Market Update Call Audio Transcript June 24, 2013

Transcription

1 Market Update Call Audio Transcript June 24, 2013 Speakers John M. De Clue, CFA Jennifer L. Vail Terry D. Sandven Chief Investment Officer Head of Fixed Income Research Chief Equity Strategist U.S. Bank Wealth Management U.S. Bank Wealth Management Opening This is a recording of the Market Update Call held on June 24, The discussion featured perspectives on recent market volatility and outlooks for what may lie ahead. Terry Sandven: Hello and welcome to today s special call on the investment markets. I am John De Clue, chief investment officer for the Private Client Reserve of U.S. Bank. Joining me for today s call are two of my colleagues within our Wealth Management Group. First, we have Jennifer Vail. Jennifer is head of fixed income research for our group. Hello Jennifer. Hello John. And secondly we have Terry Sandven. Terry is chief equity strategist for our Wealth Management Group. Hello Terry. Hello John. Hello everyone. I ll start by noting that following the so-called great recession of several years ago, there s been frankly a remarkable recovery in certain financial markets, including the U.S. stock market which is almost doubled in the past three years, as well as the U.S. bond market with the yield on the U.S. Treasury 10-year note falling from about 3.25 percent to one point less than 1.5 percent. So it s probably safe to say that one of the single most powerful influences on the markets, not just here in the United States but worldwide, has been actions taken by 1

2 the world central banks to kick-start economies in recessions or teetering on recession by one, creating massive amounts of liquidity, and by two, encouraging investors to take more risks by pushing interest rates down to levels never before seen, at least in recent history. Many have argued that these actions might sew the seeds for trouble down the road and that view has taken on some merit by the much higher levels of volatility in the investment markets that began last week following a meeting of the Federal Open Market Committee (FOMC) of the Federal Reserve (Fed) and comments made by Fed Chairman Bernanke following that meeting. Almost immediately following these comments, both the bond and the stock markets came under pressure. Currently the S&P 500 is almost five percent below the level just before Chairman Bernanke s remarks and the yield on the 10-year U.S. Treasury note has risen from around 2.2 percent to just below 2.6 percent. Let me turn to my colleagues for some perspective on this as to where we ve recently been and where we re going. And I m going to start Jennifer with you. As you know, we ve been very cautious on certain sectors of the fixed income market for quite some time now and have generally been well under our normal exposure. Nevertheless, I think it s fair to say that we, as well as most market participants are somewhat surprised by the recent level of volatility and the level of rise in interest rates. So first let me ask you to recap what was contained in the Fed statement and what Chairman Bernanke then said and then I ll come back and ask you about recent volatility. Certainly. The Fed essentially said that they are considering a gradual reduction of the purchase program, possibly as early as September. The tapering plan is directly tied to economic strengths. Tapering of asset purchases will not be instituted if the economy shows signs of weakness. If the economy becomes stronger than expected tapering could occur at a faster pace. Once tapering begins, if the economy weakens the Fed will not hesitate to halt the tapering process or even increase purchases should the economic data warrant this action. Tapering is not a tightening. The Fed was very clear that it is a slowing on the pace of accommodations. Purchases even on the smaller scales are still simulative. The Fed will preserve the existing accommodations by holding securities in its portfolio longer as there are currently no plans to sell any of the assets on their balance sheet. Also, as part of the summary of economic projections, the Fed raised their growth outlook for 2014 modestly, lowered their forecast for the unemployment rate and reduced their inflation forecast. The Fed s focus is currently on unemployment. The Committee believes that demographic factors may mean the unemployment rate can be pushed lower with less job growth. This could be why the seven percent number became the new definition of sustained improvement in the labor market, according to the Fed. Although the Committee attributed recent inflation softness to transitory factors, longer term continued subdued inflation was a key factor in the Committee s conclusion that policy rate increases were still a long way off. Voting members 2

