Early Christmas Gifts

by Shawn Narancich, CFA Executive Vice President of Research

Early Christmas Gifts

In what turned out to be a surprisingly action-packed week before Christmas, the markets finally shook off the shackles of worry concerning what would happen when the Fed began tapering its program of quantitative easing (QE). Bernanke proved that he’s no lame duck chairman and investors learned that stocks can still go up despite a slightly less accommodative Fed. In reducing monthly purchases of Treasury and mortgage-backed bonds by $10 billion per month, our central bank is acknowledging a slowly improving labor market and an expanding economy that is being boosted by several key drivers: a renaissance in U.S. energy production and manufacturing and, increasingly, the wealth effect of rising house and stock prices that is giving a nice lift to consumer spending. Looking ahead, we expect incoming Fed Chair Janet Yellen to continue what Bernanke started. Our view is that further reductions to QE will be commensurate with continued improvement in labor markets, subject as always to the Fed’s other key mandate—keeping inflation low.

Always a Bear Market Somewhere

In stark contrast to stock prices that are once again setting new highs, gold prices have fallen substantially. After attracting increasing amounts of attention as a hedge against monetary dislocation and unchecked growth in the money supply, gold is increasingly being abandoned by investors now more attracted to robust stock market returns and, for those with a lower risk tolerance, bonds that are now offering real rates of return. From its high in August 2011, gold is now down 36 percent. It may be pretty to look at, but with the Fed now in the early stages of unwinding QE, it has lost its shine.

Blue Burner

Sticking to the commodity theme, one key source of energy whose price is going the opposite direction is natural gas. Much maligned by investors because of its seeming ubiquity, the front-month contract is up 31 percent since August. Cold weather has boosted the demand for natural gas, one of the nation’s most common sources of home heating. Weather vicissitudes aside, we like the longer-term demand case for the cleaner burning fuel to take market share of electricity generation from its dirtier cousin coal. Will gas currently priced for $4.40 per-million-BTUs go to $5.50? In the short-term, probably not, because the prolific shale fields in Pennsylvania, Wyoming and Texas will induce considerably more production if prices continue to rise.

Nevertheless, key suppliers can make a lot of money with natural gas prices in the $4.00 to $5.00 range. More importantly, our economy should increasingly benefit from using low cost natural gas and natural gas liquids to generate cheaper power and manufacture plastics. In the latter case, low cost ethane, propane and butane feedstocks are displacing oil-based naptha, incenting major chemical companies like Dow and the petrochemical arm of Shell to locate plastic manufacturing facilities stateside. The beneficial result for America is new jobs, additional exports, and healthier levels of GDP growth.

In this festive season, we wish all our friends and clients a Merry Christmas and a very happy and healthy new year.

Our Takeaways from the Week

• Investors took the start of Fed tapering in stride, as stocks rallied to new highs

• A continued flow of encouraging economic data points to faster GDP growth in 2014

Disclosures

Black Friday Magic

by Jason Norris, CFA Senior Vice President of Research

Good Mourning Black Friday, Welcome Cyber Monday

Black Friday shopping numbers were not much to write home about, but it is uncertain if it is the state of the consumer or the “expansion” of Thanksgiving weekend specials to the day of turkey day or even before. Thirty-three percent of “Black Friday” shopping occurred on Thursday, up from 13 percent in 2011. Over the entire weekend, traffic remained healthy; however, sales were a bit below expectations (up 2.3 percent) and would have been negative if not for 15 percent growth in online sales over the weekend. The weakness was most notable in the Northeast.

The other phenomenon is the growth of Cyber Monday. Online sales that day (the Monday following Thanksgiving weekend) were up over 19 percent and are projected to be up 15 percent this holiday season. Online sales will account for 14 percent of the $600 billion expected to be spent this season. While Amazon.com continues to be the main beneficiary of this trend, valuation metrics can’t get us excited about the stock, but as consumers we continue to benefit.

Learning to Fly

Speaking of Amazon, its CEO Jeff Bezos was interviewed on 60 Minutes and pulled off a great publicity stunt to keep the e-commerce retailer in the news all week. If you haven’t already heard, Mr. Bezos announced that Amazon was looking at using unmanned drones to deliver packages. While Amazon has a reputation of being a visionary and willing to invest in growth, the near-term applications of this announcement seem more or less PR rather than delivery. We just hope it doesn’t get to the point where our kids can’t enjoy the snow during the holidays because they will have to be avoiding all the Amazon package deliveries from the sky.

Detroit Rock City

Looks like we are witnessing a slow motion car accident with the approval of a federal bankruptcy filing by the city of Detroit. Deidra Krys-Rusoff, Ferguson Wellman’s municipal bond analyst and portfolio manager, believes that with U.S. Bankruptcy Judge Steven Rhodes ruling that Detroit is eligible to file for bankruptcy protection it may permit them to emerge from $18 billion of debt. This ruling grants the city the power to establish a financial plan which will allow the city to provide public services while meeting adjusted debt obligations. Judge Rhodes also ruled that pensions may be adjusted under federal bankruptcy, despite the fact that Michigan’s constitution does not allow for cuts to established pension obligations. This ruling may permit the trimming of pensions and retirement benefits, taking away the “protected” status usually afforded to the plans and placing them on an equal platform to other creditors (such as bondholders).  We expect unions to fully challenge this decision, and the local union has already filed an appeal.

We believe that this event is isolated and should not have an overarching effect on the muni market. Any way you look at it though, this may end the same way as the 1976 classic song at some parties.

Stagefright

This week was the 17^th anniversary of FED Chairman Greenspan’s “irrational exuberance” speech, and investors are anxious for what to expect in 2014 after a 25 percent+ move in equities this year. While this week we have seen some weakness in stocks as rates have risen, we still don’t foresee a major sell off. Putting history in context, in the bull market run from 1990 through 1996, equities DID NOT have a 10 percent correction, and we didn’t peak until March 2000. We are not saying that history will repeat itself, but with the U.S. economy improving and inflation remaining tepid, we would be buyers of equities on any major pullback.

Our Takeaways for the Week:

• Even though stocks have run, we are still constructive on equities
• Any weakness in the municipal bond market should be seen as a buying opportunity for quality muni bonds.

 Disclosures

Giving Thanks

by Shawn Narancich, CFA Senior Vice President of Research

Early Christmas Gifts

Another week, another record close. With both the S&P 500 Index and Dow Industrials breaking into new record territory, equity investors have much to be thankful for as they celebrated the Thanksgiving holiday and began to ponder full year returns that are shaping up to be the best in fifteen years. Trading volumes slowed to a crawl in typical holiday week fashion, with fewer investors around to digest a relatively light slate of news flow.

