The second quarter was unusual in many respects. Federal Reserve Chairman Bernanke’s remarks, starting in mid-May, but, particularly, his comments on June 19, really startled markets. His announcement that asset purchases by the Fed would be reduced in coming months caused many asset classes to sell off in June. What was surprising, though, was that the more conservative asset classes, including municipal and investment grade bonds (as reflected by indices quoted by Bloomberg), sold off more than equities. For the quarter, US equities were positive and other asset classes (High Yield, MBS, Munis, Gold) were negative. Consequently, despite the turmoil, equities have remained the asset class of choice, and more diversified portfolios have suffered. Why has that been the case?
There has long been a suspicion that the liquidity from quantitative easing was providing the underpinning for both bonds and stocks. Certainly, the "carry trade" – financing long-dated assets with short-term debt – has been useful is supporting markets. Bernanke has stated that recovering prices in real estate and stocks would create a "wealth effect", encouraging consumption. In theory, more consumption should translate into more demand for goods and services. Since the official end of the recession in 2009, that theory has not worked, and economic growth has remained anemic.
We have long believed that there is a high degree of correlation between economic activity and stock market performance. Yet, in the weakest post-recession economic recovery since World War II, equity prices have soared. The Bank Credit Analyst (BCA), in a report to clients on July 2nd, put some clarity around this apparent disparity. Indeed, their analysis suggests that there is a "broad correlation between annual growth rates of real non-financial sector EBITD (Earnings Before Interest, Taxes & Depreciation) and real GDP. And because profit margins have a strong cyclical component (tend to rise during expansions and fall during downturns) EBITD margins have also tended to move broadly with economic growth." As discussed in previous commentaries, profit margins seem to affect equity prices.
Yet, this historical correlation has not held up in this market cycle. The BCA study highlights the divergence between EBITD margins and the economy in recent years. The recession induced decline in margins was modest relative to the contraction in GDP, and subsequent margins increased to a post-World War II high despite an unusually weak economic recovery. "The strong rise in margins over the last decade owes a lot to the ability of companies (rather than employees) to capture an unusually large share of the benefits of rising productivity. Additionally, a spike in productivity gave an extra lift to profits in the early stage of the recovery, despite a subpar pace of economic activity. Subsequently, EBITD margins have stayed at a high level because the level of productivity has held up and compensation growth has remained subdued."
We concur with the BCA study that "the expansion in earnings during the past four years has been truly remarkable given the subpar performance of the economy." They add "…the ability to boost the bottom line via cost-cutting is now limited given that all the easy savings have already been made. Meanwhile, the additional earlier tailwinds from falling charges for depreciation, interest costs and taxes have now ended. Thus profits have become much more dependent on gains in revenues, which in turn depend on the pace of economic activity."
For the time being, there does not appear to be any pressure on labor costs as unemployment remains at elevated levels. Capital spending may stay at the current subdued pace, keeping depreciation low. Moderate raw material prices should help sustain current margins. Corporate profits may remain at healthy levels. In our opinion, the key to future performance will be economic growth, not Federal Reserve Policy.
The views expressed are provided for information only and are not to be used or considered as an offer or solicitation to buy or sell securities or investment products. They are those of the authors. Investing involves risk, including loss of principal. All performance referenced is historical and is no guarantee of future results. Municipal bonds are subject to availability and change in price. They are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as interest rates rise. Interest income may be subject to the alternative minimum tax. Municipal bonds are federally tax-free but other state and local taxes may apply. Precious metal investing involves greater fluctuation and potential for losses. The economic forecasts set forth in the presentation may not develop as predicted, and there can be no guarantee that strategies promoted will be successful. Diversification/Asset Allocation does not ensure a profit or guarantee against a loss. Stock markets are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments.