MARKET COMMENTARY

Second Quarter 2016 Perspective: Economic and Investment Outlook

Moving Forward in a Tortoise Economy; Slow and Steady

06.28.2016 - Ronald J. Sanchez

Following a sharp bout of volatility midway through the first quarter of 2016, US equities are showing signs of stabilization. Relatively positive economic data, a clearer sense of monetary policy and easing global pressures pulled the market off its recent lows.

The broadest measure of economic growth, GDP, was off to a slow start in 2016. But expectations have improved enough to suggest growth of about 2% for the year.

Importantly, several economic undercurrents were supportive. As of May 30, oil prices continued to trend higher and financial conditions eased, credit spreads remained firm and the dollar, while moving higher, was still well below its January peak. Interest rates also remained low and supportive of economic conditions.

In no uncertain terms, the US economy is moving forward in low gear. Our economy is advancing incrementally, inch by inch, and we believe it will probably continue to proceed at that pace for an extended period.

The Backdrop for This Unique Economic Cycle

Frankly, from our vantage point, a 2% economy is nothing new. The average quarterly GDP growth since exiting the financial crisis during the second quarter of 2009­—exactly 2%. But previous economic cycles have conditioned investors to expect a stronger rebound and ramp-up in growth.

Explanations for the absence of a strong recovery range from the difficulties associated with digging out of the banking crisis to the regulatory environment, subdued productivity and aging demographics.

In this unusual environment, businesses have been slow to ramp up capital expenditures but quick totake advantage of low interest rates to repurchase stock and engage in other forms of financial engineering. Capacity utilization, a measure of how fully companies are using their production capabilities, remains below pre-crisis levels and has, in fact, been trending lower over the past year.

Whatever the cause, the unique nature of this cycle has perplexed many investors, economists, CEOs and policymakers. But at this point we are reluctant to label this cycle of incremental growth either negative or positive, encouraging or discouraging. We accept it for what it is.

Acknowledging the Sustainability of the Current Cycle

One reason we are comfortable forecasting modest but positive GDP growth rather than an economic downturn is that the underpinnings of the US economy appear solid. In our view, the modest pace of economic expansion means this cycle could have durability and longevity.

The simple fact is that the US economy has been expanding slowly for many years and appears likely to continue along that trajectory for the foreseeable future.

Still, some pundits and armchair economists argue that the economy is fragile and that a recession could be right around the corner. One of the weakest arguments they make, in our opinion, is that our current expansionary cycle is long in the tooth, so it must be approaching the end of its natural life.

While it is true that this economic cycle is longer than average, economic cycles don’t come with “born on” dates or expiration dates and they don’t follow the calendar.

The US economy has been expanding for 82 months, but at least three other cycles since 1950 have lasted longer and were much more vigorous (CHART 1).

In addition, leading economic indicators have been improving since 2010 but have not yet returned to their pre-crisis levels, possibly because the recession was so deep and the economic recovery so gradual (CHART 2). So this cycle may still have room to run.

CHART 1: An Unusual Expansion: Slower and Longer than Most Others

Cumulative GDP growth during US economic expansion cycles (1950 through March 2016)



CHART 2: This US Economic Growth Cycle Could Have Durability

Leading economic indicators (January 1975 through April 2016)



Finally, we do not see the excesses and imbalances that typically precede a recession—vigorous economic expansion followed by higher salaries, which embolden consumers, encourage aggressive borrowing, drive up inflation and push interest rates higher. When those excesses reach a tipping point, the economy falters and all the counterbalances of a recessionary cycle kick in.

Then the economy resets and a new economic cycle begins.

Investing in This Slow and Steady Economic Cycle

Asset prices have risen meaningfully since this backdrop of slow economic growth appeared in 2009.

But participation in the equity market has faded. According to the Gallup Organization, just 55% of Americans are invested in the stock market today versus 62% in early 2008. Individual investors have pulled more than $750 billion from the equity markets since the financial crisis (CHART 3).

CHART 3: In This Cycle, Investors Have Been Rotating Away from Equities

Net amount of individual investor money flowing in or out of the stock market, on an annual and cumulative basis


What happened? In our view, the unusual nature of this economic cycle may have been a contributing factor.

Investors never heard the “all clear” signal—unambiguous evidence that a strong economic recovery was underway. The signals were not compelling enough to restore their faith in the stock market and bring them back into the fold. Predictions of a Great Rotation of investors from fixed income to equity never materialized, even as bond yields approached zero.

Perhaps the remnants of 2009 continue to weigh on the psyche of individual investors.

What’s Next?

In our view, however, this environment of slow economic growth and lean market returns opens up new opportunities to generate alpha—risk-adjusted returns above and beyond the benchmark. In this challenging environment we are exercising a high degree of selectivity, searching for companies that appear to offer high-quality management teams, healthy balance sheets and durable growth potential.

In other words, we are investing in a “market of stocks” rather than the stock market. Companies that can perform well in a 2% economy do exist and we are determined to find them.

KEY TAKEAWAYS

  • Slow and Steady Expected GDP Growth
    Key economic indicators are showing signs of stabilization, reinforcing our view that GDP will continue to advance at a slow and steady pace.
  • Modest Market Returns Are Likely
    Muted returns from the S&P 500 for the foreseeable future may reveal the limitations of beta investing (i.e. passively tracking a market index).
  • Pockets of Opportunity Exist
    Our quest for alpha includes searching for pockets of opportunity—sectors and companies that can thrive without the tailwinds of strong economic growth.


This communication is intended solely to provide general information. The information and opinions stated are as of June 1, 2016, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

CFA® and Chartered Financial Analyst® are trademarks owned by CFA institute.

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