The Autus Review

July 8, 2014

2014 Second Quarter

The Economy

The great bull market continues, as investors have been strangely dismissive of any impending worries, economic, geo-political, or otherwise. Besides the fact that there have been very few attractive investment opportunities other than stocks, the rally has been fueled by liquidity from an accommodative Federal Reserve and a slow-developing, modest economic expansion.

Now in its fifth year, the recovery in the U.S. economy has been tepid, uneven, and unpredictable. In fact, many were surprised by the -2.9% GDP contraction for the first quarter of 2014, even though economic conditions were largely impacted by poor weather in much of the country.This negative growth was likely an aberration, and we expect the economy to return to a 2%-3% growth trend in
the coming quarters. In order for this to occur, we’ll need to see continued improvement for the consumer, as well as a pick-up in capital spending by businesses.

The consumer component of the economy is experiencing moderate improvement, driven by a better employment picture. Since February, job gains have topped 200,000 a month, and the unemployment rate has fallen to 6.1% (it had exceeded 10% at the depths of the down cycle). The “quality” of the improvement could certainly be better. The labor force participation rate is near its lowest levels
since the late 1970s and the number of people working part-time because they can’t find full-time employment is still concerning. Also, much of the recent job gains have come in low-wage fields. But overall confidence has been improving and, along with modest wage gains, consumption should continue to contribute to economic growth.

Business spending should begin to accelerate at this point in the cycle. Coming out of the 2008-2009 recession, corporate uses of cash were focused on raising dividends and buying back stock. The next phase of spending was for companies to grow by buying existing capacity through mergers and acquisitions. As M&A opportunities get pricier, it becomes cheaper to “build” rather than buy. With the factory utilization rate near 80%, the U.S. trade deficit improving, and total corporate net cash flow reaching almost 105% of nominal GDP, a cyclical resurgence in capital spending is to be expected.

Overall, the slow recovery should continue. Several key factors are showing moderate improvement; auto sales and production, housing, non-residential construction, cap-ex. These, along with positive secular trends like a domestic energy boom, a favorable aerospace cycle, and a budding manufacturing renaissance, bode well for continued fundamental economic health going forward. And without excesses yet developing, the Fed should continue its generally accommodative stance for the next few years.

Capital Markets

The U.S. stock market recently passed the 1,000-day mark without experiencing a correction. It’s been nearly three years since we’ve seen a 10% drop in the S&P 500 Index. This milestone marks the fifth longest stretch in the last 90 years without a correction, and the longest since the mid1980s.

Markets that move in one direction for too long become concerning. A pause or a modest pullback would be “healthy,” consolidating some of the gains and moderating speculation. That said, it would appear the path of least resistance for stocks in the next couple years continues to be upward. Valuations remain reasonable and earnings per share growth is strong. Corporations have $2 trillion of cash on their balance sheets, which will be deployed with more acquisitions, business investment, dividend increases, and share buybacks… all good for the market.

Portfolio Implications

Since the market rally began in 2009, low-quality companies have outperformed those with higher-quality characteristics. It seems easy monetary policy and low volatility have emboldened equity investors to take on risk. Companies with leveraged balance sheets and lower stability of earnings and dividends have done meaningfully better. However, we do not see this trend as sustainable. We continue to believe investors will be rewarded over the long term by holding higher quality assets, emphasizing balance sheet strength, healthy profit margins, attractive top-line growth prospects,
and solid business fundamentals.

Fixed Income
Interest rates should be gradually moving upward. An increasingly stable economic outlook means the Fed will likely be shifting toward a more neutral monetary policy. Bond yields have not yet reconnected with the economic cycle. As such, we remain cautious in our outlook for the
bond market and are not inclined to “reach” for yield by extending durations or lowering credit quality standards. We’re finding relative value with investment grade corporate bonds, generally in the 3-8 year maturity range.

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