A Quiet Time

Those manning their desks were left to digest new housing data that showed a drop-off in October pending home sales juxtaposed against another strong Case-Schiller report, which showed house prices nationally up over 13 percent in September. For us, the tie-breaker was new residential housing permits for October, which rose 6.6 percent sequentially, to annualized levels exceeding one million units. While new apartment complexes drove the gains, permitting for single-family homes also rose, an encouraging development given the political upheaval that occurred last month. Housing has been a key driver of the U.S. expansion to date, and remains vital to our expectations for economic growth next year. In turn, interest rates on the 10-year Treasury are a key input to setting mortgage rates. As such, the Fed is paying close attention to them as it considers its next move. Tapering QE too soon or too quickly could spook bond investors, causing prices to fall and mortgage rates to rise. With housing data more mixed recently, this is the type of outcome the Fed is attempting to avoid, and a key reason why we think policy makers will err on the dovish side.

Black Friday (Thursday?)

Whether Santa Claus will deliver a Christmas bounty or a lump of coal to retailers is yet to be seen, but judging by the overflowing crowds seen at key shopping venues like Wal-Mart and Best Buy, shoppers’ enthusiasm for a deal is as strong as ever, incenting some to venture out as early as Thanksgiving Day. Estimates for holiday sales growth seem to be settling out around the 3-4 percent level, but the question as always for retailing investors is the price at which those sales transact. In addition to the level of sales growth, investors will attempt to discern the profitability of those sales, and the underlying gross margin data does not typically arrive until retailers report their financial results in late February. As indicated in last week’s web log, we believe the best success will be had by those focused on either the high-end or low-end, with general merchandisers like Kohl’s and Target caught betwixt and between.

That said, we bid our readers happy shopping on this Black Friday, so named for the day’s typically heavy selling pace that can swing retailers from losses to profits for the year. Moreover, we wish our clients and friends a peaceful and most enjoyable holiday season!

Our Takeaways from the Week

• Amid low trading volumes, stocks scaled new heights in a holiday shortened week

• Retailers are in the spotlight as the Christmas selling season begins

Disclosures

Gaining Elevation

by Shawn Narancich, CFA Senior Vice President of Research

Dow 16,000

A slow growth, low inflation environment that continues to enable highly accommodative monetary policy remains a recipe for stock market success. With year-to-date gains now topping 25 percent on the S&P 500, the venerable Dow surpassed another 1,000 point threshold as key equity benchmarks forge further into record territory. With retailers book-ending third quarter earnings season this week, investor attention is being redirected back to the global economy, where key U.S. reports continue to indicate the possibility but not likely the probability that the Fed will begin tapering its program of quantitative easing before year-end. Domestic inflation decelerated for the third consecutive month in October, to an annual rate of 1.0 percent not seen since deflation beset the economy in 2009. With next to no wage pressure and a domestic energy boom keeping natural gas and oil prices well contained, incoming Fed Chair Janet Yellen can afford to be patient. Will Ben Bernanke presiding over his next-to-last FOMC meeting next month steal her thunder? Barring a surprisingly strong November jobs report, probably not. Those betting on an early taper would point to last month’s better than expected payroll gains and this week’s surprisingly strong retail sales report, in which strong auto sales, restaurant spending, and furniture sales drove better-than-expected 3.9 percent growth.

Crystal Clear

While retail sales were surprisingly robust in an October disadvantaged by the partial government shutdown, investors are clearly witnessing a case in which a rising tide is not lifting all boats. In the plus column is Home Depot, which posted U.S. same-store sales exceeding 8 percent for its fiscal third quarter. For a retailer with $80 billion of yearly sales, such growth is impressive and speaks to where consumers are spending – on durable goods like washing machines and new carpet for a typical house that now has home equity. Where consumers are not spending as much is in categories like apparel and center aisle grocery, negatively impacting the likes of Target and packaged food companies Campbell Soup and JM Smucker. In contrast to another beat-and-raise quarter from Depot, each of the aforementioned fell short of investor expectations, with the stocks being summarily punished.

Winners and Losers

In an environment of muted wage gains and still elevated unemployment, consumers are increasingly price sensitive, but in contrast to past economic cycles, technology has enabled them to be smarter shoppers. Armed with smart phones able to compare prices across retailers and internet sites at the touch of an app, bricks-and-mortar retailers like Best Buy are having to offer price matching (think deals on Amazon) to keep up with online competitors. While Best Buy’s stock has performed spectacularly this year (up 231 percent year to date), it suffered a setback earlier this week because same-store sales missed expectations and the company warned of a heavily promotional holiday season.

Our final observation from the land of retail would be the high-end, low-end dichotomy. We expect the Nordstroms and Louis Vuittons of the world to post much healthier Christmas sales than general merchandisers like Wal-Mart, Target, and Kohl’s, reflecting lower rates of unemployment for college educated, upper income shoppers and record stock prices that are having a beneficial impact on higher-end spending.

Our Takeaways from the Week

• Stocks are setting new highs amid a benign economic backdrop
• Retailers concluded the third quarter earnings season, reporting mixed results

Disclosures

Ch-ch-ch-ch-changes

by Ralph Cole, CFA Senior Vice President of Research

If the hearings yesterday on Capitol Hill are any indication, Janet Yellen should have smooth sailing to her confirmation as our next Federal Reserve Chairman. She was clear and concise in her answers, and conveyed a clear understanding of the job at hand. She gave the capital markets confidence that there would be no unsettling changes to current policy, while comforting legislators' concerns by stating the Federal Reserve’s oversight of banks would become a higher priority during her tenure. After reading her testimony, we believe that further improvement in employment will lead to tapering sometime in the first quarter of next year.

Not So Fast My Friend

A contrite President Obama stood in front of reporters yesterday and admitted that the administration had fumbled the roll out of “Obamacare” (the Affordable Care Act). Because of ongoing website problems individuals have found it nearly impossible to sign up for coverage online. In response, the administration has relaxed some deadlines, which will simply delay the implementation of the Affordable Care Act. As such, we are maintaining our current strategy for the healthcare sector, which focuses on companies that benefit from an increased volume in healthcare services, because with more people covered by insurance, more services will be used.

Tiny Bubbles?

