Around the World and Back

By Ralph W. Cole Senior Vice President of Research

Around the World and Back I had the opportunity last week to travel to Hong Kong and Mumbai and meet with investment industry experts. Both economies appear to be improving, or at least, bottoming.

The Chinese have a fascinating process of selecting their new government leaders. While jockeying goes on for years in advance, the final selection process takes approximately a week behind closed doors. The announcement is made as the new regime takes the stage in The Great Hall of the People in Beijing. The country is literally waiting and watching to see who comes out on to the stage, and in what order. The seven members were led by Xi Jinping, who is the new President. Xi Jinping is viewed as somewhat of a reformist, but overall the seven member group is viewed as conservative, and reforms will continue at a slow pace. This selection process takes place once every ten years, which allows the Chinese government to be a little more strategic than ours here in the U.S.

As we all know, democracies can be messy, and while India’s is messier than most, they are making real progress. In the last couple of months India has passed pro-growth initiatives including: companies’ bill for improved corporate governance, and the allowance of foreign direct investment in aviation, multi-brand retail, insurance, broadcasting and power exchanges. Management teams in these industries will improve profitability, but more importantly, drive infrastructure improvements throughout the country. Several more government actions are expected to take place in the coming quarters.

Man Bites Dog The International Energy Agency said the U.S. will overtake Saudi Arabia as the world’s leading oil producer by 2017 and become a net exporter by 2030. The IEA went on to say that natural gas will surpass oil as the largest fuel in the U.S. by 2030. We have written extensively about the shale oil and gas revolution ongoing in the U.S., but even we were surprised by this headline. We will continue to weave this theme throughout client portfolios in the coming years.

Anyone Tired of the Fiscal Cliff yet? The President and Republicans have begun jockeying on the fiscal cliff and long-term fiscal reform. Having won the election, the President is pushing for higher tax revenues of $1.6 trillion over the next ten years. This is double the $800 billion that was almost agreed to last year during the debt ceiling debate. The President appears to be going “all in” on his populist platform, but the Republican House will be the key check on his ambitions. We hope that the initial salvo from the Oval Office is only a negotiating technique, and both sides can come to a reasonable agreement. The S&P 500 finished the week down 1.36 percent and the 10 year treasury yield drifted lower.

Our takeaways from the week

• Political and economic reforms occurring in India and China should make the countries more attractive to investors

• Market volatility will likely continue as long as lawmakers debate solutions to the fiscal cliff

Disclosures

Post-Election and Earnings Season Recap

by Shawn Narancich, CFA Vice President of Research

What’s Old Is New Again

 Investors on both sides of the aisle hoping that the certainty of having a declared winner of the U.S. presidential elections would lift stocks out of their recent funk were sorely disappointed this week. The post-election landscape looks much like the one that existed before Tuesday: a split Congress, an Obama presidency, and plenty of uncertainty about how the national leadership will address the fiscal cliff. Despite some evidence from both parties indicating a willingness to compromise, stocks fell sharply after the election and retreated 2.4 percent for the week. In contrast, fixed income investors took heart in an Obama presidency that would retain Bernanke and his easy money policies (for as long as he’s willing to serve), leaving Treasuries well bid in an environment of open-ended QE. Coupled with increased uncertainty about the fiscal cliff and its effect on economic growth, Treasury bonds gained, pushing the already low yield of the benchmark 10-year security to a slimmer 1.61 percent.

Jockeying for Position

The equity sector moves that followed Tuesday night’s drama spoke volumes about how investors view the post-election prospects for various industries. While the stock market was experiencing its worst daily decline in months, hospital stocks like HCA and Tenet Healthcare surged on the now certain implementation of ObamaCare, which promises to boost patient volume and reduce the bad debts of this industry that has long suffered write-offs from uninsured patients unable to pay their emergency room bills. In contrast, bank stocks like JP Morgan and Wells Fargo sank, as investors speculated that a continued slow-growth economy would mute loan volumes and hinder profitability. Energy stocks were also hit hard on concerns about more exacting environmental standards and a reduction of potentially available drilling acreage. And while consumer stocks outperformed on the belief that demand for Tide laundry detergent won’t vary much regardless of who occupies the White House, the typically defensive utilities sector outperformed by a surprisingly small margin due to concerns about tax rates on dividend income that are poised to rise.

Taxes … Nowhere to Go but Up?

Which brings us back to the fiscal cliff, the $600 billion of tax increases and spending cuts set to occur on the first of January absent Congressional action between now and year-end. We believe that lawmakers and the President will reach an agreement to forestall the most austere aspects of the cliff, but the more important question is, “When will true tax and spending reform occur?” If political leaders kick the proverbial can down the road and fail to establish a permanent tax structure while forestalling the entitlement reform necessary for putting the nation back on a sustainable fiscal path, new investment and hiring are likely to remain depressed. And while the fiscal detail is impossible to know, investors are correct to assume that taxes are going to increase and government spending is likely to fall. If any “grand bargain” is to occur between the Democrats and Republicans, it must contain both elements.

A Book End to Earnings Season

As investors continue to speculate about which platforms will prevail in the smart phone wars—Android, Apple’s iPhone or the new Windows 8 for those who prefer out of the money call options—one industry participant common to all three platforms continues to win … Qualcomm. Snapdragon chipsets flew off distributor shelves in the most recent quarter and, unlike most semiconductor companies, its chip prices actually increased. Against a backdrop of declining stock prices, Qualcomm’s stock rose 4 percent for the week as sales and earnings blew past expectations.

 Our Takeaways from the Week

•  U.S. elections reverberated through financial markets, pushing stocks broadly lower as investors jockeyed for position amid the new political reality
•  Fiscal headwinds are intensifying and threaten to slow the growth of an already modest economic expansion

 Disclosures

Weekly Market Makers - Week Ending 11/2/12

by Shawn Narancich, CFA Vice President of Research

A Perfect Storm?

