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“Customized Portfolio Management for over 25 Years”
First Quarter 2015 Review and Outlook
April 9, 2015
Q1 2015 Performance and Highlights
U.S. equity and bond markets generated slight gains in the first quarter of 2015. Financial market volatility increased in
the quarter. Macroeconomic factors — central-bank policies, currency fluctuations, and oil price declines all contributed
to nervous markets. On six occasions the Dow Jones Industrial Average posted triple -digit point gains and nine times
suffered triple-digit point declines. The S&P 500 had thirty consecutive trading days without back to back up days — the
longest stretch since 2001. For the quarter the S&P 500 gained 0.4%, while the NASDAQ composite index gained 3.5%, led
by technology stocks (the ninth consecutive quarterly advance for both averages). Ten-year U.S. Treasuries finished the
quarter yielding 1.93% down from 2.17% at year-end. Bond yields have declined for five sequential quarters for the first
time since the recession in 2001. Crude oil futures remained under pressure and closed the quarter at $47.60/barrel.
Industrial commodities and gold prices finished the quarter lower, continuing trends from 2014. Strongly impacting
financial markets, the U.S. dollar extended last year's gains against foreign currencies in Q1, particularly the euro. The
euro recorded the largest three month decline against the dollar since it was created in 1999, dropping 11%. In the first
quarter, both Asian and European equities outperformed U.S. equities primarily due to more accommodative monetary
policies respectively.
The U.S.Economy and Interest Rates
The U.S. economy expanded at a 2.2% annualized pace in Q4 2014, led by the largest gain in consumer spending in eight
years. Consistent with recent years, economic momentum slowed in the first quarter. Severe weather, a West Coast port
delay, and an 8% surge in the U.S. dollar, all contributed to a “nonrecurring” slowdown of economic activity. In the six
month period ending February 2015, the leading economic index increased 2.4% (approximately a 5.0% annual rate),
slower than the growth of 3.7% during the previous six months. Industrial Production in February only grew by 0.1% and
was revised downward for January from a gain of 0.2% to a decline of 0.3%. Manufacturing, housing , and confidence
readings also declined modestly in Q1. Employment continued to grow in the quarter desp ite March employment data
coming in below consensus estimates. Inflation remained low in the quarter. While consumer prices edged up 0.2% in
February, the first time since last October, core producer prices declined .5% and are only up 1% year-over-year. Q1 GDP
forecasts predict 1.4% growth for the quarter. Most economists forecast a rebound in the economy in Q2 and a 3.5% GDP
growth rate. For all of 2015, the U.S. economy is now projected to grow at a 2.5% rate. With consumer spending
representing two-thirds of domestic GDP, we believe the consumer benefit associated with lower oil prices will provide
an important boost to the economy in 2015. The U.S. economic recovery is continuing, albeit at a modest pace. On balance,
it also appears at this time that global economic activity is improving over last year.
Federal Reserve policy might prove to be easier to predict than GDP and interest rates. Since culminating Quantitative
Easing (QE) last October, the Fed has consistently communicated the objective of normalizing short-term interest rates as
soon as it can be determined that rate increases are justified. Recently, Fed Chairwoman Janet Yellen indicated the timing
of any rate increase hinges on how the economy performs in the months ahead, and it would be gradual. Based on the
Federal Open Market Committee (FOMC) forecast released on March 18, the central bank expects the federal funds rate
to reach a level of 0.625 by year-end 2015. It appears the new key phrase at the Federal Reserve is “reasonably confident”
a departure from the previously pledge of being “patient”. The Fed appears to be focusing on four economic criteria to
become more “reasonably confident” as to the timing of raising interest rates: 1) Labor markets. Yellen indicated “a
stronger labor market is one factor that would tend to increase my confidence.” 2) Core inflation. Yellen remarked, “we
expect inflation to remain quite low because of the influence of energy price declines and the strong dollar…we will be
looking at the inflation data carefully.” 3) Wage growth. “We will be looking at wage growth.” 4) Inflation expectations.
