The Autus Review

January 4, 2015

2014 Fourth Quarter

The Economy

The U.S. economy finished the year on strong footing. During the third quarter the economy expanded at an annualized rate of 5%, supported by strength in both household and corporate spending.

Interest rates declined during the year, providing additional support for the expansion. A growing supply of credit, low inflation expectations and improved credit risk, along with the perceived safety of U.S. debt, all contributed to falling yields. Additionally, consumer confidence was bolstered by an improvement in the job market. During the year the unemployment rate dropped to 5.8%, a level not seen in over 8 years.

Finally, another positive factor boosting growth expectations is the dramatic decline in oil prices that began during the second half of the year. Clearly, falling oil prices will have a negative impact on high-cost energy producers and exporting countries, but most of the world should experience a net benefit from lower energy costs.

Emboldened by the perceived durability of the current economic expansion, the Federal Reserve concluded their quantitative easing program in October. Given that inflation is seemingly under control and the job market continues to show improvement, a monetary policy shift to begin normalization of interest rates is likely in 2015.

While our domestic economy appears to be hitting its stride, the same does not hold true for the rest of the world. China’s economy is working through a structural transition that is causing growth to slow from the rapid pace set during the last decade.

Both Europe and Japan continue to struggle with slow growth and the threat of deflation. While the “danger” of falling prices does not sound that concerning, when caused by a reduction in the supply of credit due to a shrinking money supply, the economic impact can be troublesome and stubbornly enduring.

In theory, a deflationary environment can restrain consumption and harm producers while increasing the real burden of debt for borrowers. Adjusting to a deflationary environment can be difficult due to the inability to reduce nominal wages to reflect lower prices and profits. As we’ve seen in Japan over the last 20 years, even lowering interest rates to nearly zero can have little effect on enticing consumption when prices are expected to continue falling. Fortunately, Europe and Japan appear committed to heading off deflation and reigniting growth through monetary stimulus and quantitative easing.

Capital Markets

Uneven global growth caused a divergence between equity markets around the world. While domestic equities performed well during the year, international developed and emerging stock markets underperformed. This theme will most likely carry into 2015 as international economies struggle to gain traction while the U.S. economy continues to experience moderate growth. The impending monetary
policy shift and geopolitical risks in Eastern Europe and the Middle East may keep market volatility on the rise in the near term.

As we move into the New Year, it is difficult to predict the direction of interest rates. The Federal Reserve has made it clear to investors that a shift to normalize monetary policy is on the horizon and that higher rates should be expected sometime in 2015. However, other variables that influence rates such as supply and demand for credit, inflation expectations and credit risk all point to continued low rates for the time being.

Portfolio Implications

Uneven global economic growth supports our investment thesis of focusing on high-quality domestic stocks. We will continue to underweight energy dependent sectors while overweighting sectors that will benefit from a boost to discretionary income thanks to lower fuel costs and a stronger dollar. We will maintain our underweight to international equity markets for the time being while carefully monitoring the situation for undervalued opportunities.

Fixed Income
The yield curve has flattened during 2014 but remains positively sloped. Rates remain near historical lows and the risk/reward characteristics of the bond market do not appear favorable for lengthening duration at this time. We will continue to focus on short to intermediate investment
grade corporate bonds, targeting attractive spreads.

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