3 slightly pushed out the timing of the first rate hike. Currently 15 of the Fed s 19 members expect an increase in the Fed Funds rates to occur no early than As I listen to you Jennifer, that all seems to make sense and the Fed has been known for being very, very communicative if you will which I think most market participants appreciate. But I need to ask a follow up. So why do you think the market has responded so aggressively to the FOMC statement? Well although we applaud the Fed for trying to be transparent and provide detail around the tapering process, the consequence was a market focused on the entire Fed exit strategy instead. We believe the Fed s intent was likely to present more of a dovish tone. Unfortunately, given the sheer volume of information presented for investors to digest and the mere mention of a potential end to the purchase program, the market perceives this to be a more hoggish statement. This extreme surge in yields has likely gone too far. The market is currently pricing in a Fed funds hike in Even though Bernanke stressed several times that they do not expect an increase in short-term rates until Part of this overreaction can be attributed to the Fed s revised employment outlook which shows the unemployment rate potentially reaching 6.5 percent in That said John, the Fed has stressed that 6.5 percent is a threshold not a trigger. During the Q&A session following the statement release, Bernanke even hinted that the Fed might lower the 6.5 percent unemployment rate threshold for a policy shift. Thus, we feel concerned about a Fed tapering leading to a quicker onset of Fed tightening are likely overdone. We also believe the timing of any potential Fed Funds increase will be founded on actual growth and the inflation outlook. When asked about inflation, Bernanke stated the more subdued the outlook for inflation, the more patient the Fed will be. If yields continue to rise, we would not be surprised to see Bernanke re-emphasize the need to maintain stimulus for longer given the lack of inflation. And lastly John, it s interesting to note that for the first time Bernanke has suggested that even when economic recovery is well under way, the Fed will raise interest rates at a much slower and steadier pace then in a normal tightening cycle. So it s interesting what you say, Jennifer. Maybe the market is now just feeling this and it s settling in a little. But looking at my screen at least it seems the 10-year early this morning touched almost 2.66 percent, but now is down to about 2.54 percent. So maybe that s a trend that will continue. My next question is that many of our clients have expressed concerns that although the economy is improving at first glance, it doesn t appear to be strong enough to consider a reduction in stimulus. Does the Fed see something that the market doesn t see? Why do you think the Fed is considering a potential reduction of purchases at this time? Well if you ll recall one of the objectives of quantitative easing, which is pushing asset prices higher, has largely been successful. Home prices have risen by double digits, interest rates achieved record lows as you mentioned earlier and equities have more than doubled. These wild swings in asset prices have been key to producing two 3

4 recessions in the last 15 years. Continuing to push asset prices higher from these elevated levels could potentially increase the risk of another asset level. Now this does not mean that the Fed will no longer provide stimulus to the economy. A reduction of the purchase program in Bernanke s own words is like taking your foot off the gas pedal. In addition, the Fed has maintained that they will hold their balance sheet at current levels for a longer period of time, perhaps even indefinitely. The sheer volume of securities remaining on the Fed balance sheet is also accommodative. Now it s inevitable that the Fed will begin to reduce stimulus. The challenge will be how to accomplish this without causing the economic recovery to default. Economic data will certainly play a much larger role in moving markets going forward. I want to turn now to Terry Sandven, but I d like to come back to you Jennifer in a minute on forward-looking thoughts that you might have reflecting our group s thinking. So, Terry Sandven, chief equity strategist for U.S. Bank Wealth Management, up until just recently equities frankly have been remarkably resilient over the past eight months, stock prices have managed to forge higher through U.S. elections last year, the year-end fiscal cliff, sequestration, associated tax increases, spending cuts and on and on and on so it s pretty remarkable. Now the focus is on the Fed. How are Fed discussions surrounding tapering and eventual ending of quantitative easing impacting the equity markets? It seems they are having a significant impact. Terry Sandven: Well they are John. The stock market is clearly impacted by Fed action. While reduction in quantitative easing does not imply that the Fed will raise interest rates soon. As Jennifer has stated, it does reflect the change in trend and with change can come uncertainty, a degree of investor anxiety and increased volatility. That certainly was the case last week, and as well as again today. To me, for U.S. equities, last week s price decline was based solely on Fed comments and seems like an overreaction. As Jennifer has mentioned, the Fed reported what we already know. The economy is showing signs of improvement, the Fed is entertaining when to begin ending quantitative easing and Fed rate hikes are unlikely until the unemployment rate declines at 6.5 percent and even possibly lower. So I suspect the volatility in the equity market last week and again today may be as much related to concerns about second quarter results as it is about upcoming Fed tapering decisions. Nonetheless, last week s Fed discussion did serve as a useful excuse to take profits. In fact, even with the sell-off in recent days, the popular U.S. indices are still up above expectations. At present, the Dow Jones Industrial Average, the large company-oriented S&P 500, small company-oriented Russell 2000 are still up approximately 10% in just the first six months of this year. These are certainly respectable performance numbers that are impressive in all economic environments. Yes and to your point about maybe it was time to take some profits off the table. Individuals and professional money managers have had quite a year and maybe it s just a dialing back and protecting of some of those profits. Let s look forward a little 4

