Jeff Pantages

EYE ON WALL STREET: US equities rise in May; Brexit mulled

It was another positive month for U.S. stocks as the large company S&P 500 index flirted with its all-time highs. It was up 1.8 percent on a total return basis on better economic data. It’s climbed 3.6 percent year-to-date. Small and midcap equities also gained ground with midcaps leading the way up 2.3 percent over the month and 7.5 percent YTD. The S&P REIT index that proxies the returns from commercial property gained 2.2 percent and has posted 5.9 percent YTD gains. U.S. Treasury and investment grade bond returns were flattish over the month. The ten year Treasury closed to yield 1.85 percent. Global equities performed poorly in U.S. dollar terms as the greenback strengthened. Emerging market equities gave up most of their YTD outperformance losing 3.7 percent in May while the more developed EAFE countries posted a loss of 0.9 percent. Broad commodity indices were range bound in May but remain up almost 9 percent so far this year. Oil ended the month close to $50 a barrel. Recall it began the year at $37 and dipped to $26 in February. Brexit and the Federal Reserve Do you remember the Neil Sedaka song “Breaking Up Is Hard To Do”? Here are a few lines that would seem to mirror the European Union’s plea as Great Britain decides whether to stay or leave the common market. I beg of you don’t say goodbye Can’t we give our love another try? Come on, baby, let’s start anew Cause breaking up is hard to do The vote is June 23, just three days after the Fed meets to decide on U.S. interest rate policy. While the betting markets put the chance of Brexit at 30 percent, recent polling suggest it is much closer. Questions of sovereignty and Britain’s place in the world are at the heart of the matter. The economic and financial consequences of Britain leaving the EU would certainly be disruptive in the short term and add to uncertainty. Analyst George Friedman thinks this is part of a trend as nation-states reassert themselves and rebel against supranational organizations like the EU, IMF, and multilateral trade treaties that are seen as not being in the national interest. Many thought the Fed might hike interest rates in June. That idea is probably moot now given the weak May employment data released June 3. While the unemployment rate fell to 4.7 percent (mainly because 458,000 people dropped out of the labor force) only 38,000 new jobs were created compared to the 200,000 or so monthly average over the past year. Despite the report, the labor market is tightening. Average hourly earnings were reported up 2.5 percent from a year earlier and real wages have finally surpassed their 2009 peak. The recent Verizon settlement will give workers a cumulative 17 percent increase over four years, which works out to 4.3 percent a year. Not bad for workers in an intensely competitive industry. Labor’s share of corporate revenue is increasing at the expense of profit margins. That partly explains the lack of earnings and modest gains in stocks over the past 12 months. It is always difficult to differentiate between “noise” and “signal” when looking at monthly data that is subject to revisions. U.S. economic indicators had been generally good recently so we think the employment report is probably noise. The widely followed Atlanta Fed’s “GDPNow” model forecasts a solid 2.5 percent growth in the second quarter. We remain broadly diversified in light of modest global growth, low inflation (it is percolating in the U.S.) and middling valuations across most asset classes. Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.

