Market Update Call 10-23-2013 transcript - US Bank...2013/10/23 · Market Update Call – Audio Transcript October 23, 2013 Speakers David R. Heidel, Jr. Terry D. Sandven Regional

MARKET UPDATE CALL TRANSCRIPT – October 23, 2013 Important disclosures provided on page 11. 1

Market Update Call – Audio Transcript October 23, 2013

Speakers

David R. Heidel, Jr. Terry D. Sandven Regional Investment Manager Chief Equity Strategist Opening: This is a recording of the Market Update Call held on October 23, 2013. The discussion featured perspectives on current global economic and market conditions. Insights and outlooks were also shared about the U.S. equities markets.

David Heidel: Welcome everyone to our market update discussion. I'm Dave Heidel, Regional Investment Manager for The Private Client Reserve. With me today is Terry Sandven. He's our Chief Equity Strategist for the U.S. Bank Wealth Management Group. Terry is here to share his insights and expertise with respect to global stock markets. So, thank you very much Terry very much for joining today.

Terry Sandven: Good to be here Dave. David Heidel: Before I turn to Terry, let me begin our conversation by briefly discussing two

subjects I think are of critical importance and probably top of mind for you, our clients.

First I want to share our thoughts about the recent shutdown and reopening of

the federal government and the budget talks that will continue later this year. And let me break it into good news and bad news.

Here's the good news. The government shutdown seems to have done very

little damage to stock and bond markets. Post the shutdown, equity markets have hit all-time highs domestically and bond prices have rallied.

The bad news is that a resolution to the issues that caused the shutdown have

only been postponed and will be in the middle of negotiations again as soon as the end of this year.


All of us in the Wealth Management Group of U.S. Bank will continue to

carefully monitor the negotiations in attempt to try to understand how whatever comes out of them will impact markets in your portfolios.

Second, we recently reached out to our clients around the country to ask them

about the top concerns they have about their investment portfolios. In fact, you should have received a handout with this call information. On that handout, we've listed the top five concerns that our clients have told us, and I just want to briefly run through a couple of them because I think they're important to acknowledge.

The first item that you'll see on the sheet is "What should I do with my fixed income or bond investments?" I think this is a very logical question to ask. We had kind of a scare in the bond markets earlier this year after comments from the Federal Reserve Chairman, Ben Bernanke regarding the tapering program. A lot of money moved out of fixed income and I think a lot of people were very alarmed about that portion of their portfolio. Our message to clients in regards to this is don't be alarmed. There may be new opportunities, and even in a rising rate environment there may be attractive areas to look at. In fact, one of the charts that you'll see on the sheet that we've provided shows the opportunities that we think still exist in the municipal bond space. So even though we as a firm have an underweight in fixed income compared to our strategic asset allocation, we do think that there are areas of value and we think the market may have overreacted earlier this year.

The second item that clients posed to us as a major concern was inflation and

will it return to haunt me? I think the genesis of this concern is probably the fact that there's been a lot of money printed in the various different quantitative easing programs. And a lot of people, rightly so, are worried that maybe this will cause inflation to creep up in our economy and maybe around the world. Our response is that really there is none in sight and none projected. And there's another chart that's on that handout that shows that really our projections for inflation are fairly flat over the coming years. Remember, there are a lot of different inputs to inflation including wage prices, and we really haven't seen much pressure in that arena at all.

Let me go to the last one, which is politicians here and around the world, will

they ever get it right? And I guess that kind of dovetails with my opening comment about the government shutdown and reopening. It's interesting, we've seen a lot of things happen in the political sphere that have been concerning, but we've also seen politicians take a lot of very positive steps around the world in making sure that economies and markets and interest rates have been low and stable. So we'll see. We'll continue to monitor the issues in Washington and other governments around the world to see what effect that these issues will have on investment portfolios. But so far, it’s definitely been mixed reviews when it comes to the effects that politicians have had on the markets recently.


So, let's get into the granularity of equity markets because I think that might

be the most interesting aspect of the market landscape to look at currently. And I want to turn things over to our guest today for that level of detail. Once again Terry's our Chief Equity Strategist.

Terry, U.S. equities are near all-time highs. What's your assessment of year-

to-date performance and why has it been so strong? Terry Sandven: Well thank you Dave. The year-to-date performance of U.S. equities has been

superb and remarkably resilient. It's also largely exceeded expectations. Clearly, emotions have run high for most of the year. In fact, it really doesn't feel like performance has been as good as it has.

If you think back to the first of the year, we started with concerns about the

fiscal cliff, sequestration, impact that budget cuts and higher payroll taxes would have on the economy. Then there were preliminary debt ceiling discussions, geopolitical issues surrounding Egypt and more recently Syria, and of course most recently the government shutdown.

Yet through it all, year-to-date as of today, the S&P is up over 20%. It's near

all-time highs. Nine of ten sectors are up over 10%. Four of ten sectors are up over 25%. So by most measures, performance of U.S. equities has clearly exceeded expectations.

David Heidel: Oh absolutely Terry. You've definitely sold me that equity performance has

been strong this year. As we look back since the beginning of the year, what have been some of the key drivers pushing equity prices higher? What have been the main things that have moved the markets?

Terry Sandven: Well we think the strong equity performance in 2013 can largely be attributed

to three items―Fed-driven liquidity, price-earnings multiple expansion and economic improvement.

Let's first look at Fed-driven liquidity, and frankly that's a fancy way of saying

interest rates are low. In short, the Federal Reserve, or Fed as it's commonly referred to, has been doing what they can to keep interest rates low to help spur economic growth. And the belief is that consumers and businesses are more apt to spend money or expand operations when interest rates are low. And the Fed's current $85 billion per month purchase of Treasuries and mortgage-backed securities program―this is often, of course, referred to as quantitative easing or simply QE―is designed to do just that―keep interest rates low, particularly the long-dated maturities, in the interest of promoting economic activity and inflating asset prices. And that has helped push equities to higher levels year to date.


Second, price-earnings multiple expansion has been a driver. And that sounds

more complicated than it really is. The question is, what is the appropriate number to multiply (or take times) the earnings estimate of say the projected earnings for the S&P 500, which is currently around $110 for 2013, to determine a fair valuation and price target? And historically, during similar economic conditions―and I would take you back to the 1960s and early 1970s―that number ranged between 15 and 18 times. At the start of this year, the consensus was that a multiple of 14 to 15 times was appropriate.

As the year has progressed and as the market has worked through one

headline after another, expectations for a higher multiple have also climbed to now where a multiple in the 16 to 17 times range is considered both appropriate and warranted. So clearly, multiple expansion has been a driver of higher equity prices so far this year.

And the third driver for performance, and arguably where there is more

uncertainty, is economic improvement. The U.S. economy has shown signs of improvement throughout the year, which has helped obviously move equity prices higher. The level of improvement, however, remains a work in progress. And Dave, of debate is whether the economy is strong enough to operate on its own without Fed assistance.

David Heidel: Terry, on that note, let's spend a few minutes discussing the economy. As it

seems, recent indicators have been kind of mixed actually regarding economic growth. What are the key drivers that you see most significantly impacting equity performance as we go forward?

Terry Sandven: I note four―housing, employment, retail sales and manufacturing, with the

general conclusion being that signs of economic improvement are occurring. Let's first look at housing. Housing has been a bright spot. Home prices are

up, inventories remain relatively low and housing starts remain below historical levels implying there's still room for still more construction activity.

And we're seeing only isolated incidences of bubble characteristics, such as multiple bids on the same property, speculation buying, speculation building. As a result, we believe housing has contributed to economic growth and favorable sentiment, thus helping to push equity prices higher.