As of this writing, the S&P 500 index and S&P earnings stand at all-time highs. When Janet Yellen was asked during her testimony about bubbles in the stock market, she asserted that on most valuation metrics, the stock market is far from bubble territory. That said, the zero interest rate policy that the Fed is currently maintaining may ultimately cause a bubble. The last two recessions were caused by the dot-com bubble and the real estate bubble. As investors, it is important that we keep a vigilant watch for the next potential bubble… At this point we don’t see one on the horizon.

Takeaways for the week

• Janet Yellen will almost certainly be confirmed as the first female Federal Reserve Chair
• While stocks continue to set new highs, valuations remain reasonable

Disclosures

Shifting the Gears of Focus

by Shawn Narancich, CFA Senior Vice President of Research

Super Mario?

 As the sun begins to set on third quarter earnings season, investors are increasingly turning their attention back to the broader economy. With regard to key data, this week provided plenty to ponder. Mario Draghi’s surprising decision to cut short-term rates in Europe speaks to the European Central Bank’s concern about last week’s surprisingly low inflation reading, which has spawned talk about potential deflation on the Continent. And while the U.S. administration may not like the fact that Germany generates half its GDP from exports, the likes of BMW and Siemens must have been raising a toast to the resulting drop in the euro, which promises to make German exports that much more competitive. Only time will tell if more aggressive actions might be necessary in Europe, but from a monetary policy standpoint, the ECB retains more dry powder (reducing the rate that the central bank pays on excess bank reserves, quantitative easing, etc) than its U.S. counterpart, which has already spared no dollar in an attempt to stimulate the economy.

Less than Meets the Eye

As the Fed ponders its next move, investors got their first dose of the third quarter GDP data, which showed that the U.S. economy grew at a surprisingly robust 2.8 percent rate. Peeling back the onion, the underlying detail paints a less rosy picture—consumption spending up a lackluster 1.5 percent and reduced levels of capital spending more indicative of an economy growing at a slower pace. After subtracting a build-up of business inventories, real final sales rose by that not-so-magical number of 2 percent that investors have grown increasingly accustomed to seeing from the U.S. economy.

Taper Talk

Juxtaposed against the uninspiring GDP data was Friday’s payroll report which was surprisingly robust. Despite the early October government shutdown, the economy added a net 204,000 jobs to nonfarm payrolls during the month, boosted by hiring in the manufacturing sector and better hiring trends in retail, leisure and hospitality. The response from financial markets was mostly predictable, as bonds fell, gold declined and the dollar strengthened—all in anticipation of the Fed tapering its program of quantitative easing sooner than otherwise expected. What is encouraging to us was the reaction by equity investors, who bid stocks higher to close the week. As we have indicated in past commentary, when the Fed does begin to taper, it will be for the right reasons.

Our Takeaways from the Week

• With nearly 90 percent of large U.S. companies having reported, an acceptable third quarter earnings season is drawing to a close
•  Despite added volatility, stocks remain well bid in a rising interest rate environment

Disclosures

What to Expect When You Are Expecting a New Fed Chair

by Brad Houle, CFA Senior Vice President

Ben Bernanke’s tenure as Fed Chairman is coming to an end this year. He became Fed Chairman in 2006 and led the organization through the financial crisis. Prior to his tenure as Fed Chairman, he was an economics professor at Princeton University. One of his primary areas of interest was the Great Depression and that perspective shaped the Federal Reserve’s response to the crisis.

Janet Yellen has been nominated as the next chair of the Federal Reserve Open Market Committee. She is expected to be confirmed and would start to serve her term in early 2014. The financial markets are in favor of a Yellen Fed in that her viewpoint is thought to be similar to the outgoing Ben Bernanke. She is characterized as being “dovish” which means that she is in favor continuing zero interest rate policy and quantitative easing for an extended period of time until unemployment is reduced to a more acceptable level. Financial markets crave as much certainty and continuity as possible and the Yellen Fed fits the bill. She was tasked by the outgoing Chair Bernanke to facilitate a more open and transparent Fed. It is expected that Yellen will use this platform to steer expectations of market participants.

Countless articles and endless analysis of the Yellen Federal Reserve in the financial press have debated the minutia and theorized what a Yellen Fed will be like. At Ferguson Wellman, we have a unique perspective on the Yellen Federal Reserve. Jim Rudd, CEO of Ferguson Wellman, had the opportunity to serve as the Chair of the Portland Fed for several years under Janet Yellen who was then President of the 12^th District of the Federal Reserve of San Francisco. Having witnessed her management skill first hand, Jim commented that she embraces the culture of the Fed and has the ability to manage the process of setting monetary policy. He also indicated she was on the front line of the real estate crisis in the Fed 12^th district during the Great Recession and that had a lasting impact on her and how she views the fragility of the recovery.

Takeaway This Week

• There were not a lot of surprises from the Fed minutes released on Wednesday. The only material change was language surrounding an acknowledgement of a slowing in the housing recovery

Disclosures

Technically Speaking

by Timothy D. Carkin, CAIA, CMTSenior Equity Trader 

With the partial shutdown of the government behind us, the equity markets have been on a near constant rise seemingly setting new highs daily. “Kicking the can down the road” gave investors the excuse to jump back into the markets as evidenced by the S&P 500’s 100-point gain since October 9. As the market ran up, Chicago Board Operative Exchange Volatility Index (VIX) was dropping. This is positive – it signals investors’ acceptance of the continued market highs. Looking further into the equity markets we see confirmation of the rally with industrial, healthcare, and consumer discretionary sectors setting new highs. Not surprisingly, almost 70 percent of the Dow Transportation Index are within 3 percent of their 52-week high. Strength in these sectors, coupled with an increase in volume, and a reduction in volatility is a recipe for a continuation of the bull market.

The market’s reaction to Microsoft’s earnings this morning, opening up more than 6 percent, was supportive of a bullish rally. In a typical market rally, quality stocks lead the market up. As the proverbial rising tide lifts all boats, the lower quality stocks rally as well. As the market exhausts, investors seek out newer opportunities and start to buy up those riskier, lower quality stocks, eventually driving valuations to excess leading the market to correct. Continued leadership of other bellwethers like Boeing, Verizon, Nike and American Express is a good sign of the health of this rally.

With all that said, one simple truth is that the market does not go straight up. Most equity markets can handle a loss of a few percent without losing their bullish momentum. As you can see in the chart below, we are at the upper bounds of the market channel. Trading down to the trendline would be perfectly normal and still maintain the trend. However, if that pullback is preceded by higher volatility or rallying lower quality stocks, this might indicate a more significant pullback.