“Market-based measures of expectations are too low. If they were to move up over time that would probably serve to
increase my confidence.” The question is not if the Fed is going to raise rates, but when. If the U.S. economic data
accelerates in Q2, the Fed will likely raise the Fed Funds rate in the second half of 2015. Importantly, the current Federal
Reserve policy indicates that the economy is transitioning into a self-sustaining phase for the first time since the financial
crisis began in 2008.
Alternatively, U.S. interest rate flucuations are currently subject to more than just shifting Federal Reserve policy and
domestic economic data. Globally, 50% of all sovereign debt trades at less than a 1% yield while 20% of all sovereign debt
trades with a negative yield. The German 10-year Bund currently yields .19% while a Japanese 10-year Treasury yields
.39%. Eighteen different developed nations 10-year debt trades at lower yields than U.S. 10-year Treasuries. The European
Central Bank (ECB), Japan and most recently China all are providing meaningful monetary stimulus to their economies.
U.S. debt should continue to be well received given the smallest Federal budget def icit since 2008, a stronger relative
economy, a strong dollar and yields on Treasuries that are higher than in almost all other developed nations. Also
influencing interest rates, inflation remains very low domestically and abroad. Recent weakness in energ y and industrial
commodity prices have put further downward pressure on global inflation rates. According to former Fed Chairman Ben
Bernake recently, “what matters most for the economy is the real, or inflation-adjusted, interest rate (the market, or
nominal interest rate minus the inflation rate). The real interest rate is most relevant for capital investment decisions…”.
While U.S. interest rates should increase with Federal Reserve tightening and a higher Fed Funds rate, it is difficult to see
interest rates increasing meaningfully given low inflation, a strong dollar and much lower interest rates internationally.
Modest global economic growth, accommodative monetary policies and persistently low inflation rates should continue
to keep bond yields low for the near-term.
Energy Impact
A wildcard for Federal Reserve policy, interest rates, the economy and financial markets continues to be crude oil prices.
When crude oil prices fell almost 60% last fall, financial markets were initially riled on fears of deflation. It appears as
though low-inflation and not deflation will be the result of lower oil prices. Today, one clear impact of lower oil prices is
on U.S. corporate earnings. Lower oil prices have essentially eliminated S&P500 aggregate corporate earnings in the first
half of 2015 because the energy sector represents such a large portion of total S&P 500 earnings. Alternative energy
investments have noticably depreciated in this environment of low oil prices. The debt of tertiary companies in the oil
sector have been marked down meaningfully; many are now junk status. A once booming corporate finance business in
oil shale and fracking has dried up. Many unprofitable North American oil companies have put themselves up for sale. It
is estimated that over 20% of North American producers will cut capital spending by over 60%. Major oil companies have
cut capital expenditure budgets and initiated substantial employee reductions. Additionally, domestic exploration and
production for oil has declined dramatically with the decline in oil prices. The oil rig count in the U.S. has dropped from
over 1600 to 800 in four months. Despite this dramatic drop in the rig count, U.S. oil production continues to make new
record highs now topping 9.4 million barrels per day or about 1 to 2 million barrels mo re than the U.S. consumes each
day. Moreover, despite the collapse in the number of drilling rigs, the rate of domestic oil production increase has not
slowed (15% YoY). Shale producers are simply pumping more oil out of their best performing wells and shu ttering lesser
producing wells. Recently, domestic storage capacity for growing oil production has become noteworthy and has
contributed to crude oil price volatility. U.S. oil stockpiles are more than 25% above their five-year average. While oil prices
have rebounded from their lows primarily due to geopolitical concerns in the Middle East, it appears to us that the near term risk in oil remains on the downside. While global demand for energy continues to grow annually, at this point in the
oil commodity cycle, it appears that oil supplies continue to outweigh demand…for now. Longer-term, investors should
stay focused on growing emerging and developing countries’ demand for energy.
