Market Overview
While 2005 was full of surprises that had the potential to derail the economic expansion, perhaps the year's real surprise was the fact that the economy remained very robust in the face of the negative shocks. Despite oil prices hitting $70 per barrel and the City of New Orleans devastated by natural disaster, the economy still posted better than average growth. The long Treasury note did not rise, core inflation remained benign, and the dollar strengthened despite the pessimists' fixation on the trade deficit.
True to its form, the U.S. economy has once again demonstrated its resiliency and breadth. Unlike the late 1990's expansion that was driven primarily by the Information Technology and Telecommunication Services sectors, the current economic expansion enjoys broad participation across many sectors. Looking back, our optimistic view of the underlying economy was essentially correct, as was our expectation of continued strength in the global equity markets, although the U.S. equity markets' performance proved lackluster in the face of a rising U.S. interest rate environment.
U.S. Market Outlook
Now, with interest rate rises largely behind us and the underlying economy remaining in the middle of its stable-growth phase, we believe that the equity markets are poised for a good year. When considered in the context of interest rates, the market P/E level is at the low end of the historical range. We have had a record 13 straight quarters of double-digit earnings-per-share growth, and expect earnings to continue to grow at similar rates in 2006. With corporate balance sheets in great shape, capital spending should also continue at a healthy clip. Additionally, relatively low inflation and interest rates should continue to provide further fuel for the equity markets
The economic outlook reflects the mid-phase of the economic cycle which, if it remains on track, can last for several years. Entering 2006, strong economic fundamentals are providing a positive backdrop to the financial markets. We currently see many potential positive influences on the economy and financial markets, including:
- Oil prices may decline, easing the consumption squeeze for the lower half of wage earners
- Housing prices remaining in an uptrend
- Corporate spending continues to be strong
- Wage and salary levels increasing at a faster pace
- The Fed nearing the end of raising interest rates
- Recently reduced tax rates on capital gains and dividends likely to be extended
- Europe and Japan joining in on the global expansion
- Iraq is stabilized and Iran held in check
- The U.S. trade deficit shrinks
U.S. Market Review—Fourth Quarter 2005
The broad equity market (as represented by the S&P 500 Index) posted another positive quarter, up 2.08%, bringing the 2005 return to a modest 4.91%. Performance continues to come in spurts, with the majority of the fourth quarter gains stemming from a strong November, with the S&P 500 up 3.78% during that month.
Across market sectors, Energy was the worst performer for the quarter down almost 8%, giving back some of its gains from earlier in the year. Despite its fourth quarter retrenchment, Energy remained the best performing sector for 2005, returning 29% for the year. On the positive side, Materials and Financials were the best performing sectors for the quarter, up 10.6% and 7.5% respectively.
During the 4Q, we were encouraged to see large-cap—and what we would view as higher quality companies—up 2%, placing them on par with the mid-cap segment. Small-cap stocks underperformed again, up only 1%. For 2005, the mid-cap segment was once again the clear winner, with the Russell Midcap® Index up 12.7%. Small-cap stocks, as measured by the Russell 2000® index, however, underperformed with a mere 4.6% return for the year. While large-cap securities, as measured by the Russell 1000® Index, rose 6.3% in 2005,the large-cap growth universe has lagged mid-cap and small-cap growth stocks for some time now as indicated in the following charts. With the performance gap and the valuation opportunity becoming as wide as it has been in a generation or more, the relative cost of growth is cheapest in the large-cap universe.
Current Portfolio Positioning/ Outlook
Portfolio construction is not static from one calendar year to the next, but instead evolves—often incrementally—and will change as the year proceeds and events occur. As for our current portfolio positioning, we continue to believe that we are in the middle phase of the economic cycle, which is characterized by solid growth, although not at the dramatic levels witnessed in the earlier recovery phase of the cycle. In response, the portfolio is positioned for a market ready to recognize the economy's strength and benefit from strong corporate profits, increasing capital expenditures, and solid consumer sentiment.
We remain constructive on the Information Technology sector and favor companies with supply-side driven business models, high ROIC ratios, and healthy cash positions on their balance sheets. We continue to increase exposure to the Financials sector which has the potential to benefit should consumers shift to saving and investing in order to maximize household net worth. Given the sustained high energy prices and its impact on lower-income earning consumers, we have reduced Consumer Discretionary throughout 2005, focusing on companies within the sector that serve the high-end consumer. Overall, we are finding more attractive risk/reward opportunities among larger-cap higher quality companies with stable growth records, which is consistent with our assessment of being in the middle phase of the growth cycle.
2006 U.S. Equity Outlook
Questions and Answers
Question: What are your overall expectations for 2006?
Our current position appears to be quite close to the consensus, which is not typical for us. Being close to the consensus does not make us complacent, but instead makes us even more vigilant in looking for the potential positive or negative surprises that may affect the markets. Overall the U.S. economy is in very good health and growth is apparent in all market sectors. Interest rates are low and inflation appears to be low at the core level. Corporate balance sheets and cash flows look solid and the consumer is in better shape than debt levels and spending seem to indicate. Corporate spending should continue at a robust clip and consumer spending will continue to provide relief. This appears to be a good backdrop for equity and equity linked products, and a reasonable environment for bonds. While demographic trends favor fixed income over equity, valuation levels favor equity over fixed income indicating equity should provide a better return than fixed income in 2006.
Question: Given your overall positive outlook, what do you expect for stock and bond markets in 2006?