Our Takeaways from the Week

• Market momentum is strong, even at market highs
• As the rally continues, watch for signs of stress

Disclosures

Let's Make a Deal

by Jason Norris, CFA Senior Vice President of Research

Let’s Make a Deal

After two weeks of a partial government shutdown and on the eve hitting the debt ceiling, the Senate cobbled together a short-term fix to reopen the Federal government and kicked the debt ceiling “can” down the road for a couple months. Despite all the hysterics in the media that included dire warnings and countdown clocks, the U.S. economy, as well as the equity markets, held up fine. While we expect a short-term hit to economic growth due to the shutdown, we do not believe it will have a lasting effect. Though equity markets have been volatile during this period, stocks actually traded higher in October, resulting in an all-time high for the S&P 500. We believe that consumer confidence will pick back up through the remainder of the year. The wildcard in Washington is whether or not there will be a “grand bargain” before we hit the debt ceiling again or will the short-term band aids be more common, thus creating more uncertainty.

While interest rates fell a bit over this time, it was another story for the U.S. dollar as the major European currencies are close to 52-week highs relative to the greenback. While this may not positively impact a planned European vacation, it will benefit major exporters because their goods will be relatively cheaper in the world market.

Blackened Big Blue

IBM reported a disappointing and sloppy quarter earlier this week. While once a bellwether for the technology space, the company has struggled in recent years, and have been unable to post revenue growth on a year-over-year basis for eight quarters. However, IBM has been able to hit profit targets due to reduced costs, lower tax rates and share buybacks. The key metric we have been watching is free cashflow and this has not been compelling enough for us to step in at current levels, even though the stock is 20 percent off its high.

Earnings Redux

Third quarter earnings have been coming in mixed across the market. Semiconductor stocks are seeing a slower fourth quarter while Google’s growth continues to exhibit strength. The regional banks are experiencing sluggish loan growth and some compression in net interest margin. However, they are hitting profit targets due to cost cutting. Although the big industrials, such as GE and Honeywell, have delivered healthy reports this week, they are showing a bit of caution in their outlooks over the next few quarters. Looking toward 2014, overall corporate earnings are still forecasted to grow close to 10 percent. While this may prove to be too optimistic, we remain bullish on equities due to continued earnings growth and low inflation, which should translate into further P/E expansion.

Out Takeaways from the Week

• Even at current levels, equities are still attractive on growth and value metrics
• While Washington tried its best to slow down the U.S. economy, we believe overall growth with continue as consumer confidence picks up

 Disclosures

Amid Government Dysfunction, Yellen Tapped to Lead Fed

by Shawn Narancich, CFA Senior Vice President of Research

More Than Just Political Theatre

A rollercoaster week in financial markets came to a favorable end for stock investors, who are beginning to equate a resumption of budget negotiations with a potential deal to end the government shutdown and raise the U.S. Treasury’s borrowing authority. The emergence of political comity in D.C. is being forced upon both political parties as poll numbers show Americans’ increased frustration with Beltway gridlock. As well, eleven days of partial government shutdown is taking its toll on the economy: a lack of FDA inspectors causing delays in reviewing key drugs for approval; small businesses unable to obtain SBA financing because of staff furloughs; and a lack of customs inspectors to approve a variety of imported and exported goods. Dislocations began to show up in weekly unemployment claims, which surged by over 20 percent as furloughed workers applied for benefits. Against this backdrop, economists are cutting their estimates of fourth quarter GDP, with projected economic growth once again settling near a lackluster 2 percent rate. At the Fed, policymakers are lacking key economic data such as the latest payroll report, retail sales and inflation statistics necessary for informing their latest evaluation of proper monetary policy.

It’s All Over But the Yellen

While the Fed at present may be flying blind to a certain extent, investors learned this week who will be piloting the plane. As expected, current Fed Vice Chair Janet Yellen received the nod to become the Federal Reserve’s next leader, set to replace a retiring Ben Bernanke. If confirmed by the Senate as we expect, she will become the first female Chair in the institution’s 100 year history. Our expectation is for a seamless transition of leadership, but Yellen’s policy making is thought to be somewhat less collaborative than Bernanke’s and more influenced by the Keynesian school of economic thought. Despite some concern that Yellen leans dovish, we believe she will keep policymakers focused on the Fed’s dual mandate supporting both full employment and low inflation.

A Slow Start to Earnings Season

With metals producer Alcoa one of the few names to rally following its third quarter numbers, earnings reporting appears to be off to a lackluster start. Of eight key earnings reports that we reviewed this week, only Alcoa and Wells Fargo reported ahead of consensus expectations, and Wells did so despite a disappointing top line that was burdened by a dramatic pullback in mortgage underwriting. Chevron pre-announced disappointing numbers citing weaker refining margins, fast food operator YUM Brands was burdened again by a hangover from its chicken supplier issue at its KFC business in China and JP Morgan’s legal tangles with the federal government caused it to report its first ever loss under chief executive Jamie Dimon’s leadership. Despite the week’s plurality of discouraging news from corporate America, investors should realize that earnings season has just begun, so it’s too early to pass judgment. Earnings season kicks into high gear next week, when investors will digest financial results from an increasing number of big banks, including Citigroup, Bank of America, Goldman Sachs and Morgan Stanley. Earnings reports are also on tap from the likes of GE and Google. For large cap stocks in aggregate, we expect a quarter of low single-digit revenue growth accompanied by a mid-to-high single-digit increase in earnings.

Our Takeaways from the Week

• Stocks rose for the week amid investor optimism about budget negotiations in Washington

• Although it is very early days, third quarter earnings season is off to a somewhat discouraging start

Disclosures

Fannie and Freddie's Fate

by Brad Houle, CFA Senior Vice President

There was plenty of controversy this week in Washington with the government shutdown and the looming deadline for raising the debt ceiling. However, there was another controversial situation at play that has been pushed further off into the future. Fannie Mae and Freddie Mac are government sponsored enterprises that guarantee and securitize mortgages for U.S. homeowners. These entities perform an important function in the U.S. economy by guaranteeing the payment of principal and interest and securitizing or “packaging” mortgages for sale to institutional investors. Americans will recall that Fannie Mae and Freddie Mac both got into financial distress during the financial crisis due to excessive leverage and lax underwriting standards. As a result, the U.S. government had to step in and take Fannie Mae and Freddie Mac into conservatorship in September of 2008.