EYE ON WALL STREET: A volatile month for stocks; eying Fund earnings bills

After a rocky start to the year, the financial markets settled down mid-February with oil and U.S. equities rebounding in the latter half of the month. The foreign equity markets have rallied a bit, but are still in a funk. Bond yields remain at historic lows. The 10-year Treasury yields 1.8 percent, which looks positively mouthwatering compared to Japanese and German government bonds that are flirting with negative yields. Dipping into the Permanent Fund As everyone knows, Alaska is facing some difficult fiscal decisions as a result of plunging oil prices and declining production. Approximately 90 percent of general fund revenue is directly tied to oil. Oil is just over $30 a barrel and the Department of Revenue is assuming $60 a barrel for budgeting purposes. At the $60 level, the state faces a $3.5 billion budget deficit both this year and next. We are spending $5 billion and taking in $1.5 billion. At current spending levels it would take a price of $115 per barrel to balance the budget. What to do? Well, we can’t just cut out $3.5 billion. The state’s annual domestic product, or GSP, is around $50 billion so $3.5 billion is 7 percent. Reducing spending by 7 percent of GSP (even forgetting about multiplier effects) would be disastrous. The Great Recession of 2008 saw the U.S. economy fall just over 4 percent and that was pretty scary, pushing unemployment up to 10 percent. The state has saved a lot to help us get through this current crisis, something we didn’t do in front of the economic crisis in the late 1980s. But we’re burning through that savings quickly. At current rates it would be gone in several years. There are three plans for addressing the budget crisis that are currently being debated in Juneau. I won’t go into the details, but all three draw on the Permanent Fund. The Governor’s plan (SB 128) is a bit more complicated (and comprehensive) than the other two (SB 114 and HB 224). Let’s ignore that in the interest of simplicity. Callan Associates, the longtime consultant for the Permanent Fund, was in town a few weeks ago and analyzed what these three plans would mean for the Fund. The firm analyzed the impact on the Fund of drawing roughly 4 percent to 5 percent net out of the Fund (actually the Realized Earnings Reserve) each year, depending on the plan. The Fund’s expected return over the long run is 6.9 percent, so that seems doable and would leave enough room for the fund to grow, albeit slower than before. To get a handle on how market volatility would affect the analysis, Callan ran Monte Carlo simulations over several thousand future market scenarios to look at the dispersion of results over 10 years for each plan. (APCM uses this technique for modeling balanced accounts and the probabilities of reaching horizon goals. It’s standard operating procedure in the asset allocation business.) Guess what? It looks like all three plans are reasonable and leave the Permanent Fund with a median real value of just over $50 billion at the end of 10 years — about where it is today. Each plan can withdraw at least $2 billion per year from the get-go to help with the budget deficit. A combination of cuts and tax increases would need to be debated and adopted to close the remaining $1.5 billion deficit. While tapping the Permanent Fund is not a perfect solution, doing so would buy some time to consider other options. What about the Permanent Fund Dividend? The Governor’s plan provides for a $1,000 dividend this year, followed by modest declines as oil production decreases over time. The other two plans allow for the existing dividend formula to play out for a year or two and then it will probably be up to the Legislature to decide if future dividends are feasible. If it is decided that the Permanent Fund should be used to help close the budget deficit, using the current payout method for the annual dividend would likely prove unsustainable. Under current laws the Legislature can only distribute earnings from the Fund for any public purpose (including dividends). However if there are no earnings reserves it would require a constitutional amendment (and vote of the people) to make a principal distribution. There is no easy or perfect answer in this situation, but moving forward with a plan that balances the budget over time is best done sooner rather than later. Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.

Eye on Wall Street: Investors are in for a bumpy ride

“Fasten your seat belts, boys. It’s going to be a bumpy ride.” While cars didn’t have seat belts back in the 1950s, planes did; but somehow I don’t think Betty Davis had planes in mind when she uttered that memorable line in “All About Eve.” Investors were in need of seat belts given the rough January we saw in the markets. It was one of the worst starts to a year ever as investors were unnerved by fears about a China slowdown and capital outflows, the knock on effects in the emerging markets and falling oil prices. Stock markets rebounded later in the month, but they still fell 6 percent in January as measured by the MSCI All Country World Index (ACWI). Safe haven assets like Treasury bonds, gold and the U.S. dollar rallied. History buffs point out that a bad January does not necessarily make a bad year, although it does increase the odds! Ed Yardeni notes in the 88 years since 1928, there have been 33 down Januaries, with 58 percent correctly predicting a down year. So this “January Barometer” gave a false reading 42 percent of the time. Since 1950, there have been 26 down Januaries with 54 percent correctly predicting down years. The market says... The market has priced in a 59 percent probability of a recession according to a model provided by Evercore ISI that is based on stock market volatility, junk bond prices, and the yield curve. But the vast majority of economists easily put the odds at less than 20 percent. In other words, the “recession trade” has become increasingly crowded and is reflected in current market pricing. Alaska Permanent Capital Management believes a recession in the U.S. is unlikely given decent job growth, steady consumer spending, and a lift from increased government spending in 2016. Besides, the stock market has a spotty forecasting record. Economist Paul Samuelson once quipped that, “the stock market has forecast nine of the last five recessions.” Given recent market volatility investors would be wise to remember the “dean” of security analysis, Benjamin Graham, who famously said that “in the short run the market is a voting machine, while in the long run it is a weighing machine.” Sentiment (yes, fear and greed) can temporarily upend the market, but with time it gravitates back to fair value. The best defense against market volatility is to be diversified and do some planning in advance. Successful investors have a long term plan and have thought deeply about what asset allocation makes sense for them in terms of the need for return while taking into account their ability and willingness to take risk. These investors can ignore the siren call to just “do something” because they already have prepared for the inevitable market storm. When it hits they can ride it out and don’t have to turn back. Lift off, we have lift off In December, the Federal Reserve hiked rates 0.25 percent for the first time in 10 years. Finally, money market investors can earn a return, albeit still tiny. Three-month Treasury bills yield around 0.25 percent and many money market funds are paying higher than the paltry 0.01 percent that had characterized money market land for the past half dozen years. For example, AMLIP, a short term money market fund for Alaska boroughs, cities, school districts, and other state government entities now offers a yield of 0.18 percent. Most economists expect the Fed to hike very slowly, especially given recent market volatility. In fact, the latest batch of economic data continues to be “bond friendly.” Witness the tepid 0.8 percent GDP growth in the fourth quarter and still very low inflation. Also, yields elsewhere in developed countries are at historic lows, making U.S. levels attractive. We believe that two more rate hikes this year are possible, but the odds are declining and everything is “data dependent” per the Federal Reserve. Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.  