The equity markets are poised for another good year as long as fiscal and monetary policy errors are avoided. By our reckoning, the market P/E level is at the low end of the historical range if one properly factors in current interest rate levels. As noted in the above commentary, we have had a record 13 straight quarters of double-digit earnings-per-share growth, and expect earnings to continue to grow at similar rates in 2006. Corporate balance sheets are in great shape and capital spending should continue at a healthy clip. We believe that the low inflation and interest rates will continue to provide further fuel for the equity markets. We also expect equity-linked debt to do well: Convertible securities in particular should benefit from good equity markets and an improvement in valuation as hedge fund selling subsides. High yield debt is probably going to face some spread widening given the amount of very low grade debt raised in the previous two years and a potential increase in the bankruptcy rate among the lowest tier debt (an arena we typically avoid) that typically follows. But, the opportunity is still very good for high yield managers focusing on companies that may continue to benefit from the economic expansion, M&A activity and equity issuance that may boost their overall credit quality.
Question: What do you think of the change in leadership at the Fed?
Federal Reserve policy is very important in regards to the economy and financial markets. As the lender of last resort, the first line of defense for the value of our currency and the first line of offense to provide liquidity in a crisis, the Fed is extremely important. Alan Greenspan has provided many years of excellent service and is credited by many for driving down inflation and interest rates over the past 10 or 15 years. The trend towards low inflation and interest rates, however, has been a global phenomenon most likely precipitated by the end of the cold war and a function of the "flattening" of the world and the opening of trade since then. Therefore, the individual new Fed chairman may be less important than the maintenance and expansion of policies that promote global free trade and technological advances.
Question: You mentioned the positive effects of globalization. How does that square with the concerns voiced about the U.S. trade deficit?
For a number of years, the U.S. trade deficit (particularly between the U.S. and China) has been a topic of concern for many economists and market watchers. We have weighed in on the debate many times and continue to feel that the trade deficit measures only a portion of what it should. For example, the trade deficit measures trade dollars but not the profitability of that trade. However, as the financial markets instead focus on the profitability of the trade, the U.S. is clearly winning when it comes to trade with China. China is willing to trade with the U.S. at a loss or breakeven position in order to keep employment increasing as millions of its citizens leave the rural areas to seek employment in the cities. As a result, the U.S. benefits from less expensive products and from a low interest rate as China purchases U.S. government debt to support the trade. The other side of the ledger for the trade deficit is the investment surplus; although not often discussed as such, it is an accounting reality as the two must balance. The U.S. is the fastest growing developed economy and as a result, consumes more and is an attractive place to invest. Many economists believe that the best way to "fix" the deficit would be a U.S. recession, but we believe that in this case the cure would be worse than the alleged malady with the policy responses to the trade deficit more likely to be worse than the trade deficit itself. We will continue to watch how the politicians deal with this issue and if protectionist measures are pursued, we will become much more conservative with our portfolio positioning.
Question: So what are the threats to the economy or financial markets?
In the past, policy mistakes that undermined the U.S.' strengths in productivity, capitalism, and entrepreneurship have almost always been the precursor to the end of great investment environments and the driver of all major market declines. Keeping productivity high with low regulations and high investment levels in capital and equipment are crucial to continued growth. Free trade is about as important as any of the factors involved in global growth and rising living standards, while private property rights and low taxation keeps capital available for entrepreneurial pursuits and helps protect the capital they create. Policies that encourage and enhance the competitive advantages America has in the global markets are a plus, while policies that adversely affect this dynamic concern us.
Question: Is the low savings rate in the U.S. a concern for you, or is there more to the story?
As U.S. consumers, we continue to be disparaged in the media for living beyond our means, being greedy and lacking fiscal discipline. But the interpretation changes when considering that average household net worth has increased dramatically during the past 30 years. In previous commentaries, we have discussed measurement problems with the official savings rates and the fact that people maximize net-worth, not savings. A report (entitled "Disentangling the Wealth Effect: A Cohort Analysis of Household Savings in the 1990's" by Dean Maki and Michael Palumbo) measured savings rates by income category and found that all of the decline in measured savings can be accounted for by the wealthiest 20% of households: This group of higher-earners reduced their savings from current income while the remaining 80% of households in the U.S. continued to save at the same rate or more. Since the wealthiest 20% account for a significant percentage of the total dollar amount of savings, their reduction in savings creates the false impression that consumers as a whole no longer save. In reality, the wealthiest 20% of households' net-worth has still grown dramatically with the strong real estate and financial markets. As a result, they have been spending some of the wealth they have built up over the years. Since financial assets make up a larger share of the wealth for this group of the population, they will be more sensitive to financial market fluctuations and to spending than to real estate valuations.
Question: In 2005 you also favored international equity markets; do you still feel attractive investment opportunities exist outside the U.S.?
In 2005, as the international equity markets outperformed the U.S. market, our global and international strategies performed very well. Overall, the global opportunity is still very good, but in some of the developed countries we believe that the markets are ahead of the fundamentals. Europe's and Japan's equity markets performed very well in 2005; despite their economies being significantly weaker than the U.S. economy, the markets generally predict economic strengths. The seeds have been sown for improved economies in Japan and even Europe, with leading indicators improving greatly in both areas and additional support from low inflation and interest rates. Voters in Germany, France and Japan have called for a change, and one should expect some strong encouragement by consumers for further growth and opportunity. It makes sense to have exposure in these markets as a change wave occurs and they join in on the global expansion.