Fannie Mae and Freddie Mac have now been stabilized and have actually been returning robust profits. Specifically, since 2011 they have paid back $131 billion in dividends to the U.S. Treasury of the $187 billion bailout they received. Fannie Mae and Freddie Mac have long been viewed as an uneasy mixture between a private enterprise and a public entity. Recently there have been legislative attempts to eliminate Fannie Mae and Freddie Mac as we know them. The current administration believes that private capital should play a larger role in the mortgage market.

Investors in mortgage-backed securities issued by Fannie Mae and Freddie Mac rely on the implied government credit guarantee. If that is removed, the cost of mortgages is estimated to rise by one to two percentage points. As such, investors will demand a higher return to own mortgage-backed bonds with a greater risk that interest and principal will not be repaid. In a housing market that is still recovering from the financial crisis, an increase in mortgage rates due to this change would hamper the pace of economic growth.

What will actually happen is still very much up in the air. One thing that is virtually certain is the payoff of Freddie and Fannie debt obligations. To back off the current guarantee would throw financial markets and especially the mortgage-backed securities market into turmoil.

Takeaways

• The evolution of mortgage financing and the eventual fate of Fannie Mae and Freddie Mac is a political controversy that does not have a simple private market solution

Disclosures

D.C. Histrionics Take the Shine off Stocks

by Shawn Narancich, CFA Senior Vice President of Research

The Circus is Back in Town

With stocks pulling back from new all-time highs reached last week, politicians become an easy target. “Blame it on the clowns in Washington!” Yet the fact that benchmark blue chip stocks stand within 2 percent of their recent highs is a testament to what we foresaw at the end of last year, which is that investor focus would turn away from the D.C. budget battles and more closely focus on company and economic fundamentals. Fed policy remains in the limelight as traders focus on the ultimate timing of “tapering,” but for Bernanke & Co., call it mission accomplished, as last week’s delay in removing a degree of monetary accommodation has stalled the upward march in benchmark Treasury yields. Although the Fed’s decision was widely panned, the recent choppiness in housing-related data speaks to the concern that policymakers ascribed to the steep rise in mortgage rates. Post-Fed decision, mortgage rates have moderated, which should help sustain the rebound in this key driver of the economy.

Window Dressing

Third quarter end is rapidly approaching, and with it, another earnings season is coming into focus. Earnings pre-announcements have been few and far between so far, but that could change in the next couple weeks as corporate finance departments close their books and reconcile numbers to investor expectations. Although the trade-weighted dollar has weakened this quarter, the much anticipated economic acceleration has yet to materialize. With the Commerce Department’s final read of second quarter GDP in the books at 2.5 percent, don’t be surprised if this ends up being the best rate of growth we see in 2013. Over the last month, economists have been busy cutting their estimates of third quarter GDP, with consensus expectations falling to roughly 2 percent. It's forward progress, but certainly not the type of gangbuster growth that would lead us to predict a big upside for corporate America’s third quarter earnings reports.

 Just Did It

For now, investors whet their earnings appetite by feasting on Nike’s surprisingly strong fiscal first quarter earnings—up 36.5 percent on 4.5 percent sales growth. Not only did key metrics exceed expectations, but the all-important futures order number rose by 10 percent on a currency neutral basis. Not bad for a company expected to book over $27 billion in sales for the current fiscal year! Despite Nike’s premium valuation, the stock sprinted ahead 5 percent on the announcement, outperforming on a down day for equities in general. 

While the dynamics of Nike’s growth owe much to its latest innovations like Flyknit shoe technology, we can’t help but notice the parallel between Nike’s geographical business performance and that of the global economy in general. Instead of key emerging markets leading the way, Nike’s China business actually contracted, underpinning a mere 1 percent growth rate in the company’s overall emerging market sales. Contrast that pedestrian performance with North America and Western Europe, where sales rose 9 percent and 11 percent, respectively, and these numbers mirror what’s happening globally, as growth at the margin is better in developed markets than it is in the emerging markets. While we don’t anticipate this being the case longer term, it’s today’s reality. 

 Our Takeaways from the Week

•  D.C. politics and slower-than-previously-expected economic growth have put a damper on stock prices
•  As the third quarter concludes, another earnings season awaits

Disclosures

Misled by the Fed?

by Brad Houle, CFA Senior Vice President

In a surprising announcement on Wednesday, Federal Reserve Chairman Ben Bernanke said that the Fed will not be tapering bond purchases this month. He indicated that the $85 billion per month of bond purchases by the Fed in an attempt to stimulate the economy will continue until further notice. Financial markets have been in a tizzy about the tapering of bond purchases since May when the Fed Chairman first suggested that the pace of purchasing would decline. Interest rates climbed following this announcement, which impacted rate sensitive stocks, emerging markets and mortgage refinancing activity.

The Fed was most likely displeased with the increase in interest rates that accompanied the first indication of tapering. To counteract the rise in rates the Fed decided not to taper purchases to drive rates back down. Treasury rates had increased about 1 percent from May to the recent peak. Mortgage rates also climbed a similar amount from 3.5 percent for a 30 year fixed rate mortgage to about 4.5 percent today. This change dramatically slowed mortgage refinancing activity and caused a slowing in the velocity of the housing recovery. As a result of the slowing in refinancing activity, in some cases the banking industry has begun laying off employees involved in mortgage refinancing. Purchase mortgage applications have dropped off dramatically since the initial May announcement.

In actuality, nothing has really changed relative to Fed strategy. Bernanke said, “If the data confirms our basic outlook” for growth and the labor market, “then we could begin later this year.”  There are only two more Fed meetings in 2013, one on October 29^th and one on December 17^th. In all likelihood, the tapering announcement will probably come at the December meeting unless there is a dramatic tick downward in economic data.

It has long been our assertion that the Fed will begin tapering for the right reasons. Looking past the wiggles in monthly economic data, the economy is improving. Employment is making gains, however lumpy the job creation might be. Capacity utilization has rebounded nicely and is moving in the right direction without being inflationary. Also, consumer confidence and auto sales have been strong.

We continue to believe that the economy will be stronger in the second half of this year and the recovery is intact.

Takeaways:

• A rare surprise announcement by the Bernanke Fed is really not a shift in Fed policy
• The brewing debt ceiling battle is shaping up to be contentious and will inject volatility into the markets. This topic will most likely dominate financial news for the next two weeks

Disclosures

Long Strange Trip

by Jason Norris, CFA Senior Vice President of Research

Bucking the normal “sell in September” mantra, stocks have rallied over 3% since the beginning of the month; specifically, the emerging markets. We entered the year bullish on the emerging market economies, thus overweight in our allocation. However, due to increasing inflation and reductions in growth forecasts, the emerging markets were down for the first eight months of the year. We have been seeing some signs of stabilization as economic data remains healthy, specifically in China. Emerging markets will now comprise over 50% of global GDP. This has resulted in a 10% move in the last two weeks. We still remain overweight and believe that the growth dynamics in these markets (both emerging and frontier¹) offer investors a great long-term opportunity.

Come Bite the Apple?

Apple announced their new iPhone earlier this week; however, investors greeted it with little fanfare. The new iPhone 5S will have fingerprint authentication and a distinctly faster processor. The 5C release, which was intended to be a lower-end phone for emerging markets has disappointed, specifically on the price point. At $550, we believe this will be too high to drive market share gains in emerging markets, which is key for Apple revenue growth. It seems that the company would rather sacrifice market share for margins, and we will see if this strategy works. Unfortunately, the wireless handset marketplace can change rapidly. A decade ago, Blackberry owned the enterprise market and Nokia owned the consumer space.

Money for Nothing

The bond market continues to welcome any issuance with yield. Earlier this week Verizon issued just under $50 billion in debt to fund its $130 billion purchase of Vodafone’s share of Verizon Wireless. This eclipses Apple’s $17 billion deal earlier this year. While their cost of debt increased due to the deal, investors ate it up and those spreads (yields above treasuries) have since declined significantly.

From Russia with Love

Earlier this week, Vladimir Putin engineered a “potential” deal with Syria to ward off a U.S. strike. Only time will tell if Syria turns over its chemical weapons to a third party; however, equity markets breathed a sigh of relief. While the humanitarian situation in Syria remains grave, investors continue to be concerned about what the effect of a strike would have on consumer confidence and gasoline prices. This concern looks to have been pushed back for now.

Our Takeaways from the Week:

• Emerging markets still offer a long-term opportunity for equity investors

• We will be deluged in the financial press for months discussing the Twitter IPO filing

¹See our blog posting from August 23, titled “Secular Vs. Cyclical,” for more details on emerging and frontier markets.

 Disclosures

Let's Talk Taper

by Marc Fovinci, CFAPrincipal

 “Ho-Hum” Employment

 All eyes were on the employment report this morning. This morning’s report is the last employment report before the next Federal Reserve meeting on September 17 and 18, and of all the economic statistics, the Fed leans most heavily on the employment report to gauge how well the economy is doing.

Today’s report showed that nonfarm payrolls increased by 169,000 in August and the unemployment rate dropped from 7.4 to 7.3 percent. Although a solid report, it only keeps pace with current “ho-hum” trends. The payrolls report underachieved what the market expected, but the unemployment rate was better than expected. Unfortunately, the good news of unemployment rate was clouded by a lower rate of workforce participation.

The “ho-hum” report does not remove the uncertainty over what the Fed will do at its meeting this month. The report was not conclusively strong enough to make a tapering of Fed stimulus a foregone conclusion. If we were a fly on the meeting room wall, we would certainly expect to witness a vigorous debate over whether to taper or not.

Currently, the Fed is adding $85 billion into the financial system each month through the purchase of securities. In June, Federal Reserve Chairman Ben Bernanke laid out a timetable for reducing the rate of these purchases, leading the market to expect the reductions to start after this September meeting. While a reduction in the size of the purchases is not a tightening of monetary policy, it is a reduction in the rate of stimulus and a new direction for the Fed.

We, along with many investors, expect a “taper-lite” to be announced. A light tapering would be a reduction in monthly purchases by $10 billion, moving from $85 billion to $75 billion per month. With Bernanke’s June timetable and the economy continuing on its trend, it seems appropriate to reduce stimulus by a relatively minor amount.

The markets seem to have already moved in anticipation of a “taper-lite,” so we would expect fairly limited market movement on the announcement: stocks have little reaction and bonds experience a minor sell-off.

The Fed Speaks

On Wednesday, three members of the Ferguson Wellman investment team had the opportunity to hear John Williams, president and chief executive officer of the Federal Reserve Bank of San Francisco, speak in Portland. Fed governor speeches tend to be well-scripted and are usually intended to clarify and explain current Fed policy, not to break new ground on policy and trends. Here are a few of President Williams’ major points regarding the Fed:

• They consider “forward guidance” a very important policy tool. “Forward guidance” is communication of what the Fed thinks policy is likely to be in the future
• They expect to keep the federal funds rate near zero until (1) unemployment drops to 6.5 percent or below, (2) they forecast near-term inflation to 2.5 percent or above, or (3) investor inflation expectations move measurably higher. His expectation was that the Fed would maintain its zero percent interest rate policy into 2015
• They expect to halt their monthly purchases (complete tapering) sometime in the middle half of next year, when they expect the unemployment rate to be about seven percent
• Tapering is not tightening. It is still adding stimulus but at a slower rate
• He emphasized on multiple occasions that Fed actions are very dependent on how well the economy performs in the future. All actions are data dependent

Our Takeaways from the Week

• The economy continues to deliver “ho-hum” performance
• Expect the Fed to announce a “taper-lite” on September 18, reducing monthly purchases by $10 billion
• Having largely discounted the event, markets should not have a large reaction to this announcement

Disclosures

A Change of Tenor

by Shawn Narancich, CFA Senior Vice President of Research

Dog Days of Summer

Change at the margin is key to the direction of stock prices, so with the month of August producing its fair share of downside catalysts, investors are left to ponder whether or not a 4 to 5 percent pullback in blue chip stocks has run its course. Weak earnings reports from benchmark retailers Target, Macy’s, and Wal-Mart, heightened geo-political risks in the Middle East, rising U.S. interest rates, and discouraging economic developments in key emerging market countries serve to remind equity owners that a good bull market is never far from a correction. With the Fed now on the cusp of paring back its program of Quantitative Easing (QE) in a month of September that historically hasn’t been so kind to investors, stock prices could experience some additional downside.

Stagflation

It’s an ugly word for investors, and one that is suddenly being used to describe the economies of several key emerging market countries where inflation is rising and economic growth is slowing. In a world of cause and effect, we see an anticipated slowing of U.S. QE producing weaker emerging market currencies (i.e. Indian rupee down 20 percent since May), which in turn threaten higher levels of inflation, as resource dependent countries like India, South Africa, and Indonesia pay more for oil and other U.S. dollar-denominated imports. Compared to developed market economies like the U.S. and Japan, commodity costs are a bigger portion of consumer spending, and thus put the onus on emerging market central banks to raise rates in an effort to quell inflation.

