Portfolio Discussion and Strategy
The dollar weakened slightly as expectations of future Fed hikes were reduced in the wake of weak International economic growth and turmoil in capital markets thus reversing a long period of dollar strengthening. Oil prices soared in March, but ended the period roughly the same. U.S economic growth remained decent at a low level, benefiting from solid consumer balance sheets. Net worth has rebounded to 2008 highs. High Yield spreads ended the period flat after January widening. U.S. Treasury yields followed other developed markets downward. U.S. yields are now very wide versus Germany. Defensive stocks, particularly utilities, which our style rarely finds attractive, led the way. High quality (B+ or better) led low quality (B or worse) stocks. Momentum, low volatility and defensive stocks continue to be very expensive. These factors led to macro headwinds to our deep value philosophy.
We underperformed our index in the quarter. Energy holdings were roughly a neutral factor, reflecting an unchanged oil price, although spot natural gas fell due to 20% fewer heating degree days than normal this winter. Drags on performance were from financial services and technology sectors. Our overweight in banks negatively impacted performance due to expectations of a more muted pace of future fed hikes. We expect each fed hike will increase Net Interest Margins for banks, particularly our asset sensitive holdings.
Interestingly, despite the market’s fed watching focus on weak international growth, which is not part of their charter, the much more important U.S. inflation outlook should be putting more pressure on the Fed to shrink hugely negative real short rates. Core CPI is up to 2.3% and the fed’s preferred core PCE is moving close to the 2% target. Increasingly, wage inflation data show acceleration, which is not surprising given we essentially are at the fed’s estimated NAIRU (Natural Unemployment rate) of 4.8%. Additionally, as stable oil prices feed through the system over the next year, base effects will lead to higher reported inflation. Even getting to a fraction of the fed’s projected future dot plot of over 300 basis points would lead to large margin increases. The forward bond curve implies less than half the Fed dot plot. Additionally, bank sell side analysts seem to imbed a lower short rate assumption than even what the forward curve implies. Our banks are on the bargain rack again, selling at roughly half the market multiple on 2017 earnings. Our underweight in REIT and insurance holdings hurt given the shift to bond proxies in the market.
Technology was a modest drag on performance despite inline overall fundamentals and earnings. Moderate emerging market exposure seemed to impact sentiment.
Outlook
Developed economies continue to grow at a moderate pace, while emerging economies slowed. The current level of oil prices is a net negative for 2016 global growth as many oil exporting countries have entered crisis stages, with second derivative effects, while the savings pass through to oil importing countries is only a mild offset.
Profit margins across an index of commodity producing companies are at 60 year lows, but it is only energy that has a near term case for fundamental improvement. Supply and demand is already tightening for both crude and natural gas. After an extremely warm winter affecting heating demand, Crude oil and spot North American natural gas are both trading at roughly half of our long- term normalized price. With Iranian crude capacity now online, global supply has begun a medium term decline after a 50% reduction in global capital spending in the last 2 years. The unprecedented reduction in capital spending in long cycle non- North American supply (90% of the world) will impact production in years to come. Non-OPEC supply from International regions is already succumbing to natural depletion rates as the North Sea, Columbia, and Mexico among others, are already contracting. These 2015 and 2016 spending cuts will show up most forcefully in 2018-2020 due to the long term nature of these projects.
With OPEC currently producing virtually at full useable capacity, and overall capacity flat over the next couple of years, talk of an OPEC production “freeze” is irrelevant. The freeze is already in place.
The only short cycle oil production that can arrest the global decline and meet annual global demand growth is U.S. shale. After shale supplied most of the world’s supply growth over the last few years, U.S. overall oil and natural gas production will be declining about 5% year over year in the fourth quarter. Shale declines will be almost twice that. A further decline in U.S. 2017 crude production is inevitable given the momentum into the year unless the rig count rises dramatically in the near term. Prices need to be significantly higher to incent that response. Given the evisceration of the U.S. shale supply chain, it will take up to 2 years from the time period when the reinvestment signal is given to start moving production up again. Excess capacity is only 1% and the geopolitical risk to supply disruptions is enormous.
The U.S. natural gas thesis is similar to oil. The gas rig count is down even more than oil in the last few months on a percentage basis due to the warm winter. We believe Energy stocks have huge upside potential and are in the first inning of a multi-year oil supply cycle that is largely locked into place. The upside in our non-Energy holdings is well above average as well. Combined, our total portfolio has valuation upside potential more than twice our long term average in a market we view as overvalued.
