Contributing Factors to First Quarter Market Movements
There are two types of factors that move the financial markets:
- endogenous factors, those that develop from within, that can be modeled, and to a certain extent that can be forecasted and
- exogenous factors, those that develop from without, are not included in most models, and cannot be forecasted.
Improvements in the labor markets, consumer spending, and the manufacturing sector of the economy tend to fall into the former category, while Middle East turmoil and the devastating earthquake in Japan definitely fall into the latter.
Endogenously speaking, the first quarter of 2011 was quite good. While still in a convalescent phase, the labor markets continued to improve. Initial claims for unemployment insurance, which averaged more than 450,000 per week during the first three quarters of 2010, started to drift lower during the fourth quarter of last year and continued that trend into the first quarter of 2011, breaking through the 375,000 level. That has allowed non-farm payrolls to start to grow once again, with close to 200,000 jobs being added in February. The improvements in the labor markets have been even more noticeable in the unemployment figures – the rate has dropped from 9.8% last November to 8.9% in February.
As the labor markets have started to recover, so too has consumer confidence and that has translated into increased consumer spending. The nominal year-over-year growth rate in retail sales has more than doubled since last summer, coming in at just under 9.0% in February. The growth rate of personal consumption expenditures, which include most of the retail sales figures, plus spending on services, has also doubled on a year-over-year basis. Measured in real terms, the growth rate rose from less than 1.5% to just under 3.0%.
It is not simply the consumer sector that has been performing well. The Institute of Supply Management’s (ISM) Manufacturing Composite Index hit a cyclical high of 61.4 in February. This is its highest reading since 2004 and one would need to go back to the early 1980s to find comparable readings. The new orders and employment components of the ISM manufacturing release are equally elevated. The Philadelphia Fed Business Outlook Survey reinforced the ISM Manufacturing report as it too posted readings not seen since the early 1980s.
As for the Federal Reserve, the Federal Open Market Committee (FOMC) met in mid-March; in its press release after the meeting it recognized that “information received since the FOMC met in January suggests that the economic recovery is on a firmer footing, and overall conditions in the labor market appear to be improving gradually. Household spending and business investment in equipment and software continue to expand.” The FOMC nonetheless remained concerned about an elevated unemployment rate, weakness in nonresidential structures, and a depressed housing sector. With the underlying measures of inflation remaining “somewhat low,” the Fed indicated that it would continue with its asset purchases (commonly referred to as QE2), and that the targeted Fed Funds rate would be kept near zero, likely to remain there “for an extended period.”
The endogenous factors, which as detailed were quite positive, contributed to solid equity market returns during the first half of the first quarter. The major market indices (Dow Jones Industrial Average Index1, S&P 500 Total Return Index2, and NASDAQ Composite Index3) were all up more than 5% through mid-February. Unfortunately, good endogenous news does not usually bode well for the bond market and this was no different. The yield on the 10-year U.S. Treasury Note rose by about 50 basis points.
Turning now to the exogenous factors, there were problems during the first quarter of 2011. The turmoil that spread throughout the Arab world began in Tunisia in December of last year. Protests that were sparked by a self-immolation resulted in the ouster of the Tunisian President in mid-January, ending 23 years of control. That seemed to embolden the rest of the Middle East. At the end of January, protests and riots spread to Egypt, a larger and far more important country, causing President Mubarak to resign in mid-February. There were similar riots in Yemen and Bahrain, citizens in Saudi Arabia and Syria staged sporadic protests, and Libya disintegrated into a full fledged civil war that resulted in the developed world deciding to intervene.
Unrest causes uncertainty; the greater the level of unrest, the greater the uncertainty. The equity markets dislike uncertainty and as the unrest spread throughout the Arab region, the markets’ discomfort level rose, causing the markets to drift lower. At the same time, the turmoil contributed to a $10 USD per barrel spike in oil prices. Rising oil prices tend to act as an economic headwind. While most would agree with the Fed that the economy was on firmer footing, most would also admit that they are not so sure that the footing is sufficiently firm such that it can withstand sustained headwinds.
The earthquake and resulting tsunami that devastated Japan in March, plus the subsequent nuclear crisis, were extraordinarily tragic events. Thousands of lives have been lost, property damages are in the hundreds of billions of dollars, and the environmental damage is likely to linger for years, if not decades. While these are the issues that require our greatest attention and sympathy, the fact of the matter is that the events in Japan added to the markets’ concerns, and possibly added to the economic headwinds. That caused equity markets to ratchet lower in mid-to-late March, and the ensuing flight to quality pushed U.S. Treasury yields lower.
The markets are moved each quarter by some combination of endogenous and exogenous factors. The first quarter of 2011 stands out given the magnitude of its exogenous events. It does, however, provide an important investment insight. Exogenous events, by definition, cannot be easily modeled, or forecasted. And given their random nature, we believe investors are best served by concentrating on the long-term fundamentals, applying time-tested investment strategies, and looking to make investments at reasonable prices – the investment approach that Manning & Napier has applied for more than 40 years.
A Glass Half Full Perspective
What classifies something as “half full” instead of “half empty?” It’s really a matter of expectations and perspective. The distinction between the two views may not be significant. However, a realistic understanding of the general trend is important, especially from an investment standpoint.
As the U.S. and global economy work to establish a solid footing, Manning & Napier would classify our outlook as “half full.” Put another way, we are cautiously optimistic about the prospects for a slow growth environment going forward. The economy has made noteworthy progress, but there are distinct structural issues such as a difficult job market and elevated government debt burdens that still need to be tackled.