Hurricane Sandy left investors with idle stock screens this Monday and Tuesday as the New York Stock Exchange closed for two consecutive days—the first time that weather has done so since 1888. The loss of life and property is sobering. Our collective thoughts and prayers go out to those affected by this killer storm, which left traders and media commentators to speculate about its economic and company specific impacts. Home improvement retailers Lowe’s and Home Depot, United Rentals and pump maker Pentair were among the winners when trading resumed Wednesday. Stocks succumbed to a late Friday sell-off that left the major indexes largely unchanged for the week, with benchmark Treasuries rallying modestly.

Our best guess is that Sandy will negatively impact fourth quarter GDP, but that a massive rebuilding effort in the nation’s most densely populated corridor will result in somewhat faster economic growth early next year. Insurable losses, excluding flood damage backstopped by the federal government, are estimated to be as high as $20 billion. Catastrophic claims will ding the near-term earnings of insurers like Allstate and Chubb, as well as their reinsurance partners, but the more important question for investors is whether Sandy will precipitate the kind of rate hikes that have historically enabled property and casualty insurers to exchange near-term pain for long-term gain. Ironically, both Allstate and Chubb recently reported better-than-expected earnings, with both citing benign claims activity.

Silver Linings

Despite the hurricane, the U.S. government hewed to its plan of releasing the October payroll report as originally planned. The numbers out Friday were better than expected, with net job creation totaling 171,000 and the previous two months’ job tally being upwardly revised by a cumulative 84,000 jobs. Service sectors such as retail and healthcare were notable contributors, and manufacturing jobs rebounded. The headline jobs number was encouraging, but an uptick in unemployment to a 7.9 percent rate coupled with an underemployment rate that remains near 15 percent are stark reminders of how just how slow the labor market recovery has been. Third quarter productivity gains of 1.9 percent confirm the job market weakness, portraying a private sector that favors squeezing more output from its existing employees to hiring anew. Because unemployment remains high, workers have little leverage to demand higher wages and, as a result, unit labor costs are falling. So while revenue gains are hard to come by at this point of the economic cycle, productivity is helping buoy corporate America’s bottom line.

The Late Innings of Earnings Season

Meanwhile, earnings season rolled on. Notable misses came from oil giants ExxonMobil and Chevron, both companies displaying continued declines in petroleum production exacerbated by cyclically low natural gas prices domestically. On the flip side, automakers GM and Ford reported surprisingly good numbers in light of the losses they continue to incur in Europe. Capacity there is being curtailed, but cutting jobs in Europe is a process, not an event.

Our Takeaways from the Week

•  Hurricane Sandy is exacting a substantial human and economic toll, but a resilient U.S. economy will likely recover lost output longer term
•  A surprisingly poor earnings season is beginning to wind down

Disclosures

Weekly Market Makers - Week Ending 10/26/12

by Shawn Narancich, CFA Vice President of Research

More Questions than Answers

Evidence of business malaise and a maturing business cycle continued to pile up in week three of the third quarter earnings season, with stocks succumbing to questions about peak sales and profit margins. For corporate executives, discretion is proving to be the better part of valor. Hesitancy to provide outlooks for 2013 reflects a European recession, slowing growth in China, and approaching fiscal headwinds that threaten to weaken a U.S. economy already flying at close to stall speed. Against this backdrop, earnings estimates and stock prices are falling. Benchmark Treasuries rallied modestly as large cap U.S. stocks fell 1.5 percent.

Hand in Glove

An initial read of 2 percent domestic growth for third quarter GDP provided apt context within which to consider the earnings of Caterpillar, DuPont, 3M and chipmaker Broadcom— all cyclical companies that told investors to reduce their fourth quarter profit expectations. Corroborating the weakness in machinery, chemical and semiconductor sales seen anecdotally in corporate America, the Commerce Department reported today that a decline in capital spending detracted from third quarter economic output. The irony of 10 percent growth in government spending lending a boost to third quarter GDP ahead of the looming fiscal cliff failed to give investors much confidence in the economy’s ongoing durability. Exports also detracted from GDP, confirming the slowdown in global trade. A bright spot is housing, which stands out for the contribution it is once again making to the GDP equation.

Exceptions to Every Rule

In a slow-growing economy exhibiting late cycle characteristics, the rare company reporting good third quarter earnings news was amply rewarded. For such disparate companies as Peabody Coal, Procter & Gamble and Yahoo, the lift these stocks received from earnings had much more to do with company specific factors than diverging views about the macroeconomic outlook. Peabody’s investors were greeted by 13 percent gains in the stock following a rare sales beat that occurred despite shuttered mines and low coal prices, with earnings benefitting from good cost control. At Procter & Gamble, better-than-expected sales and earnings cleared a low bar set after a string of disappointing quarters in which the consumer staples stalwart has ceded market share and attracted activist investor Bill Ackman. While the latest numbers were enough to alleviate some of the pressure on top management, P&G still needs to reinvigorate its top line and pare a bloated cost structure. Yahoo’s investors finally caught a break as well, with new CEO Marissa Mayer presiding over a quarter where numbers beat low expectations despite continued lackluster display add revenue.

Halfway through third quarter earnings season, an unflattering die has been cast and expectations reduced. Next week investors will tune into to reports from automakers GM and Ford, blue chip energy producers ExxonMobil and Chevron, and a slew of utilities that may have benefitted from an unusually warm summer that boosted air conditioning demand.

 Our Takeaways from the Week

• Poor third quarter earnings reports reflect a slow growth economy facing fiscal headwinds
• Limited earnings visibility has caused stocks to consolidate recent gains

Disclosures