U. S. Market Environment
The second quarter of 2015 was marked by a combination of uncertainty and complacency as interest rates and oil prices jumped, domestic equities returns were flat to slightly negative and the U.S. dollar was basically unchanged versus most major currencies.
For the quarter, the Russell 3000 Index posted a 0.14% return, as the domestic equities market traded within a fairly narrow band. Interest rates experienced a dramatic reversal as the yield on 10-year U.S. Treasury rose from 1.90% at the start of the quarter to end at 2.40%. Oil staged a strong rally as domestic prices surged nearly $12 per barrel to end the quarter above $59, while the price of gold was flat.
Portfolio Discussion and Strategy
The Financial Services sector in general enjoyed a strong positive quarter, but within the sector, returns were more disparate and largely a function of interest rate sensitivity. With the increased expectation that the Fed will authorize its first rate increase in September, industries where higher short-term rates will help, such as banks and thrifts (where we were overweight) were embraced by investors, while industries where higher rates may cause issues, such as the REIT market, were quite challenged.
For the money center banks, new enthusiasm from investors appears to be driven almost exclusively by continued improvements on the expense side of the ledger. Better cost management continues to be a critical part of the bank recovery story as branch, mortgage related and investment bank costs all continue to decline, helping offset the growth in compliance and regulatory costs. It is also becoming clearer that we are near the end of the large litigation charges that have plagued the banks for several years.
For the regional and community banks, both the revenue and expense sides of the ledger appear to be improving. Mortgage banking volumes and profitability are up significantly, helped by the positive start to the housing season and a wave of refinancings. As short interest rates rise, the pressure on net interest margins will lessen, further bolstering the bottom line. The credit outlook is encouraging and the consumer trends are benign and improving. Loan growth, while mildly disappointing, should still grow 45% versus last year. However, the intense competition for commercial and industrial lending has dampened returns to such a degree that some banks are walking away from potential business, despite having excess capital.
Expense management is a continued focus and is yielding favorable results. The reduction in costs from closing branches and trimming headcount is having a positive impact, and residential charge-offs are down significantly. Overall, the regional and community banks are stable and still mostly “running in place”, but multiples are expanding as an inflection point in the rate cycle is nearing.
The price of oil, as measured by West Texas Intermediate crude, was up nearly 15% during the quarter on solid global demand growth. In what could be seen as a positive environment, returns for the Energy sector were, somewhat surprisingly, moderately negative. Investors were particularly harsh regarding the oilfield services and exploration and production industries, and appeared to view many of these companies from a “glass-half-empty” perspective.
The domestic energy market has responded to the fall in prices by cutting drilling activity at a rate much faster than even the most bullish forecasts had postulated. The dramatic decline in the rig count (down 18% at the end of Q2 2015 versus the end of Q1 2015, and down 56% from the high water mark registered at the end of Q3 2014) has likely reached its nadir. Overall, the U.S. market will likely see a sequential decline in production for oil in the second half of 2015 due to the lagged response to the rig count.
As the E&P industry continues to scale back its capital expenditures, the pace of drilling is down as companies postpone new projects, shut-in existing wells, defer completions of newly drilled wells and reduce their employment levels by laying off their weakest employees. That said, expected improvements in operational efficiencies, including optimized well completions, pad drilling and a focus on the most productive fields (“core-of-the-core”) have partially offset underlying natural declines. While geology remains the primary key to success, more efficient operations and lower costs are providing select E&P’s an opportunity to jumpstart activity levels ahead of a full recovery in commodity prices. The stated goal of many firms is to manage their business within cash flow and the aforementioned operational improvements and reduced cap-ex expenditures will be critical to achieving this goal.
Overall, the industry has shifted from a focus on maximizing production (when oil prices were high) to minimizing expenses: unlike its major global competitors, the U.S. energy sector is much more nimble in its ability to quickly accelerate or decelerate the level of activity in response to market forces, helping to protect returns and avoid subpar projects.
Outlook
Interest rates, especially in Germany and to a somewhat lesser degree the U.S., have risen dramatically during the quarter. With yield on the 10 year German bund rising from near zero to, at one point, above 1.00%, fixed income investors were shocked and the discussions about what may happen when some central banks eventually reverse their loose monetary policies were re-ignited.
For the second year in a row, the U.S. economy was negatively impacted in the first quarter by bad weather as reflected in the slightly negative GDP numbers. This slump in real GDP reflected declines in goods exports (notably capital goods such as autos and parts) and business investment (especially in mining exploration, shafts, and wells), but were partially offset by increases in consumer spending on services (health care, housing and utilities) and investment in non-farm inventories. Even when the weak first quarter of 2015 is factored in, the year-over-year real GDP growth, as calculated by the U.S. Bureau of Economic Analysis (as of March 31, 2015), was 3.0%.
Overall, while margins held firm, sales and earnings reported for the first quarter were muted. The effects of a very strong dollar lessened the competiveness of companies with operations outside the US and contributed to the sluggish start to the year.
While the unemployment picture continues to brighten, the reported numbers do tend to mask the true labor picture. The “official” unemployment rate (called the U-3 rate), which now stands at 5.3%, only tracks people seeking full-time employment. In contrast, the broader U-6 rate which also counts marginally attached workers and those working part-time for economic reasons, is 10.5%, still well above a more normal 9%. Of interest, some of these part-time workers counted as employed in the U-3 calculation could be working as little as an hour a week and the "marginally attached workers" in the U-6 rate include those who have gotten discouraged and stopped looking, but still want to work. In addition, the prime age (25-54) employment to population ratio (EPR), which is highly predictive of future wage growth, has been stuck at 77.2% for the last four months, a rate 2.5% below the two-decade, pre-crisis average, implying that labor remains in excess supply. Overall, these employment measures are shining a harsh light on the true strength of the employment rebound.
Wages have begun to slowly improve, which is an additional sign of a healing economy. The employment cost index accelerated to 2.8% in the first quarter and is being led by changes in compensation for lower quality jobs, especially in the retail and fast food industries. While the increases may be justified as these wages have been depressed for quite some time, there is fear that this change will threaten corporate profit margins. However, as many of these employers have the wherewithal to pass through higher costs to the consumer, the impact on margins may be nominal. In addition, as noted above, the low participation rate, the prevalence of part-time employment as well as the subdued EPR will tend to dampen the pace of any wage increases as labor supply will help hold down wage demands.
Oil markets remain dynamic as OPEC voted to maintain its current production levels and the Saudis responded to higher prices with accelerated production to pump at very high levels. In the U.S., oil production, one-half of which comes from shale, will decline sequentially in response to the overall lower energy prices and will tighten the modest overcapacity in the industry. The rapid response of the US energy industry to these market forces will help shorten the timetable for the eventual recovery in prices. Overall, the energy sector remains out of favor as investors have focused on many of valuation-stretched small cap names in technology, as well as in health care. We believe that this pessimism, which has led to investor apathy, or in some cases, the shorting of the more leveraged energy names, will be proven to be short-sighted. As global supplies begin to come into balance and prices stabilize and gravitate upwards, the great investment opportunities we see in this sector will begin to be realized.
