Recent weakness in the S&P 500 has led to a lot of chatter regarding the inevitable pullback in equities. While the last few weeks have exhibited some weakness, stocks are still up close to 5 percent, year-to-date. While the United States continues to show improving growth, as seen in recent jobless claims and the Purchasing Managers Index (PMI), global political affairs have wound the markets tight. Russia continues to make noise in the Ukraine while the Middle East is demonstrating that nothing has (nor will) changed for decades. This uncertainty coupled with growth concerns in both China and Europe has led to a rally in bonds as well as a minor sell-off in equities.
The 10-year Treasury now yields just above 2.4 percent, which is the lowest in over a year, as global investors flock to the U.S. dollar and park cash in “risk free” assets. This flow of funds has resulted in weakness in equities. U.S. equities are down close to 4 percent from recent highs which have led to some talking heads focusing on an impending sell-off. However, these 2 to 5 percent pullbacks are normal in bull markets. For instance, over the last 30 months, we have seen nine 2+ percent pullbacks, but the S&P 500 is up over 60 percent in that period. What we continue to watch is improvement in the U.S. economy, growing corporate revenues and reasonable valuation. The current environment is favorable for all of those.
Messin’ with a Hurricane
This week brought the first hurricane to the Hawaiian Islands in 22 years, as well as a “storm of headlines” regarding U.S. companies relocating offshore. The equity market was not too happy with Walgreens’ decision earlier this week not to seek a “tax inversion” with its pending acquisition of Alliance Boots in Switzerland. While domiciling in Switzerland would have saved Walgreens billions of dollars in tax expenses, the company decided stay committed to the state of Illinois. There is speculation that the Obama administration’s use of the bully pulpit was a key factor in management’s decision to continue to pay higher taxes. We believe that an inversion would be more difficult for Walgreens to pull off since most of their revenues are generated in the U.S., thus no offshore cash to repatriate. On the other hand, companies like Abbvie and Medtronic have meaningful amounts of international business, thus their “inversion” acquisitions (Shire and Covidian, respectively) would be easier to justify.
What this recent trend highlights is the need to restructure the U.S. tax code so companies can be more competitive globally. While many of these deals may still be pursued, the tax savings is a key attribute in the overall structure. What can’t get lost in the noise is that although U.S. companies may change their mailing address, they will still bring their offshore cash back to the U.S. and reinvest domestically. With a mid-term election this year, major tax reform may not happen at least until 2015, and possibly not until after the 2016 presidential election.
Too High to Fly
A few weeks ago, the state of Washington started selling recreational marijuana which coincided with the cracking of the high-yield bubble. High-yield bonds have been a strong performer over the last several years; however, like stocks, the month of July hasn’t been friendly to the high-yield market. Spreads have started to increase in the face of lower Treasury yields. This culminated with over $7 billion exiting high-yield funds last week. We don’t believe this is a “canary in the coal mine” with respect to corporate America; however, we are watching it closely. High-yield bonds are trading at historically tight levels, just over 3 percent above Treasury yields, as investors seek income. The long-term average spread has been close to 6 percent higher than Treasuries. Therefore, we would not be surprised if that market continues to show poor performance as we revert back to the mean. While, there are times we may venture into lower rated bonds, we believe that the market as a whole is a bit rich and would wait for spreads to widen further before we allocate additional capital.
Our Takeaways for the Week
- Minor equity pullbacks are common and investors need to stay focuses on the fundamentals
- While July saw a “risk-off” market, we still believe equities will outperform bonds for the rest of 2014