Tilt to Growth Stocks is Paying Off
At the beginning of the year,
investors were driving up the prices of defensive stocks (health care, utilities,
and consumer staple) over more growth-oriented stocks (financials, cyclical, industrials. In a traditional bull market, growth stocks lead the charge. At
the time, investors were willing to pay almost as much per dollar of earnings
(expressed by the P/E ratio) for safety and income as they were for growth. In
fact, utilities were trading at a higher P/E than industrials and financials. The
market was being driven by fear and growth stocks were not being rewarded.
We knew that would change. As we
stated in our May 20, 2013 Take Aways, “The market will begin to be driven more
by greed than fear. As that happens, we expect investors to shift their focus
from defensive sectors to more growth-oriented, cyclical stocks.”
To position our portfolio in a way
that would take advantage of the future shift to growth, we tilted approximately
12% of our portfolio away from some of the defensive sectors into more cyclical,
growth-oriented sectors. The stocks we bought have outperformed the defensive
stocks we sold by around 8% on average.
Interest Rates to Stay Low
Led by Senior Fixed Income Manager Joe
Zabratanski, our macroeconomic committee forecasts that the recent scare and
uptick in 10-year Treasury yields will eventually die down. This will leave the
10-year U.S. Treasury yield residing in a range between 2.5% and 3.0% for the
next 12 months. Here is why:
1. Slow Economic Growth
Rising interest rates are usually an
indicator that the economy is heating up. While the outlook for the U.S. and
global economies is improving, economic growth is still muddling along. U.S.
nominal GDP continues to be a very meager ~3%. This low growth environment is
not conducive to rising interest rates.
2. No Inflationary Pressure
There is a long-term positive
statistical relationship between inflation and the 10-year Treasury yield.
Inflation has and continues to be very low. In July, the Bureau of Labor
Statistics reported the Consumer Price Index (CPI) was 1.8%. There is simply
not enough economic demand to push employee wages or prices higher.
3. The Fed Won’t Let Rates Rise
The Fed wants interest rates to stay
low in support of home purchases, business investment and continued economic
growth. If economic indicators do not improve as expected, the Fed could
continue Quantitative Easing (QE) for longer than forecasted. The unemployment
rate is nowhere near the Fed’s 6.5% target and inflation concerns are more
about deflation than reaching the Fed target of 2.5%. Bernanke also stated that
the Fed intends to hold onto the bonds on its balance sheet for some time,
which would put additional downward pressure on interest rates - even after QE
is ended.
The combination of these 3 factors
is compelling evidence that interest rates will remain low for the foreseeable
future. Bernanke stated that the Fed will keep rates short-term interest rates
low until at least 2015. We believe it.
When the Dust Settles...
There is a lot of confusion right
now in both the stock market and the fixed income markets.
Fixed income investors have been
selling bonds like they expect rates to go up to 4%. We don’t see that
happening. Detroit’s default has made municipal bond investors fearful that
there are more cities like Detroit out there. We believe those fears are
largely unfounded. Worries about Europe collapsing are receding, but investors
are now concerned that China’s economic data has not been as good as expected.
Earnings in the U.S. were not great, but were better than expected.
When
the dust settles, we expect that interest rates will continue to stay very low.
The chances of a recession in the United States are still very unlikely.
Unacceptably low rates will force investors to seek alternative ways to produce
income and return. This continues to make stocks attractive, especially those
who are committed to paying and consistently growing dividends year-after-year.
These are the opinions of the Donaldson Capital Management Investment Policy Committee. Take Aways from the IPC's weekly meetings are also posted here.
These are the opinions of the Donaldson Capital Management Investment Policy Committee. Take Aways from the IPC's weekly meetings are also posted here.