5 bit and let me ask you Terry what are some of the upcoming catalysts that you see as potentially impacting equity prices going forward? Terry Sandven: John that s a key question. The list of items or events that have the potential to impact equity prices is perhaps endless. I m focused on three. Clearly the Fed and timing of when quantitative easing tapering is likely to begin is one. Let me get some additional insight into the thinking of Fed officials following last week s meeting in the upcoming minutes scheduled as you may know for release on July 10 and of course the following federal open market committee meeting on July 30 and 31. Second, quarterly results. Many companies are scheduled to report second quarter results beginning in mid-july and frankly the current sentiment is somewhat cautious for the quarter. Investors will undoubtedly be looking at revenue and earnings growth, as well as insights that company managements may have about the strength of the economy and the prospects for their businesses and associated spending plan. A third catalyst is economic indicators. We will need to see, I think, continued improvement in the U.S. economy for equity prices to trend higher. The bulls say that the economy is strong enough to stand on its own merit without Fed assistance. The bears argue the opposite. So that s the debate. I would focus on the employment report. The June report is scheduled for release on July 5 so attention will be directed to the number of nonfarm payroll jobs and the unemployment rate which currently stands at 7.6 percent. Also, watch housing. Housing has been a bright spot. In fact while the pace of improvement is likely to moderate some, particularly if mortgage rates continue to trend upwards, I believe housing needs to continue to improve for equity prices to trend higher. As you may know John, housing remains an important component of the economy. It adds to employment, confidence, consumer net worth as well as consumer spending. So housing is key to economic growth. And if I were to add a third economic indicator, as Jennifer has referenced, watch inflation. Inflation is key for equity prices. Without meaningful inflation, interest rates are likely to remain constrained and valuation price earnings multiple that has the potential to expand. Terry Sandven: So talk to us about the near term. What do you suppose investors might expect over the coming days and weeks? I suspect continued volatility and today s market action would serve as one example of that. At present, the Dow Jones Industrial Averages were down 66 points earlier this morning and the market was down 250 points. So I think you re likely to see continued volatility. I think U.S. equities in general seem to be going through a period of what I ll call digestion particular given the strong year-to-date performance results. While this process can be unsettling, it can be a good thing as well. A sideways trending market will likely bring some skepticism back into the market, lower expectations and possibly set the stage for higher prices later in the year. Thanks Terry. Jennifer, I want to come back to you and return to the fixed income markets. Let me now ask you to bring out your crystal ball. What should the markets expect to see in the next few months? 5

6 Terry referred to it as digestion, but in the bond markets it looks more like indigestion. That said we will not be surprised to see the Fed governors making speeches in the comings weeks. They re going to try to clarify their thoughts on future Fed Funds rate hikes because that s where the perception for the biggest mispricing in the bond markets currently sits. In the interim though, considerable volatility is going to persist until there s some more clarity around the reduction of purchases. The volatility could continue all the way until the beginning of the tapering process when the actual detail is released on the reduction plan. Over the last five years, rates have been at extremely low levels thus this resurgence of interest rate volatility can be very disruptive to the broader markets in the short term. We do not expect a broad-based asset sell-off to be sustainable. The bond market is already fully priced and tapering as well as the 50 percent probability of a Fed Fund hike in We do not believe rates will sell off aggressively from here for multiple reasons. First, the Fed will continue to hold a substantial book of assets on their balance sheets. Also, the increased regulatory demand for safe assets remains in place. The net issuance of government securities is going to continue to decline and the backdrop of extremely low levels of inflation. As we mentioned a couple of times on this call, that puts downward pressure on rates. And then lastly, the Fed has explicitly stated that they will not be considering Fed Fund increases until employment reaches that 6.5 percent threshold and likely not even until employment reaches a six percent level. Thus, the scope for Treasury yields to rise significantly higher from here appears to be a bit limited. Now although we expect volatility to continue for several months, we expect the 10-year Treasury to settle down to the 2.4 to 2.5 percent range by year end. Over the longer term, we do believe we are in an environment where unfortunately yields will gradually be on the rise over the next few years. The bull markets and bonds are just a bit long in the tubes. Although we do not see in the evidence of a credit bubble at this point, we are seeing signs of a mature credit cycle. Now that said, we do not expect to see the repeat of the bond blood bath we experienced in That severe price action was the direct result of an aggressive Fed raising short-term interest rates by more than 300 basis points within a 12-month window. Frankly John, that s just not the environment we re in today. We have a sluggish economy attempting to pull itself out of one of the worst recessions we ve seen in decades. In addition, we have a much more transparent Fed that s committed to keeping the Fed s Funds rate on hold for an extended period of time until the economy is on a much more solid footing. Lastly, the Committee has already stated that even when the economy is stabilized they expect to raise rates at a much slower and steadier pace than in previous cycles. 6

7 The purchase reductions will largely impact the intermediate- to long-end of the yield curve, resulting in a steeper curve. As the short-end of this curve again remains anchored with the Fed Funds rate on hold, unlike 1994 where the majority of the movement was on the short end which created an actual flattening of the curve. Thus, any sustained rise in rates is likely to be an incremental process with rates remaining volatile and rising gradually not sharply. So Jennifer, we talk about the bond market or the fixed income market. but as you know that covers a lot of landscape. We ve got high yield bonds, we ve got municipal bonds, we ve got corporate bonds and on and on. Talk to us if you could about sectors or strategies that investors should implement given the recent market sell-off and in preparation for steady rise and interest rates. John, the credit sectors of the market are usually the most resilient given the Fed s tapering plan and due to a strengthening economy. So in other words, the strengthening in economy usually equates to a stronger credit factor. Unfortunately fund outflows have had the greatest negative impact on high yield and municipals. Most of these redemptions have occurred via the retail investor rather than the institutional investor. Now this is because when any form of fear sets in, the retail investor can easily be spooked into moving into cash to weather the storm. Going forward, high yield is historically the least sensitive sector to interest rate rises given the higher coupons. Now an environment of steady economic growth should support credit, albeit with some additional volatility now. We expect that once rates stabilize a bit and the fund flows or outflows decline, high yield will again be one of the more promising sectors of the fixed income markets. Now switching over to municipals. The sector does become more attractive. Municipal ratios should compress as municipal tax exemption becomes more valuable at higher yield levels. We would encourage clients additionally to avoid adding to positions in interest rate-sensitive sectors such as Treasury and mortgagebacked securities. Even with the price decline that we ve seen recently in mortgagebacked securities, these are going to be the sectors that are going to be more sensitive to any potential rate hikes. Also clients may wish to favor moderate maturities in the steeper part of curve. That s where they re actually being compensated for taking the risk of being in bonds. And lastly, focus on higher coupons within all credit sectors or all sectors and all credit qualities as the higher coupons tend to be a bit more resilient to interest rate rises. Now all of that said John, longer term future appreciation and bond prices are likely limited. The modest curve steeping we expect going forward does not present significant opportunities for total return investors. Thus, we are maintaining our underweight fixed income in favor of equity exposure. Thank you Jennifer I appreciate your thoughts very much. And so Terry Sandven you get to bat clean up here. I m going to go back to you for some final thoughts on the equity market. I guess specifically get that crystal ball out again and look further into summer and towards year end. How do you think equity markets are likely to react? 7

