Investment Perspectives
AP RIL 2015
JANNEY MONTGOMERY SCOTT LLC
Chart A: Growth Is Near Or Below 7%
Year of the Goat
By Mark Luschini, Chief Investment Strategist
twitter.com/luschini_janney
The Goat comes eighth in the Chinese Zodiac. There are twelve
animals represented, with each repeating in a cycle of twelve years.
China recently celebrated its Lunar New Year, ushered in by festivals
and parades with many participants joining in sporting goat costumes.
Now officials are back down to the business of running the world’s
second largest economy, and continuing to implement the structural
reforms that have been underway for several years. Importantly,
China’s most recent 5-year plan adopted significant market reforms
which, in our view, will rebalance the economy on to a more
sustainable and predictable path.
(Source: BCA Research)
Because growth has slowed, (the research firm Bank Credit Analyst
estimates that GDP is currently operating below the 7% figure, and
others actually suggest growth could be even lower) officials are taking
measured steps to reflate economic activity. Some fiscal projects that
fit in the 5-year plan have been announced, such as infrastructure and
rail, and others have social benefits like expanding affordable urban
housing space, loosening credit and regulatory standards to encourage
urban migration, and home ownership.
A critical part of this plan is to successfully shift its economy from one
that is led by investment, to one that is instead increasingly reliant
upon consumption. By way of comparison, consumer spending in the
United States represents approximately 70% of the economy, while
in China it’s just about 35%. The savings rate in China is exceedingly
high, around 52% of the GDP, so Chinese policymakers have been
introducing services, like pension plans and other social safety nets,
in order to create disincentives to save. This in turn should leave room
for Chinese consumers to spend, thereby lifting the percentage that
consumption represents to economic growth. The shift will be gradual,
and likely not without some bumps, but it ultimately will lower the pace
of GDP even further in the years to come. In the meantime, China’s
Premier Li Keqiang, recently confirmed the country’s target growth
rate this year of “around 7%.” This, like last year, is a clear breakaway
from the tradition of a firm target, and suggests there is some flexibility
in achieving it. Chart A illustrates the glide path in Chinese growth,
which ran at a better than 10% clip during the 2000s, but has now
downshifted to a “new normal” (China’s President Xi Jinping’s term for
a less-rapid expansion) growth rate, and yet one that is still sufficient to
achieve its state-designed goals and maintain social stability.
Contemporaneously, but glacially, the People’s Bank of China has
employed a more traditional monetary tool—lowering interest rates—to
stimulate activity. Worried about igniting a credit bubble, and wrestling
with large (and in some cases non-performing) credit balances at its
state-owned and other banks, policymakers have been reluctant to cut
rates meaningfully. However, just last month, Zhou Xiaochuan, governor
of the People’s Bank of China (“PBoC”), said that growth had slowed
too sharply, and offered sympathy for the notion of lowering interest
rates further, and even to employ “quantitative” measures. That last
remark insinuated some form of a bond-buying program similar to
what was underwritten by the U.S. Federal Reserve, and now the Bank
of Japan and European Central Bank. We suspect that is a tool of last
resort, and unlikely to be introduced soon, if ever. More likely, given that
China hosts very high interest rates relative to most other countries, the
PBoC will lean on lowering rates in an accelerated fashion compared to
previous reductions. In Chart B, rate cuts have been few so far—and at a
level above 5%, leaves plenty of room to lower them further—especially
as inflation is running well below 3%, the country’s stated target.
(Continued on page 2)
INVESTMENT PERSPECTIVES • JANNEY MONTGOMERY SCOTT LLC
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APRIL 2015
(Continued from page 1)
While it is unlikely China will ever grow in the double digits again,
cyclical conditions are likely to improve rather than deteriorate this year.
Chinese investors are probably at the very early stages of a potentially
massive portfolio shift from real estate assets and private wealth
products, to common stocks. Returns on property have fallen, and the
default risk in wealth products is escalating as the economy has slowed.