David Heidel: Terry, you bring up a good point. Housing has contributed economic growth

throughout the year. Is the near-term outlook for housing being impacted by higher mortgage rates? Are rising interest rates dulling the luster of housing?

Terry Sandven: Well Dave, to a degree, yes. The recent uptick in mortgage rates has slowed

the trajectory of growth. That said, the outlook for housing still remains favorable. Even if mortgage rates trend upwards of 5% or even above that, they remain below the historical average.


In fact, the 50-year annualized run rate of housing starts according to the Census Bureau is approximately 1.5 million units, and that's currently considerably above the roughly 900,000 current run rate. So housing appears to still have legs and that's important. Housing remains an important component of the economy. It adds to employment, confidence, consumer net worth, bank activity and consumer spending. In fact, I would argue that it's hard to envision equities being able to trend higher without a favorable housing environment.

If we look to employment―on average, employment trends are improving

albeit at a slower rate that many had hoped. In general, recent results have been inconclusive. And then frankly we saw that again yesterday. As you may know, the September jobs report was reported after being delayed because of the government shutdown. And the results were mixed. On one hand, the non-farm payrolls increased a disappointing 148,000, but below expectations for an increase of 185,000 jobs. So this implies sluggish economic growth and arguably justification for the Fed to keep facilitating growth through low interest rates.

On the other hand, the unemployment rate declined from 7.3% to 7.2% and

manufacturing and construction employment increased, as did temporary employment, which is often a leading indicator of permanent hires. So at a minimum, this and other economic releases in the coming days and weeks are likely to be discounted as I think it'll take a month or two to determine the true impact that the government shutdown has had on the economy.

And just quickly on sales, they have been mixed. Cars, electronics, furniture

sales have been relatively strong in recent months. Conversely, clothing, department store sales have lagged. So there's a mixed review on the retail sales.

David Heidel: You just raised an interesting point that actually disturbed me for a minute

because I haven't done any Christmas shopping yet and I'm thinking of the calendar now. You just mentioned that retail sales have been somewhat soft and rather mixed. This could be problematic. It would seem to raise some uncertainty as we look toward year-end holiday sales. What are your thoughts?

Terry Sandven: Well it does. We know that there's been some pent-up demand for

automobiles in recent months and favorable furniture sales can partly be attributed to the housing market. But, apparel sales have been generally flat. They've lagged as consumers have refrained from extending themselves or overextending themselves. That said, I think it's too early to have a good read on the level of holiday sales, plus expectations are low. So I think the outlook for holiday sales will become more visible after more companies report third quarter results, which they're doing right now, and offer some year-end guidance. So we'll get more clarity from that aspect in the next two, three weeks.


Conversely, manufacturing continues to improve and gain momentum. The

Institute of Supply Management Manufacturing Index, which is a gauge of manufacturing conditions, is at a two-year high. Increased demand, both home and abroad, plus low input costs such as energy are helping to drive earnings and share prices of many industrial-related companies. And we expect that pattern to continue into year-end and into 2014.

David Heidel: Well let's stay on that thought―talking about the future in 2014. What is our

outlook for U.S. equities as we move towards the end of the year and to the early part of next year?

Terry Sandven: In our view, U.S. equities are likely to trend generally sideways with an

upward bias toward year end. As we look further into 2014, we see U.S. equities moving higher, albeit at a more moderate pace than what is experienced in 2013.

Let me further explain. Near term, Washington remains a wild card. You

alluded to that earlier. There are significant Washington-related events on the horizon that are likely to impact equity prices, at least in the interim.

Fed tapering is one headwind. Following yesterday's jobs report, the

consensus is now for the Fed to announce the tapering of its quantitative easing program after the first of the year, and perhaps not until March, versus the December Federal Open Market Committee meeting.

And this may explain some of the recent strength in equities and the recent days as the proverbial runway for Fed-driven liquidity may be extended a few months longer. I do think it's important to note that, nonetheless, it's only a matter of time before the so-called unconventional Fed monetary stimulus ends.

