Relatively Speaking, A Benign Forecast
Everything in life is relative. One can compare mundane things like the days of the week; Mondays tend to be worse than Fridays, not because the workload is different, but because the former means the weekend is over, while the latter means the weekend is about to begin. One can compare important things like one’s salary; the satisfaction associated with the dollar amount of a paycheck is dependent on how it compares to the prior week, the prior year, and more often than not, how it compares to the paycheck of those that work around you. Even the big picture is relative; minor aches and pains can be annoying, but they pale in comparison to life threatening illnesses.
The financial markets are no different; they are a never ending series of relative comparisons. For instance, consider the markets’ actions during the third quarter of this year. The equity markets did well relative to where they were on June 30th. The Dow Jones Industrial Average1, the S&P 5002, and the NASDAQ Composite3 all rose in the neighborhood of 5%. The comparison is not quite so good however, relative to the returns posted this past spring; the Dow Jones Industrial Average1 is down about 5%, while the S&P 5002 and the NASDAQ Composite3 are down closer to 10%. Of course all three are up dramatically from their March 2009 lows, down dramatically from their late 2007 highs, and looking longer-term, the Dow Jones Industrial Average1 and S&P 5002 effectively unchanged since the start of the decade. The NASDAQ Composite3, on the other hand, remains much lower than where it was ten years ago.
Relative comparisons are just as common in the fixed income markets. The yield on a 10-year U.S. Treasury note is below 3.0%, which puts it about 100 basis points below this year’s highs. The yield is so low that it has triggered multiple discussions as to whether a bubble has developed in the bond market. That’s an entirely different topic, but as low as the yields are, they are still above the lows of late 2008. While current yields are down from their levels from the start of this decade, and substantially lower than their early 1980’s highs relative to inflation, Treasury yields do not appear quite so extreme. The difference between current 10-year yields and inflation, as measured by the CPI, is below the 30-year average, but that difference was even lower at the end of 2000, in early 2003, and from mid-2004 through mid-2006.
One can also look at inter-market comparisons. For instance, U.S. Treasury yields are now so low that stocks have become relatively competitive with bonds on an income generating basis. At the end of August, the dividend yield of the S&P 5002 was 2.13%, only 57 basis points below that of the 10-year Treasury. The average difference over the ten years leading into the credit crisis of 2008 was closer to 300 basis points. A slightly different income metric is the S&P 5002 earnings yield (i.e., the inverse of the P/E ratio). Over the past 50 years, the advantage of the S&P 5002 earnings yield relative to U.S. Treasuries was only this wide in the mid-1970s, the early 1980s, and at the height of the credit crisis in 2008. Through the 1980s and the 1990s, the earnings yield was generally less than that of Treasuries. The current elevated advantage is not due to a high earnings yield, since that measure is only slightly above its 50-year average (7.25% vs. 6.70%). Instead, it is attributable to the fact that U.S. Treasury yields are so low.
Treasury yields have dropped to especially low levels given growing concerns about the near-term rate(s) of economic growth, and because inflation fears have been dissipating, with an increasing number of market pundits discussing deflation. The concerns about the economy were summarized quite nicely in the Federal Open Market Committee’s (FOMC) August 10th press release, specifically:
“Information … indicates that the pace of recovery in output and employment has slowed in recent months. Household spending … remains constrained by high unemployment, modest income growth, lower housing wealth, and tight credit. Business spending is rising; however, investment in non-residential structures continues to be weak and employers remain reluctant to add to payrolls. Housing starts remain at a depressed level. Bank lending has continued to contract … the pace of economic recovery is likely to be more modest in the near term than had been anticipated.”
As was the consensus opinion regarding inflation:
“Measures of underlying inflation have trended lower in recent quarters and, with substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to be subdued for some time.”
While the FOMC did not explicitly mention the potential for and/or concerns about deflation, its comment about bank lending continuing to contract can be construed as an implicit reference, especially when one considers that statement in conjunction with the slow rates of M2 growth, the broadest monetary aggregate. On a year-over-year basis, M2 is growing at a rate of less than 3%, a rate of growth seen only in the early 1990s and briefly in 1970. With that in mind, the FOMC announced:
“… the Committee will keep constant the Federal Reserve’s holdings of securities at their current level by reinvesting principal payments from agency debt and agency mortgage-backed securities in longer-term Treasury securities. The Committee will continue to roll over the Federal Reserve’s holdings of Treasury securities as they mature.”
While the economic figures released during the month of September improved modestly, allaying the worst fears of most market participants, the road ahead is likely to remain bumpy. The consensus call on the economy, based on a Bloomberg survey, is for GDP to grow at a relatively muted rate of 2.5% in 2011 and for inflation to remain quite benign at a year-over-year rate of 1.5%.
The terms “muted” and “benign” bring us back to our initial point that everything is relative. It is a ubiquitous truism, especially as it pertains to the financial markets. When it comes to what that means for investors, a quote by Thomas Fuller sums it up quite well: “comparison, more than reality, makes men happy or wretched.” Fortunately, Manning & Napier’s fundamental approach and time-tested strategies allow our clients to find themselves, more often than not, in the former rather than the latter category.
Reflecting on the Past, Preparing for the Future
Manning & Napier is proud to be celebrating 40 years of helping clients meet their long-term investment goals. At this milestone anniversary, we are looking back on the key attributes that have proved essential to our success, but we’re also looking forward to ways we can continue to improve and better fulfill our clients’ needs. From the beginning, Manning & Napier has always emphasized strong client service, solving client problems, a team structure, and process over people – so that success could be repeated. Over time, our extensive experience has come from learning lessons along the way and never failing to ask what we could have done better.
