between banks.
A risk we will need to monitor is if growth at the biggest banks becomes excessive such that they might be deemed “too big to fail” in the event of a financial crisis.
Russia is another influential emerging market economy experiencing measurable growth challenges lately. Its problems stem from two major issues: Western sanctions imposed after Russia began agitating in Ukraine and falling oil prices. Russia is the world’s second largest oil exporter so a weak global oil market translates to a weak economy in Russia. An official report from Russia’s Economic Development Ministry in late December said the economy contracted 0.5% year-over-year through November. Meanwhile the ruble’s value has been plummeting. About two weeks prior to the economic growth news the Russian central bank aggressively raised interest rates (from 10.5% to 17% on the one-week repo rate) to prevent further currency depreciation.
Our Perspective
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. Regarding investor sentiment, 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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