However, returns on stocks have been good of recent, which will draw
more retail capital into the equity market. We believe that there is still
substantial upside potential for Chinese shares, as almost all sectors in
the Chinese investable universe are trading at hefty discounts relative
to their global and emerging market counterparts. In Chart C, the top
panel shows Chinese policy interest rates relative to its global peers, and
its equity prices relative to an emerging market universe. Interest rates
are high compared to global central bank policies, and yet equity prices
after a sizeable period of bottoming, have finally begun to outperform.
In the lower panel, Chinese H-shares (those Chinese incorporated
companies listed and traded in Hong Kong) are still very inexpensive
when compared to both developed and other emerging market stocks.
We think that valuation disparity is unlikely to last, as measures taken by
Chinese officials to stimulate growth are validated by better economic
data, which we expect to see released over the coming months.
Therefore, we remain constructive on Chinese equities in both absolute
terms, and relative to other Emerging Market bourses.
Chart B: Expect More Aggressive Rate Cuts
(Source: BCA Research)
Some pundits express concern that the country is highly indebted,
and therefore the constraints to loosen policy are too tight, otherwise
policymakers’ risk exploding the financial system. The debt China
has incurred is mainly because savings need to be transformed into
investment. Therefore, a country with a high domestic savings rate
probably also has a high debt/GDP. Since many countries do not
have the capital market maturity of the U.S., with a deep and liquid
bond market, they have to rely on banks for financial intermediation.
Government debt levels are very low and the country runs a current
account surplus that adds to its sizeable reserve balance. For these
reasons, officials have the shock absorbers to maneuver and ensure
growth is maintained as the rebalancing of the economy takes place.
Chart C: Chinese Shares Should Perform Well
(Source: BCA Research)
INVESTMENT PERSPECTIVES • JANNEY MONTGOMERY SCOTT LLC
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APRIL 2015
Interest Rates
Should Be No Puzzle
By Guy LeBas, Chief Fixed Income Strategist
twitter.com/lebas_janney
It’s been since December 2013 that we focused the fixed income
segment of Investment Perspectives solely on Federal Reserve policy.
Regular readers should be forgiven for not noticing—after all, we’ve
written on the topic extensively in other forums, Fed chatter is pretty
much universal these days, and nearly every professional stock picker
has suddenly turned into an expert able to parse the smallest change
in central bank policy language. Nowhere was the debate more visible,
nor more inane, than in the day leading up to March’s FOMC meeting,
in which the financial media spent hours with experts trying to guess
whether the word “patient” would have a place in the Fed’s policy
statement. The irony is that the one word has never meant less.
Chart D: Yields vs. Expectations for Overnight Interest Rates
3.00%
2.50%
2.00%
1.50%
1.00%
0.50%
In 2015, the beauty of the Federal Reserve’s communication policy is
that it gives us a very clear way to value bonds with maturities between
three months and five years, and even gives us good information on
how to value longer-term bonds. The first key piece of the puzzle has
nothing to do with the FOMC’s statement, or comments from Janet
Yellen; instead it stems from several pieces of data the Fed releases on
a quarterly basis. These pieces of data are from the “Summary Economic
Projections” (SEP), which represent policymakers’ forecasts for growth,
employment, inflation, and crucially, overnight interest rates. One way to
think about the SEP is as a policy strategy. The Fed is essentially telling
us, “If X and Y happens, then interest rates will be Z%.” We can then
use this policy strategy, plug in our own economic expectations, and spit
out what we believe short-term interest rates will be.
0.00%
Five Year Treasury Note
Janet Yellen's Expectations
Fed Median Expectations
Combining piece one (the Fed’s projections) and two (definition of a
bond) yields a fairly simple way to generate a fair value for a bond of
3-months to 5-year maturity. Simply average expectations of the Fed’s
overnight interest rates over the next five years, and use that average
to determine whether the yield on a 5-year bond is high, low, or fair.
At the time of authorship, the fair value of a 5-year Treasury note,
assuming the Fed’s “median” case of economic growth, is 2.46%.
That assumes economic growth of 2.5% over the next three years, and
inflation returns quickly to 2%. If we plug in the market expectations
for overnight interest rates over the next five years, that fair value
for 5-year interest rates drops to 1.52%, which is much closer to the
market yield on 5-year bonds today.