David Heidel: That's a very interesting point Terry. And I'm thinking back, since the

September Federal Open Market Committee Meeting, several Fed officials have noted that the decision not to taper following the September meeting was really a close call, presumably implying that December is a possibility for tapering to begin. Yet to the point that you just made, I see the consensus among economists is increasingly shifting towards March as when tapering is likely to begin. Is this change in sentiment among economists an outcome of the recent government shutdown, or what explains it?

Terry Sandven: Well to a degree, yes. Many readings or indicators of economic health were

held hostage by the Washington budget and debt ceiling impasse. As such, the quality of the data is likely to be questioned for the next couple of months and perhaps even longer. Either it was not collected or the validity of the data is being questioned because of the impact of the shutdown.


So I suspect it will take a month or two of economic releases to get a good read on the health of the economy. But Dave, this also raises the question of how is the equity market likely to react once the tapering decision is announced. And we suspect it may initially be down on the news as we are in uncharted territory. And at a minimum, tapering represents a change in trend. And with change, I should note, comes uncertainty and volatility. But, we also think any downdraft associated with tapering is likely to be short lived.

Tapering would effectively be a signal from the Fed that we see the economy

being strong enough to stand on its own without Fed support, and that implies economic growth, a favorable environment for equities. So tapering sooner versus later may also imply the reduced likelihood of future Fed-induced inflation, and so that's a good thing.

David Heidel: I appreciate that you brought up the inflation topic, especially since inflation

was the number two highest-ranked client concern. So what impact specifically is inflation having on equity returns?

Terry Sandven: Well inflation is a key indicator to watch. We continue to believe that the

fundamental backdrop remains favorable for higher equity prices into year-end and 2014 in part because inflation is benign. In fact, think back to periods of high inflation. An easy time period to assess was the late 1970s and early 1980s when inflation begin to ramp, followed by rising interest rates. In fact, the 10-year Treasury, I believe rose to north of 14%, almost close to 15% in 1981. And during that period, price-earnings ratios fell to the 7 to 8 times range before bottoming.

But that's not our environment today. Inflation is benign. In fact, there is an

equal concern of deflation. So in addition, it's hard to envision widespread inflation in a slow-growth environment where the unemployment rate is 7.2% and wage growth is plus or minus 1%. So in the absence of inflation, price-earnings ratios that we spoke of earlier are likely to stay near current levels with arguably some upside room for expansion.

I would note that another reason to expect equities to grind higher is valuation.

Valuation is fair, not at high or low extremes in our view. We talked earlier about the broad equity market trading at roughly 16 times 2013 earnings estimates. That again is within the 15 to 18 times range of past cycles where conditions were similar.

In addition to benign inflation and fair valuation as reasons to expect equities

to trend still higher, sentiment is favorable. And that's driven in part by a favorable housing environment and the wealth effect associated with higher stock prices. So admittedly Dave, while sentiment still applies, the merits of the argument are somewhat inconclusive. For instance, the recent uptick in mortgage rates has slowed housing at least temporarily, and the recent government shutdown has weighed on consumer and business confidence. And that presumably is negatively impacting spending, as well.


David Heidel: Yes, I understand Terry. That makes sense. So let's look beyond the next

three, four months and assume that we get through the next round of budget and debt ceiling discussions in January, February as well as the first round of Fed tapering without any major disruptions. How is next year likely to be different than 2013? What will we feel is different about next year's market activity?

Terry Sandven: I think that's a key question Dave. 2014 is likely to be a transition year in our

view, which explains why we believe U.S. equities will continue to trend higher, but at a more moderate pace than what is experienced in 2013. For example, we talked earlier about drivers of equity prices in 2013, namely Fed-driven liquidity―in other words low interest rates―and price-earnings expansion.

Fed-driven liquidity is likely to moderate. The Fed simply cannot keep buying

securities indefinitely. And while we do not expect the Fed to raise rates anytime soon, the market will eventually begin to anticipate future rate hikes, and obviously that's a headwind for equities.

Secondly, additional price-earnings multiple expansion beyond current levels

seems limited. That implies that we could say the primary driver for equities in 2014, unlike 2013, are company earnings. So on that note, we need to see an improving economy to drive earnings, and accelerating earnings are needed to drive equity prices to meaningfully higher levels. And this is why third quarter results and company guidance are currently being watched closely, particularly given that many of the key indicators that we spoke of earlier are tainted because of the government shutdown.

David Heidel: That makes sense Terry. What about international? I skipped that client

concern when I was going through my list, but to what extent does international factor into your thinking?

Terry Sandven: Well clearly there remains a lot of uncertainty with international markets, but

we're cautiously optimistic. We know performance has varied year to date. International developed and emerging markets lagged in the first half of 2013. More recently developed international has rallied.

We're also hearing from U.S. multinational companies with an international

footprint that conditions in Europe are showing signs of modest growth, while emerging markets appear to be generally stabilizing. So if these trends continue, this seemingly suggests that U.S. multinational companies could get a boost to earnings in 2014, at least to a greater extent than was the case this year.


David Heidel: Excellent Terry. A fantastic amount of information for us to think about and

digest. Before we conclude, do you have any other final thoughts that you want to share with us?

Terry Sandven: Sure. I would just summarize by saying that performance, as I mentioned

earlier, has been remarkably resilient in 2013. In fact, it has largely been a “buy on the dips” equity market throughout the year.

As we look toward year end and 2014, I still think there's reason for continued

optimism. Many of the drivers that are responsible for pushing equity prices higher remain in place. Interest rates are low, valuation is fair, inflation is benign and sentiment is generally positive. This presents a favorable backdrop for equities and are reasons why we expect U.S. equities to trend still higher in 2014.

But Dave, that said, the degree of upside is likely to be more moderate in 2014

than this year as earnings acceleration is arguably required to push equities to meaningfully higher levels. And for that to happen, we need to see more widespread evidence of economic improvement. We should get a glimpse of that by the first quarter of next year.

David Heidel: Very good. Terry, before I let you go, I hope you don't mind me doing this,

but I have to ask you as our Chief Equity Strategist, any predictions for S&P 500 year end and 2014?

Terry Sandven: Certainly. In fact, I'll give you an insight as to where we think this year is

going to end, as well as next year. If you look toward year end, the S&P 500 is essentially at our published price target right now of $1760. As we speak, the S&P is at $1743, and that's based on a price-earnings multiple of 16 times our 2013 estimate of $110. We do see some room though for some modest multiple expansion, perhaps to the 16-1/2 range. If you apply that to our $110 estimate, you come up with a price target of about $1850. That's roughly 4% above current levels. If you look out to 2014, our price target is $1900 for the S&P 500, and again that's based on a 16 multiple times our 2014 estimate of $119, roughly 10% above current levels.

David Heidel: Okay Terry. Thank you very much for an excellent summary of the equity markets. I appreciate it very much and I especially appreciate your insights along the way. They certainly helped clarify it for me.

Let me briefly cover our current tactical asset allocation positioning. Our

tactical guidance is more short-term in nature than our strategic guidance. It really tries to look at where markets are currently and come up with some actionable advice.


As always, please keep in mind that not all investment solutions or strategies

mentioned may be appropriate or available to all clients. Your U.S. Bank investment professional will be happy to discuss with you your particular situation.

That said, despite recent domestic political drama and the strong rally we've

seen in equity markets this year, we continue to believe that stocks are reasonably valued and may be positioned to do well for the remainder of the year. So we are modestly overweight equities. Within the equity space, we are currently emphasizing emerging market equities due to attractive valuation, as well as hedged equity strategies.