— Number of U.S. Rigs
— U.S. Oil Production
The Equity Market
As previously mentioned, Q1 2015 has witnessed a substancial increase in stock market volatility. A strong dollar (negative
currency translation for companies with international business) combined with a collapse in energy sector earnings have
led market analysts to lower S&P 500 earnings estimates for 2015. S&P 500 Q1 earnings are now projected to decline 3%
with the majority of the decline coming from the energy sector (-63% for the quarter). Q2 2015 earnings are now projected
to decline approximately 2% while Q3 earnings estimates have also been lowered to a gain of 1.5%. It appears that fullyear 2015 S&P 500 operating earnings will be equal to that of 2014. Without the backdrop of growing earnings, stocks
would appear to be vulnerable to the often discussed “overdue” 10% correction (last seen in 2011). Further, the current
bull market in stocks is entering its seventh year providing additional angst for investors. We believe the stock market
resiliency in Q1 2015 is revealing. Despite substantial S&P 500 earnings revisions downward, the equity markets continued
to make new all-time highs in Q1 2015 (albeit modest percentage new highs). Excluding the oil sector, S&P 500 earnings
in Q1 should grow 5%. Interest rates and inflation continue to be very low. Global monetary policy remains ultrastimulative and continues to positively impact equity markets.
Historically, the early stages of a Fed tightening cycle have been good for U.S. equities. Highly respected Thomas Lee of
Fundstrat recently pointed out that economic conditions during a Fed tightening cycle have a strong influence on
subsequent stock market performance. “Today’s slow growth, low inflation and low inv estment spending environment
has historically produced better future equity returns.” Merrill Lynch notes that S&P 500 returns averaged +16% annually
in the five previous tightening cycles dating back to 1987. However, returns have been low in the six months prior to the
onset of tightening, averaging only +0.4%.
U.S. stock market valuations, while higher than two years ago, still appear to be reasonable. Depending on valuation
methodologies, the S&P 500 is selling slightly below its 20-year average multiple and slightly above its 50-year average
multiple. More importantly, equities are far more attractively valued when compared to fixed Income or cash alternatives.
Over 50% of S&P 500 stocks have a dividend yield higher than five-year Treasuries. In January, for just the fourth time in
over 50 years, the S&P 500’s dividend yield moved above the yield on the 10-year Treasury note. U.S. corporate balance
sheets continue to add to already record cash troves suggesting a continuation of dividend increases and share
repurchases. Stock market sentiment does not appear to be overly exuberant and, in fact, recently has become more
cautious. Institutional and individual investors continue to remain underinvested in equities. The lack of conviction and
caution demonstrated by investors in Q1 2015 can be viewed constructively and optimistically. Most importantly, we view
the risks of recession in the U.S. to be low at this time. With continued economic improvement domestically and
internationally, we believe stocks can continue to outperform fixed income alternatives.
Summary
While the first quarter of 2015 has been volatile for financial markets, both stocks and bonds did appreciate in value
modestly. Federal Reserve policy, international monetary accommodation, low interest rates, low inflation and weak oil
prices were the dominant investment themes in the quarter. U.S. corporate earnings are now projected to be flat in 2015
owing to a strong dollar and a decline in oil company profits. The Federal Reserve is likely to raise the Fed Funds rate later
this year. Equities continue to look more attractive than fixed income alternatives. Recession risks appear to be low at this
time.
Sonora Investment Management strongly believes that investing in companies that generate strong free cash flow is
imperative for stock and bond investors alike. We favor equity investments in U.S.-listed, dominant businesses —
companies with significant competitive advantages, strong balance sheets, growing dividend yields and compelling
business models. In fixed income, we continue to be cognizant of the risk that interest rates can increase. Accordingly, we
suggest a short-term, laddered fixed income approach primarily invested in convertible and corporate bonds. Convertible
bonds remain an investment cornerstone at Sonora Investment Management. Exceptional ris k/reward characteristics
combined with a greater immunity to interest rate increases make convertible bonds particularly attractive today.
Convertibles have historically been less sensitive to interest rate risk because of their equity characteristics. Thi s can make
convertibles a compelling alternative to traditional fixed income securities, particularly in today’s low interest rate
environment.
Sonora Investment Management’s primary investment objective for investors continues to be preservation of principle, a
competitive income yield and the potential for growth.
As always, thank you for your support.
Sonora Investment Management
4720 E. Cholla St., Suite 100, Phoenix, AZ 85028 | 480-474-4188 | 877-468-6468
2343 E. Broadway Blvd., Suite 116, Tucson, AZ 85719 | 520-624-4554 | www.invmgmt.com |[email protected]