The second key piece of the puzzle revolves around the definition of a
fixed-rate bond. There are obviously many ways to conceive of a bond,
but for our purposes, a bond is synonymous with an overnight loan for a
fixed term at a fixed interest rate. In other words, buying a 5-year bond
is the same thing as loaning someone money overnight at a fixed rate
for the next five years. In that sense, the fair value of the interest rate on
a 5-year bond is simply the average of expected overnight interest rates
for the next five years. An academic would describe this concept as the
“rational expectations” theory of interest rates.
INVESTMENT PERSPECTIVES • JANNEY MONTGOMERY SCOTT LLC
Market Expectations
(Source: Janney Fixed Income Strategy & Research, Federal Reserve; Yellen’s expectations based on
fourth-lowest Fed forecast.)
What can we take from the differential between the Fed’s median
forecasts and the markets’ expectations for overnight interest rates?
The key difference is that, while policymakers are hopeful inflation will
return to the Fed’s 2% goal reasonably quickly, market participants
aren’t so sure. As a result, markets are betting that the rise in
overnight interest rates will be slower than the Fed themselves are
forecasting. And given how abysmal the Federal Reserve officials’
records in forecasting economic activity have been, that seems like a
pretty reasonable bet these days.
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APRIL 2015
Chart F: Various Economic Measures (January 2013 – March 2015)
80
70
60
Y-earning for More
50
Empire State Index
40
ISM Index
Philly Fed Index
30
By Gregory M. Drahuschak, Market Strategist
20
Chicago PMI
Richmond Fed Index
ISM Services Index
10
0
The march to a new market high largely reached the destination, but the
stay was short-lived. The Dow Jones Industrial Average reached its new
high destination the first trading session in March, but within the month
it was approximately 600 points below the new high. The S&P 500 set
new intraday and closing peaks March 2, and then fell back 3.66% by
the middle of the month. The Nasdaq Composite Index and the Russell
2000 took longer to reach new highs, but a mid-month shift toward
smaller capitalization stocks enabled both indices to set new highs
before they, too, pulled back.
‐10
‐20
(Source: New York Federal Reserve, Institute for Supply Management, Philadelphia Federal Reserve,
Chicago Purchasing Managers, Richmond Federal Reserve, Janney Investment Strategy Group)
The market began to focus more intensely on what first quarter
earnings reports would show. Nearing the end of March, 93 companies
in the S&P 500 had issued negative earnings guidance, while just 18
companies issued positive guidance. First quarter year-over-year earnings
for the S&P 500 were projected to drop 4.6%, which if realized would
be the first year-over-year earnings drop since the third quarter of 2012
when earnings fell 1.0%, and the largest year-over-year decline since the
third quarter of 2009.
Chart E: Index Results
20.00
15.95 15.00
10.00
1st Qtr results
March
5.00
3.48 5.44 1.25 0.44 (0.26)
(1.97)
(1.74)
(1.26)
(5.00)
3.93 2.70 1.52 0.07 0.00
(1.19)
(3.14)
(4.36)
(5.02)
(2.68)
(1.46)
The consensus 2015 estimate for the S&P 500 dropped for 26
consecutive weeks, from a high of $132.36 to $118.46 at the end of last
week. Estimates for nine of the ten S&P sectors were down, but the rate
of descent in the energy sector estimate (down 54.91% through this
period) far exceeded anything else. Beyond energy, however, estimate
reductions have been relatively modest, with only one of the nine nonenergy estimates down modestly more than 10%. The average estimate
cut for the nine non-energy sectors has been only 3.43%.
(2.15)
(10.00)
D J
Industrials
S&P 500
NASDAQ
Comp
SOX Index
Biotech
Index
DJ
DJ Utilities MSCI EAFE
Transports
ETF
Gold ETF
Russell
2000 Index
(Source: Thomson Financial, Janney Investment Strategy Group)
Chart G: % Change in Sector Estimate Through the Past 16 Weeks
The inability to sustain these peak levels largely stemmed from the flow
of economic data that was not bad, but not as rosy as it had been. As
illustrated in the Chart F, numerous economic measures slipped in the
last few months.