Turning to fixed income or bond obligations, we remain underweight due to

the low level of interest rates on an absolute historic basis, but we are overweight in hedged fixed-income strategies in this space.

In regard to commodities, our exposure is modest and we maintain a neutral

stance, primarily as a hedge against unforeseen price spikes in certain key commodities, such as oil. Nevertheless, our expectations for commodities going forward are fairly limited.

We believe that REITs, or Real Estate Investment Trust, valuations are

relatively high on a historic basis, but we remain neutral due to our expectation that a yield-hungry investor environment will probably continue to provide support for the REIT market.

To close, Terry, thank you very much again for joining me today. For those of

you on the call, I want to thank you very much for your relationship with us and for taking time to attend the call today.

Again, please contact your U.S. Bank representative if you'd like more

information on these or other timely topics. I'd also refer you to our website where we have a number of different publications that go into more detail on some of the items that we just listed. The website is reserve.usbank.com. Thank you very much and have a good day.

Closing: Thank you for listening. We invite you to join us for future calls. Details can be obtained from your Wealth Management Advisor.


IMPORTANT DISCLOSURES

This information represents the opinion of U.S. Bank and does not constitute investment advice and is issued without regard to specific investment objectives or the financial situation of any particular individual. Since economic and market conditions change frequently, there can be no assurance that the trends described here will continue or that the forecasts will come to pass. These views were presented on October 23, 2013 and are subject to change at any time based upon market or other conditions. The information presented is for discussion purposes only and is not intended to serve as a recommendation or solicitation for the purchase or sale of any type of security. The factual information provided has been obtained from sources believed to be reliable, but is not guaranteed as to accuracy or completeness. Data and research information and statistics have been gathered from a variety of sources. U.S. Bank is not responsible for and does not guarantee the products, services or performance of its affiliates and third party providers. Any organizations mentioned are not affiliates or associated with U.S. Bank in any way.

Based on our strategic approach to creating diversified portfolios, guidelines are in place concerning the construction of portfolios and how investments should be allocated to specific asset classes based on client goals, objectives and tolerance for risk. Not all recommended asset classes will be suitable for every portfolio. Hedged equity and hedged fixed income investment strategies are typically available via hedge funds which may not be appropriate for all clients due to the speculative nature and high degree of risk involved in these investments.

Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Indexes are unmanaged and are not available for investment. Equity securities are subject to stock market fluctuations that occur in response to economic and business developments. International investing involves special risks, including foreign taxation, currency risks, risks associated with possible differences in financial standards and other risks associated with future political and economic developments. Investing in emerging markets may involve greater risks than investing in more developed countries. In addition, concentration of investments in a single region may result in greater volatility. Investment in fixed income debt securities are subject to various risks, including changes in interest rates, credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications, and other factors. Investment in debt securities typically decrease in value when interest rates rise. The municipal bond market is volatile and can be significantly affected by adverse tax, legislative or political changes and the financial condition of the issuers of municipal securities. Interest rate increases can cause the price of a bond to decrease. Income on municipal bonds is free from federal taxes, but may be subject to the federal alternative minimum tax (AMT), state and local taxes. There are special risks associated with an investment in commodities, including market price fluctuations, regulatory changes, interest rate changes, credit risk, economic changes, and the impact of adverse political or financial factors. Investments in real estate securities, real estate and other non-financial assets can be subject to fluctuations in the value of the underlying properties, the effect of economic conditions on real estate or asset values, changes in interest rates, and risks related to owning properties (such as rental defaults). An investment in a hedge fund involves a substantially more complicated set of risk factors than traditional investments in stocks and bonds. Hedge funds are speculative and involve a high degree of risk.

Documents

Market Update Call 10-23-2013 transcript - US Bank...2013/10/23 · Market Update Call – Audio Transcript October 23, 2013 Speakers David R. Heidel, Jr. Terry D. Sandven Regional