In these first three months of 2011, sentiment regarding the U.S. economy and stock market has been predominantly upbeat. From consumer spending to small business confidence, much of the economic news has been encouraging, resulting in a wave of positive momentum for most of the first quarter. By the end of March, tensions in the Middle East, escalating oil prices, and the tsunami in Japan have introduced some fear and risk aversion back into the market. So far these events have not caused a pronounced swing toward pessimism, as there is still evidence of a self-sustaining recovery taking hold. Nonetheless, these unfortunate shocks serve as a reminder that we remain in a relatively uneven market environment. As we have emphasized in past communications, fluctuations of sentiment around a slow-growth trend may be part of the investment landscape for some time.
Looking at the underlying growth trend, the overall outlook for U.S. growth seems to be improving. However, that upward growth trajectory may largely be the result of temporary factors. In particular, the U.S. economy was aided recently by the second round of quantitative easing and the year-end tax compromise, which extended the Bush-era tax cuts for all income brackets. While difficult to measure, Manning & Napier believes this monetary and fiscal stimulus has lifted confidence and growth rates. Such support may be beneficial on a short-term basis, but sources of sustainable growth are what matters over the long run.
Achieving sustainable growth over the long-term is largely dependent on the consumer, which accounts for about 70% of the U.S. economy. Indeed, the consumer is undoubtedly healthier than when the U.S. entered the recession. Debt levels have subsided as consumers have paid off loans, defaulted, and/or decreased spending. Personal income growth has also stabilized due to an increase in hours worked and modest job growth. This improvement means that the worst of the consumer retrenchment process may be behind us, but we still do not expect a sharp rebound in consumption going forward. In fact, much of the growth in incomes has been dependent on government transfer payments (i.e., unemployment benefits), and the job market remains weak as well. All in all, the consumer is better, but not great. With the consumer healing process still underway, we feel a “half full” perspective for the U.S. economy is appropriate.
As the consumer slowly works through high debt burdens, U.S. growth has been heavily reliant on investment throughout the recovery. Capital spending and inventory accumulation have accounted for a noticeable part of GDP growth over the past year, although a slowdown in business investment subtracted from growth during the fourth quarter of 2010. This dependence on investment means the economy may be more sensitive to business cycles going forward, which could lead to greater volatility, and provides another reason to remain cautious in our outlook for slow growth in the coming years.
Manning & Napier’s “half full” perspective also applies to the equity markets. As the equation below shows, after rebounding off extreme lows, it would require growth in sales, margins, or valuation multiples to get higher stock market returns going forward.
Price = Sales x Margin x Valuation Multiple
As for sales, with a slow growth economic outlook, we would expect most companies’ sales to grow by mid-to-high single digit percentage points for the next few years, not enough to spark a major stock market rally. Moving to the second variable, profit margins have already surpassed 2007 peak levels as a result of aggressive spending and labor cuts. Companies have squeezed most of the efficiencies they can out of their current operations, and plans for more capital spending and hiring seem to be on the rise. Given this backdrop, expected improvement in margins from this point may be optimistic. Lastly, valuation multiples are neither at extreme positives or negatives, making it difficult to predict multiple expansion or contraction going forward. Overall, we believe the market is generally in a neutral state, with the potential for some risk as well as modest returns ahead.
Risks & Opportunities
In the context of our “half full” viewpoint, we see certain risks and opportunities over the next year. Perhaps the greatest risk is that investors start seeing visions of a “full glass,” expecting uninterrupted progress going forward. This could happen if investors believe the effects of recent fiscal and monetary stimulus in the U.S. will continue. Such sources of growth are not sustainable; they will eventually taper off, which could create some disappointment. Meanwhile, there is also the risk that external shocks such as the recent events in the Middle East and Japan create a panic in the markets. The markets have been volatile over the past year, and swings in sentiment could continue to occur as investors react to positive and negative news.
One additional risk we are monitoring is inflation. The U.S. and much of the developed world are still working through the significant amount of slack left over from the recession, which does not reflect conditions that typically result in broad-based inflation. However, as money flows toward areas of high returns, pockets of inflation are developing in certain industries and countries that have tight supply versus demand. In particular, the emerging markets and commodities such as energy and food are experiencing inflationary pressures. There is a risk that emerging market growth could be hampered by these rising inflationary pressures, especially as these governments tighten monetary policy in an effort to control escalating prices. That could result in slower overall global GDP. Nonetheless, inflationary pressures can also create investment opportunities, and we are looking to capitalize on such opportunities by owning well-positioned companies in industries that have tight supply relative to demand. Current examples include the energy and airline industries.
In terms of broader opportunities, we believe many people may be sitting on the sidelines and not looking to participate in the equity markets right now. As investors have pulled money out of the market over the past few years, equity mutual fund outflows have generally flattened valuations and increased the correlations of stocks, which means stocks have generally been rising and falling as a group instead of based upon their own merits. While such an environment may be difficult for active managers in the short-term, we believe it presents the potential to find attractive long-term investment opportunities. With this mindset, Manning & Napier is committed to our active and selective investment approach. In a muted economic backdrop, we believe companies that can achieve sustainable growth will eventually earn a premium. Therefore, we are seeking specific companies that have a competitive advantage that can drive growth, as well as “away game winners” that can successfully compete in international markets.
Manning & Napier has always been an investment manager that seeks, above all else, to produce positive returns over full market cycles. With this long-term perspective, we continue to focus on the fundamentals, adhering to the same disciplined investment strategies that we believe have served our clients well over the past four decades.