Investors witnessed this phenomenon again this week, when both Brazil and Indonesia raised their benchmark interest rates by half a percentage point, in continuation of a trend toward tighter monetary policy in emerging markets. The objective here is to contract the money supply and produce higher currency values, while at the same time attracting additional investor capital seeking higher interest rates. While higher interest rates tend to reduce economic activity in the short-term, depressed currency values provide a built-in shock absorber for economies because their exports become more attractive to foreign buyers. In a challenging environment for emerging market economies, the stocks have been notable underperformers year-to-date. That said, we continue to favor emerging market equity exposure for these countries’ faster long-term rates of growth that stem from faster population growth and an ascendant middle class consumer.

Taper Light

Anecdotal evidence of weaker retail sales, slower order rates for interest-sensitive capital goods, and below-target levels of inflation serve as the backdrop for next week’s payroll report, the last one before the Fed’s next meeting on September 17^th. Consensus believes the Fed will announce a $10 to 20 billion per month reduction in its $85 billion per month QE program, but with housing activity starting to slow because of higher mortgage rates and consumer spending threatened by the tax of higher oil prices, we believe the Fed’s error of action is to taper less rather than more.

Our Takeaways from the Week

• The near-term tenor of equity markets has deteriorated amid higher interest rates, Middle East turmoil, and emerging market turbulence; nevertheless, we continue to favor equities for their longer-term growth potential

• Ahead of Labor Day, we wish our clients and friends a safe and enjoyable holiday

Disclosures

Secular Vs. Cyclical

by Ralph Cole, CFA Senior Vice President of Research

Our days in the investment management world are spent balancing the benefits of short-term risks, against what we believe to be long-term themes or opportunities. In other words, very favorable long-term (“secular”) investment paradigms are interrupted by transitory (“cyclical”) factors. For example, we believe that over the long-term, stocks will outperform bonds, but there are times when stocks are over-priced and/or the economy lapses into a recession. During these instances, we want to own comparatively more bonds because they would most certainly outperform equities during the inevitable correction.

Those same forces are occurring in the international markets today. While in the near-term we are seeing a rebound in Europe and possibly Japan, the emerging markets continue to lag. Though they face cyclical headwinds in the near-term, we continue to believe that emerging markets offer better growth opportunities over the long-term for equity investors.

India is a perfect example of an emerging market that is facing cyclical headwinds versus positive secular demographics. India is currently experiencing high inflation, a tumbling currency, and a slowing economy. However, over the next 25 years, the working age population in India is set to grow by over 245 million, more than the current working age population in the U.S.* As such, we believe India represents a compelling long-term investment opportunity.

What Is the Difference Between Emerging Markets and Frontier Markets?

For investment purposes, the emerging markets universe is dominated by the “BRIC” countries. Specifically, Brazil, Russia, India and China are large, growing countries that still do not have deep enough capital markets, or refined enough judicial and regulatory systems, to be considered developed. MSCI specifies 17 additional countries with that designation. You can find the complete list by clicking here.

Frontier markets are smaller countries, with even less developed capital markets. Countries such as Argentina, Croatia, Kenya, Saudi Arabia and Vietnam are examples of frontier markets. The complete list can be found by clicking here.

As of late, there has been a dramatic contrast in the fortunes of these two categories as year-to-date, frontier markets are up some 19 percent, while emerging markets are down 10 percent. For investors interested in accessing frontier markets, we advise utilizing a pooled vehicle (mutual fund or ETF), rather than attempting to purchase individual stocks in these countries.

Takeaways for the Week:

• Though facing some cyclical head winds, we continue to favor both emerging markets and frontier markets over the long-term in client portfolios

• While not mentioned above, we think the back-up in rates has gotten ahead of itself and bond yields as defined by the 10-year treasury should remain in a 2.50 percent to 3.00 percent trading range in the coming months   

* Source: Merrill Lynch

Disclosures

Summertime Blues

by Jason Norris, CFA
Senior Vice President of Research

As we move into the dog days of August, both equity and bond markets have experienced some seasonal weakness due to Fed taper fears and some weaker-than-expected earnings reports. Historically, August and September are relatively poor months for equities and with concerns about the Fed taking its foot off of the liquidity gas, equities may take a breather. That said, we believe there is a 50/50 chance the Fed will begin to taper their bond buying at the September meeting, but this will be contingent on economic data for the next month.

Superunknown

Retailers delivered mixed results this week with disappointing reports from Macys and Wal-Mart. In both instances the retailers were able to maintain pricing, but volumes were weak. In short, consumers are going to the stores, but they are being more selective in their purchases.  Macy’s did state that August back-to-school shopping showed a nice pick up. We have seen some positive recent data with weekly jobless claims continuing to make post-recession lows and consumer confidence has been in an upward trend since mid-April. While these data points are positive, we realize that they are modest and may stagnate. Though the U.S. economy is improving and we are seeing improvements in northern Europe; however, as Cisco CEO John Chambers stated earlier this week, the recovery is “inconsistent.”

Highway Star

With consumers purchasing less, we are seeing a deleveraging of their personal balance sheets. Mortgage debt declined meaningfully as consumers refinanced at lower rates. Credit card debt remained stable, but auto loans saw a nice increase. While mortgage and credit card debt are meaningfully below their pre-recession peaks, auto loan is back to peak levels. We believe that with relatively low interest rates and an aged auto fleet, consumers will continue to upgrade their auto purchases. The average car in the U.S. is now 11.2 years old while in 1995 it was 8.4 years old. For the time being, rising interest rates won’t have a negative effect on auto loans since these loans are based on Prime, and until the Fed begins to raise the funds rate, prime will remain low.

Schools Out

Unfortunately, the deleveraging theme is not occurring for young college graduates as student loan debt reached the $1.0 trillion mark and shows no signs of declining. While one can debate if the loans are “worth it,” the load of debt post-graduation will impair spending. We are already seeing red flags in this market with delinquency rates meaningfully above historic levels. Over 30 percent of student loan borrowers are at least 90-days delinquent compared to 10 years ago when less than 20 percent were. There are now concerns that recent graduates may be less likely to start a small business due to their debt burden. Unlike the mortgage and credit crises of 2007 and 2008 which had a devastating effect on the banking sector, the Federal government (or U.S. taxpayer) back the student loans.