8 Terry Sandven: I like the outlook for U.S. equities as we look toward the year end and into 2014 particularly if you look beyond the next one to two months for three or four reasons. First, valuations are fair. Companies are trading at or modestly below levels experienced during similar economic periods. Sentiment is favorable. Sentiment is driven by the recovery and housing and increasing consumer net worth. In fact, consumer net worth is reportedly back to 2007 levels. That s probably the result of higher home prices and the wealth affect associated with higher stock prices. The appetite for yield remains high. Many companies offer dividends with attractive dividend yields, providing investors with both income and price appreciation. In fact at present, as of this morning, 34 percent of the S&P 500 companies have dividends yielding greater than the 10-year Treasury yield of 2.5 percent. So the opportunity for income and growth remain relatively high for select equities. And lastly, as Jennifer and I have both mentioned earlier, inflation is key. At present broad-based inflation appears benign so while volatility has climbed in recent days largely due to the uncertainty surrounding the Fed and second quarter results, inflation remains contained. This presents a favorable backdrop for equity prices to trend higher, particularly after the market works through second quarter results and looks towards year end and into So John, all things considered I still see upside potential to the equity market. Our upside price target for the S&P 500 is to the 1760 range. That s approximately 10 percent above current levels. Downside potential at or near current levels. Technically the 200 moving average for the S&P 500 is near 1500 and that s roughly five percent below current levels. So five percent roughly on a downside, and ten percent on the upside through year end. Okay thank you Terry. And so to close Terry and Jennifer again thanks so much for joining me today. To our clients on the call, please keep in mind that not all investment solutions and strategies mentioned may be appropriate or available to all clients. Your U.S. Bank investment professional will be happy to discuss our comments and the context of your particular situation. I want to thank you very much for listening in and for your relationship with us and for taking time to attend the call today. Please contact your account manager if you d like more information on these timely topics. Good bye. Closing: Thank you for listening. We invite you to join us for future calls. Details can be obtained from your U.S. Bank Wealth Management Advisor. 8

9 IMPORTANT DISCLOSURES This information represents the opinion of U.S. Bank and does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. These views were presented on June 24, 2013 and are subject to change at any time based upon market or other conditions. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Data and research information and statistics have been gathered from a variety of sources. U.S. Bank is not responsible for and does not guarantee the products, services or performance of its affiliates and third party providers. Any organizations mentioned are not affiliates or associated with U.S. Bank in any way. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes shown are unmanaged and are not available for investment. The S&P 500 Index is an unmanaged, capitalization-weighted index of 500 widely traded stocks that are considered to represent the performance of the stock market in general. The Dow Jones Industrial Average (DJIA) is the priceweighted average of 30 actively traded blue chip stocks. The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000 Index and is representative of the U.S. small capitalization securities market. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investment in fixed income debt securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer term debt securities. Investments in high-yield bonds offer the potential for high current income and attractive total return, but involve certain risks. Changes in economic conditions or other circumstances may adversely affect a bond issuer s ability to make principal and interest payments. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. Investments in mortgage-backed securities include additional risks that investors should be aware of such as credit risk, prepayment risk, possible illiquidity and default, as well as increased susceptibility to adverse economic developments. 9