On rare occasions, a seemingly small change can be an early indicator of a turning point in an important long-term trend with profound implications for the future. We may be witnessing such a tipping point in the first quarter of 2017. After nearly 35 years of generally declining interest rates, the bond market appears to be at an inflection point and interest rates globally may have bottomed.
In mid-2016, several of the world’s bond markets experienced negative interest rates in either government debt or personal savings rates. Thankfully, the U.S. has not shared that experience, although last July the 10 year Treasury did drop below 1.4 percent, its lowest point ever. If in fact we are seeing a long-term reversal of interest rates trends, this turn in the bond markets could begin to impact investors’ approach to both equity and fixed income markets.
In March the Federal Reserve (Fed) raised the Federal Funds rate, as expected, by 25 basis points (0.25 percent), and signaled that several more rate hikes are likely over the next two years. Meanwhile, the 10 year Treasury rose 80 basis points to 2.6 percent, between the election and when the Fed raised rates in mid-March, as the market expects that faster economic growth will finally raise inflation over the Fed’s two percent threshold. In fact, we have recently seen the first real signs of wage inflation and the largest increases in the past five years for two key inflation indicators, the CPI (consumer price index) and PPI (producer price index). Nearly eight years into the current economic expansion the economy is running near full capacity and plans by the new administration to reduce business regulations, lower taxes and increase spending on infrastructure could prove to be more inflationary than expansionary. Higher interest rates may be the result.
With an economy already near full employment and seven-plus years into the current economic expansion, the new administration brings with it market expectations for reduced business regulations, reduced business taxes and more fiscal stimulus spending to repair our infrastructure, resulting in slightly higher economic growth. The reality of actually achieving these expectations may prove difficult, however the honeymoon period continues with the stock market up over 13% since the election. For the first quarter, the S&P 500 Total Return (TR) was 6.07 percent. The Dow Jones Industrial Average TR was 5.19 percent. Our other key benchmark, the Bloomberg Barclays Government/Credit Bond Index Return was 0.96 percent.
Future Outlook
Rather than merely betting on Washington coming through on campaign promises, we believe the market is responding to fundamentals. The economic outlook across the country is positive as the U.S. economy is running close to full capacity and measures of both consumer confidence and small business confidence have risen to very high levels. Over the past few years, plunging oil prices, a rapid spike in the dollar and slowing growth overseas led to lackluster revenue and earnings growth at many companies. As those conditions begin to reverse, we are seeing acceleration in revenue and eanings growth. The consensus for the S&P 500 over the next two years calls for seven percent annual growth; based on current FactSet consensus estimate. The market has priced that growth into current valuations, which remain at the upper end of their historic trading ranges. There is at least one potential wild card that could positively affect the market further. If the Republican Congress and Trump administration deliver on promised tax cuts, we could see an additional one time bump in stocks.
Growth Fund Performance Review
The market continued its strong post-election performance in the first quarter of 2017. The Mairs & Power Growth Fund gained 5.15%, while the S&P 500 Total Return (TR) benchmark was up 6.07% and the Lipper Multi Cap Core Funds Index of peers rose 5.58%.
Heath care, industrials, and energy sectors were the largest contributors to the Fund’s relative performance in the quarter. Stock selection was the primary factor leading to success of the first two sectors while being underweight in the struggling energy sector was the major driver in that sector’s relative contribution. Our position in Target (TGT, Financial), discussed below, was the single largest negative factor.
Even with the market run up since the election, we are still finding opportunities for investment. Tennant Company (TNC, Financial) is a Minneapolis-based firm we have been following for several years and just recently added to our buy list. The company is a leader in commercial scrubbers and sweepers for office, warehouse and retail store environments where labor is the largest component of cost. In a seemingly low-tech industry, Tennant has been investing more heavily in research and development than its competition. The company’s newest machines incorporate on-board technology that provides user manuals in multiple languages, predictive maintenance alerts and telemetry to track machine locations and improve productivity. Longer-term, Tennant has partnered with a robotics company to develop autonomous floor sweepers and scrubbers that could operate without a human driver during off hours when a facility is closed. We predict that over the long-term, Tennant will successfully commercialize this technology, giving it a significant competitive advantage, premium pricing and above average margins.
The biggest mover in our portfolio last quarter was Target (TGT, Financial) which was down nearly 30 percent in the period. The company, like many brick-and-mortar retailers, is being hurt by on-line sales. Management has responded and has taken several steps to become more competitive online, as well as to boost in store traffic, which has been declining. While Target’s on-line sales have grown, they are less profitable than in-store sales, causing us to re-evaluate our outlook for the company’s profitability and growth potential as we continue to hold Target in the Fund. While we have seen many of Target’s competitors struggle even more, some even disappearing, we believe Target is a long term survivor that should benefit from the industry shake up currently underway.
Regarding our market outlook, we remain cautious in the near-term, though not overly concerned. With the market run up since November, valuations remain at fairly high levels limiting further potential upside movement. Expectations for government action on tax and regulatory relief may prove more difficult to achieve. However, as discussed in the Outlook section above, expectations for corporate profits are generally bullish, even without action from Washington. As we head into a slightly higher inflationary environment, our investment focus on companies such as Tennant that enjoy a durable competitive advantage, will provide an edge for investors, we believe. These companies have sufficient differentiation that they will be better able to raise prices, offsetting cost increases without losing market share.
In addition, we believe we are at an end to the historic ultra-low interest rate environment of the past several years. The interest rate outlook is something we pay attention to as equity investors. The low interest rate environment of the past several years has led to a market posture, broadly speaking, where investors have favored dividend paying stocks over bonds. Comparing 3M corporate debt to 3M stock (MMM, Financial) illustrates the point nicely. During September 2016, 3M issued a new 10 year bond paying 2.25 percent. Meanwhile the dividend yield on 3M stock was roughly 2.50 percent, creating a significant relative value challenge to the bonds. For example, if you invested $100 in a 3M bond, you would earn $2.25 annually and get your $100 back when the bond matured at the end of 10 years. If you invested $100 in 3M stock you would get $250 the first year and quite likely more the next year and subsequent years (3Ms dividend has grown 15 percent annually for the past five years) and you’d also expect your $100 investment in the stock to be worth more after ten years. Thus, aside from the relative safety of bonds vs. stocks, bonds did not offer a compelling economic advantage over stocks in 2016. While we don’t expect this relative value gap to entirely swing the other way, we do think that the relative attractiveness of bonds could increase in 2017 and 2018 if, in fact, rates do rise, lessening the demand for some stocks.
Mark L. Henneman Andrew R. Adams
Lead Manager Co-Manager
This commentary includes forward-looking statements such as economic predictions and portfolio manager opinions. The statements are subject to change at any time based on market and other conditions. No pre-dictions, forecasts, outlooks, expectations or beliefs are guaranteed.