10.00
1.23 0.00
(10.00)
(1.10)
(1.33)
(2.75)
(3.12)
(4.24)
(20.00)
(4.53)
(4.95)
(10.02)
(30.00)
(40.00)
(50.00)
(54.91)
(60.00)
(Source: S&P Capital IQ, Janney Investment Strategy Group)
(Continued on page 5)
INVESTMENT PERSPECTIVES • JANNEY MONTGOMERY SCOTT LLC
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APRIL 2015
(Continued from page 4)
As was true in 2014, the economy took a hit due to the persistently
bad weather in the first quarter, which impacted estimates for
the quarter and full year. The West Coast port strike also was a
significantly large factor, dragging business activity down. Both of
these issues are out of the way now.
Undoubtedly, the strong dollar impacted first quarter results and may
also weigh on second quarter earnings. Faced with a headwind like
this, there is a tendency among industry analysts to take an overly
conservative view of potential corporate results. By the end of April,
the market should have a good sense of the first quarter outcome, but
also of what results might be a few quarters ahead. The risk is that the
lowered estimates were not too conservative, and might not have been
conservative enough. We suspect, however, that earnings expectations
may have become too negative. Technically, we see nothing to dissuade
us from thinking that 2015 will produce positive results, albeit results
that will not match those of the previous few years.
Within the Federal Reserve Open Market Committee’s 544-word March
policy statement, one line stood out—“The Committee anticipates
that it will be appropriate to raise the target range for the federal
funds rate when it has seen further improvement in the labor market,
and is reasonably confident that inflation will move back to its 2%
objective over the medium term.”
From a global investment standpoint, Europe stands out. The valuation
discount in European equities versus the U.S. market has narrowed in
recent months, but the gap remains large. Valuation alone might not be
enough to prompt higher equity values in Europe, but tangible evidence
of economic improvement in Europe, and recently deployed (and much
enhanced) accommodative credit policy bode well for improved GDP
and corporate earnings. A recently released Janney Investment Strategy
Group report titled “The Old World is New Again,” available from your
Janney Financial Advisor, details specific reasons why equity investment
in Europe remains appealing.
The absence of the word “patient,” which previously had indicated the
Fed’s willingness to delay a rate boost for several meetings, initially
prompted concern that a rate hike might be on the near-term horizon.
Fed chairperson Janet Yellen, however, made it abundantly clear that a
relatively low rate regime would persist for a long time. The “dot plot,”
in which the Fed members indicate what they individually believe
interest rates will be at various points in the future, reaffirmed that the
Fed will move slowly in adjusting its extremely accommodative credit
policy. The consensus view appeared to be that a rate boost of modest
proportion would occur this September, but as Yellen has made very
clear, the timing of any move will depend highly on the performance of
the economy.
One final point potentially offers the economy and the equity market a
solid positive. At 101.3, the Consumer Confidence Index was 2.5 points
above the previous month, which was upwardly revised. The Expectations
Index increased from 90.0 last month to 96.0 in March. The Present
Situation Index, however, decreased from 112.1 in February to 109.1.
The report also showed that consumers have a positive view of the job
market. Consumer confidence could be a powerful economic driver.
With its 70% role in the U.S. economy, how consumers feel is important.
Improving employment conditions, rejuvenated balance sheets, and very
low debt service as a percent of disposable income are potent factors that
could propel the economy forward—which is one of the key reasons our
suggested sector preferences include a positive view of the discretionary
sector, which includes many retailers as well as homebuilders.
April dawns with the hope that it lives up to its typical performance.
In the previous 65 Aprils since 1949, the S&P 500 posted a gain in the
month 44 times. April is second only to December in the number of
instances through the post-1949 period that the month has produced
positive results. In the most recent ten years, the S&P 500 failed to
produce positive April results only twice, in 2005 and 2012. This month
the focus should not be on the time of the year, but rather on the first
quarter earnings season that may be the most important reporting
period in the last few years.
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INVESTMENT PERSPECTIVES • JANNEY MONTGOMERY SCOTT LLC
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APRIL 2015