Our Takeaways from the Week:

• Though equities are in the midst of a pullback, we believe stocks will be higher by year-end
• Economic data continues to show improvement, but the pace remains tepid

 Disclosures

Motor City Meltdown

by Brad Houle, CFA Senior Vice President

On June 6, the city of Detroit declared Chapter 9 bankruptcy, which is the largest municipal bankruptcy in U.S. history. Detroit has an estimated $18 to $20 billion in debt and over 100,000 creditors. The city has suffered a long, slow decline over the past few decades as the U.S. auto industry has withered. According to the U.S. Census 2010 findings, the population base in Detroit has declined 60 percent from 1960 to 2010. Moody’s Corporation has reported that Detroit’s general fund revenues have declined 25 percent since 2007  As the population has declined the city has struggled to provide city services due to their shrinking tax base.

Municipal bond investors are among the creditors who have effectively loaned money to the city of Detroit for operating expenses as well as capital improvements. How bondholders are treated in this bankruptcy is being carefully monitored by municipal bond investors. Part of Detroit’s debt is general obligation municipal bonds that are theoretically backed by the city’s taxing authority. In question is the value to be recovered by these bondholders who theoretically bought bonds with the assumption that they were backed by the city’s full taxing authority. In addition to debt holders, there are pension recipients that are also in the mix of creditors. Detroit also has an unfunded pension liability that is between $3 and $3.5 billion, depending upon the assumptions used in the calculations.

Unfortunately, it looks as if the bankruptcy process is going to pit the bondholders against the pension recipients and the taxpayers to see who will bear the burden. How the remaining value is going to be divided is an open question at this point. Federal bankruptcy law treats each creditor equally while Michigan has strong protections in place for public employee pensions in the event of a bankruptcy.

Detroit is an extreme example of a municipality in financial distress. While there are other cities that are facing financial challenges, such as Chicago, the probability of default is fairly low. Chicago still has a dynamic economy, a recovering real estate market and a more stable population. Detroit had no other options other than bankruptcy due to an extraordinary drop in population impacted by a revolutionary change in the auto industry. This population decline coupled with corresponding erosion in the economic base created a downward spiral that Detroit could not reverse, which may impact bondholder’s recovery potential.

While the Detroit bankruptcy has made headlines and has caused bond investors to reconsider how cities with similar problems are evaluated; historically, municipal bonds have been a safe investment. According to Moody’s, the default rate on rated bonds has been .012 percent for the 40-plus years of data available. Looking at it differently, of the greater than 1 million municipal bond issues outstanding, only 71 have defaulted since 1970.

Moody's Rated Municipal Issuer   Defaults 1970-2011
Type of Bond		Defaults	Percentage
Housing		29	40.80%
Hospitals		22	31.00%
Education		3	4.20%
Infrastructure		4	5.60%
Utilities		2	2.80%
Cities		2	2.80%
Counties		1	1.40%
Special Districts		1	1.40%
Water & Sewer		1	1.40%
State Governments		1	1.40%
Non-General Obligation		66	93.00%
General Obligation		5	7.00%
Total		71

Our Takeaways from the Week:

• The situation in Detroit is an extreme example of a city in financial distress.
• Municipal bonds historically had very low default rates and are an important component of many investors’ portfolios.

Source: Moody's Corporation

Disclosures

Amid Dry Holes, Positive Change at the Margin

by Shawn Narancich, CFA Senior Vice President of Research

Revisionist History

Amid hundreds of quarterly earnings reports daily, investors were challenged to stay on top of a slew of important economic data hitting the tape this week. While always old data by the time the report sees daylight, GDP for the U.S. economy remains an important benchmark for investors and the Fed, and the 1.7 percent growth rate came in substantially above where we thought it would for Q2. Underlying detail reveals that consumer spending continues to support growth, with housing construction and a reduced drag from government spending also helping boost numbers. That U.S. businesses had sufficient confidence to build inventories in the quarter (thus also adding to reported GDP growth) is a good sign. Comprehensive revisions from the Commerce Department, dating back to 1929, showed that GDP growth was better than expected last year at 2.8 percent, with the Great Recession also being less severe than previously advertised.

Bullish confirmation came from another number that isn’t subject to ex post facto revisions – the survey of U.S. purchasing managers. That number skyrocketed to 55.4 in July, meaningfully above the growth/contraction dividing line of 50, and the strongest reading for U.S. manufacturing in nearly two years. Coupled with better than expected manufacturing indicators in China, the news helped to confirm stocks’ recent gains and was a catalyst to push both the Dow Industrials and benchmark S&P 500 Index above the 1700 level. With blue chip U.S. stocks up about 20 percent for the year, the question now is whether the economy can attain the higher rate of growth investors increasingly expect in the back half of 2013.

Help Wanted?

Friday’s monthly payroll report completed the week’s troika of important economic indicators, and the fact that a net jobs gain of 162,000 disappointed expectations met with a yawn by investors. After all, what’s sustaining the Fed’s quantitative easing program and well contained labor costs is a jobs market that remains slow to expand, keeping pressure off employers to raise wages and pushing corporate profit margins to record levels. Second quarter earnings reports have confirmed the bottom line benefits which, when combined with share buybacks and acquisitions, promise to deliver 6-8 percent profit gains for the full year.

Dry Holes

This week, it was Big Oil’s turn at the earnings confessional, and unfortunately for them, the congregation of investors was in no mood for penance. One after the next – first British Petroleum, then Royal Dutch Shell and Exxon Mobil, and finally Chevron – delivered what we judge to be Big Oil’s worst collective set of numbers in recent memory. In Royal Dutch’s case, this Netherlands-based integrated oil company continues to be confounded by pipeline sabotage in Nigeria, a production mix weighted toward natural gas, and failure to gain traction in the booming U.S. shale plays. The stock rightfully got hammered, off almost 6 percent on the discouraging report. Aside from company-specific issues with Royal Dutch, the common denominator for the four Super-Majors was poor refining results. Contraction in refining margins was most pronounced domestically, where the rising cost of benchmark West Texas Intermediate (WTI) crude pinched margins relative to the price of gasoline, diesel, and jet fuel production. As takeaway capacity has increased from key producing basins in North Dakota, West Texas, and Canada, the anomalous discount of WTI to Brent has disappeared, and with it, the outsized profits that mid-continent refiners once enjoyed. Remarkably, all four companies missed consensus earnings forecasts and all four experienced downdrafts in their stock prices afterward.

Our Takeaways from the Week

• An important week of economic news flow was encouraging overall, and stocks responded by trading to new highs
• Big Oil was an exception to what has generally been a decent second quarter earnings season

Disclosures