During the past four decades, Manning & Napier has managed through multiple market ups and downs. From the early 1970’s downturn, to the 1987 stock market crash, or the bursting of the Dot.com bubble in 2000, Manning & Napier has remained committed to the core investment strategies that have defined our investment approach since 1970. Our investment approach has always been driven by active management and a focus on company-specific fundamentals. As such, our allocations to companies, industries, and sectors can vary widely from the benchmark, as we seek to target areas of the market that are presenting opportunities rather than areas represented by a particular index. Over the long-term, we believe this opportunistic and flexible approach has been a key factor in our ability to outperform market indices. However, over the short-term, this approach can lead us to be notably ahead of or behind the benchmark from a performance standpoint. Throughout the past four decades, there have of course been times in which we have lagged the general market. We happen to be in one of those periods today, but the good news is that our process has historically paid off over time. For instance, in the past when our Long-Term Growth Composite4 has underperformed over a six-month time period, future relative returns have been particularly strong.
Our performance may vary from the benchmark when we have a distinct investment outlook or when we have an opinion that may not yet be reflected in the market, which we believe to be the case now. Throughout this year, we have focused on high-quality companies with an identifiable competitive advantage that should allow them to grow and gain market share. This quality bias caused us to lag market returns earlier this year when all stocks rallied amid overly optimistic investor expectations. The more recent market correction, fueled by fears of a double-dip recession, hurt all companies and sectors without discriminating for quality or economic sensitivity. As a result, we have generally underperformed year-to-date on a relative basis, but we believe we are positioning our clients’ portfolios appropriately for the environment ahead.
Looking at the World Today
We continue to expect slow growth in the coming years. In last quarter’s Update, we stressed that swings in positive or negative sentiment might occur around this baseline trend of slow growth. Such oscillations have impacted short-term returns so far this year, but we believe that investing based on the fundamental economic reality will be more important over the long run. Ultimately, the economic reality is that an overhang of consumer and government debt throughout much of the developed world will likely result in a slow growth trend for years to come.
In particular, the U.S. consumer continues to work through substantial debt problems. By increasing savings and paying off debts, the U.S. consumer has made some progress, but this retrenchment process could take a while to play out. While a healthier consumer may be better for the economy in the long-run, over the near-term this rebuilding mode means that consumption is not likely to spark a sharp economic rebound, especially considering the U.S. consumer accounts for about 70% of the U.S. economy and nearly 20% of the global economy. Plus, consumers in many other major economies face high debt loads as well, which could lead to slower economic growth in much of the developed world.
Additionally, government debt levels have been rising as countries around the world have been spending heavily to dampen the economic downturn. In the U.S., fiscal stimulus is expected to start fading soon, which could act as a drag on growth in the coming quarters. Furthermore, the recent sovereign debt issues in the PIIGS (Portugal, Italy, Ireland, Greece, and Spain) have increased the focus on fiscal restraint and deficit reduction. While these goals may be important for the long-term, in the short-term they may result in policies that detract from growth as governments attempt to get their finances in order.
These pressures of a global economy working through debt problems typically push overall inflation lower. In the current environment, the significant economic slack leftover from the recession has kept inflationary forces in check, as reflected by subdued inflation expectations. While the Federal Reserve and other central bankers injected record amounts of money into the banking system in an effort to fight a debt-driven deflationary environment, there are not yet signs that this liquidity is leaving bank balance sheets. Simply put, bank lending remains depressed. For inflation to start to become a concern, we would need to see these factors reverse, evidenced by a narrowing of the output gap (i.e., the difference between potential and actual economic output), a pickup in bank lending, and higher inflation expectations.
While we do not consider inflation a near-term concern, we do believe inflation could appear in specific parts of the economy. Money tends to flow into areas of high return, so there may be pockets of inflation in industries that benefit from strong emerging market demand, such as food and energy commodities. Higher pricing power may also develop in certain industries that have a limited availability of supply because of a consolidation of competitors.
With this fairly bleak backdrop of muted growth and minimal inflation, Manning & Napier believes that active and flexible investment management provides the best prospects for success. While this type of environment may hold more risks, these conditions also present opportunities. The key is to be able to adjust allocations to companies, sectors, and asset classes as valuations and fundamentals change. In this particular environment, we believe winners will be first-class companies that can prosper and gain market share despite a sluggish economy.
Specifically, companies that have a presence in favorable foreign markets should be able to grow faster than the broader economy. Many of these companies will likely fall under our Strategic Profile Strategy, which seeks high-quality companies with a sustainable competitive advantage that will drive future growth. For example, we are currently finding opportunities in name brand consumer staples companies that have a majority of their sales overseas.
Our active stock selection strategies are also uncovering opportunities in certain industries that have a tight relationship between supply and demand. When an industry struggles through a downturn, weaker competitors are often forced to cut back or exit the business, which removes supply from the market. As demand starts to pickup, this limited supply usually allows the strongest competitors to take market share and increase their pricing power. In these cyclical conditions, we use our Hurdle Rate Strategy to target the best-positioned companies that should benefit as these pockets of inflation build up. Currently, we are seeing these types of opportunities in the airline industry.
Manning & Napier believes companies will eventually be rewarded for higher growth rates and gaining market share. Yet until the market begins to differentiate between the winners and the losers, our performance could continue to lag on a relative basis. Nonetheless, as an investment manager, Manning & Napier has always had a long-term focus. Short-term comparisons may become difficult along the way, but what matters the most is achieving absolute returns over full market cycles. As we take a look back over the past 40 years, we are pleased that our long-term investment objectives have served our clients well, and we are thankful for our many clients that have remained committed to us over the years.