EYE ON WALL STREET: 2015 market wrap-up and what to expect in the new year

The big stories in 2015 were the plunge in commodity prices to a 16-year low, turbulence in China, and coming monetary policy “divergence” which contributed to strength in the U.S. dollar. These factors took their toll on various asset classes (global stocks saw their first annual decline since 2011) and market sectors (especially energy). The S&P 500 posted a 1.4 percent total return in 2015. Corporate earnings were flat to down slightly for the year and P/E valuations remained unchanged at elevated levels. Smaller company stocks as measured by the S&P 600 were down 2 percent while REITs, a reasonable proxy for commercial property, gained 2.5 percent. Many foreign stocks did well in their own currencies, but the gains were given back when translated to dollars. The EAFE developed country stock index was up 5.3 percent in local currency but off 0.8 percent in dollars. Emerging market stocks took it on the chin posting a negative 14.9 percent dollar return in 2015. With bond yields very low, coupon income was not much protection against the modest increase in interest rates last year. The yield curve flattened with two-year Treasury yields up 0.38 percent to 1.05 percent, while 10-year yields rose 0.10 percent to close the year at 2.27 percent. Most high quality bond market returns were flattish, while the high-yield “junk” bond market was down 5.5 percent mainly because of worries over energy and market liquidity. Commodities were trounced across the board. Oil lost $30 a barrel ending the year at $35. The broad based Bloomberg Commodity Index fell 24.7 percent and is at levels last seen in the late 1990s. The bottom line was that most diversified portfolios, whether tilted to bonds or stocks provided a return of around +/-2 percent in 2015. This year will likely be better, but challenges remain. Our long-term return expectations remain subdued in the 7 to 9 percent range for stocks and around 2 to 3 percent for bonds. Economic Overview Economic growth in the U.S. remains modest and is running just north of 2 percent. There has been pretty good news on the jobs front with the unemployment rate now at a low 5 percent and decent numbers on the services side of the economy (88 percent of GDP), but frankly poor data from the manufacturing side (12 percent of GDP). We will get a nudge from fiscal stimulus in 2016. The recent federal budget deal turned previous temporary tax benefits permanent and provided for more spending to the tune of 0.6 percent of GDP. It’s positive for growth. The Wall Street Journal reports that the current expansion is longer than 29 of the 33 dating back to 1854. Slow but sure may be frustrating but it means few imbalances have built up. There is no recession in sight. Overseas, both Europe and Japan are rebounding from anemic growth. Economic growth will no doubt lag the U.S., but it is improving and supported by continued monetary easing and low oil prices. China grew at 10 percent from 1980-2010, then downshifted to 8 percent in 2011-2014, and is now coming in just under 7 percent. That’s still strong and on a much bigger base. Still, China and the emerging markets in general are a wild card in the outlook. Inflation is MIA throughout the globe, due mainly to weakness in commodities, sluggish growth and global competition. In the U.S. we may be seeing signs of wages perking up and while headline inflation is just above zero, the core CPI inflation rate is approaching the Feds 2 percent target. Low inflation has allowed central banks to be ultra-easy and keep interest rates at rock bottom levels. In fact, rates in Europe are negative for many government bonds out to five years. At yearend, the Federal Reserve finally began to raise short term rates — the first time in nine years. They have promised to go slow and caution that they are “data dependent.” With many other central banks (Europe and Japan, in particular) keeping rates near zero for several more years and the Fed hiking rates, some believe the dollar will continue to appreciate. We aren’t so sure. Certainly some of this is “in the market” and in fact the dollar is maybe 10-15 percent overvalued on a purchasing power parity basis. What to Expect in 2016 Keeping in mind the late Yogi Berra’s famous admonition that “forecasting is difficult especially when it’s about the future,” here are our thoughts: It’s a slow and low world. Slow economic growth. Low inflation. Low interest rates. Probably low returns on financial assets. Seven years after the Panic of 2008 and Great Recession we are still suffering from the aftereffects of too much debt and challenging demographics. After a seven-year bull market, U.S. stocks are fully valued, so future gains will hinge on earnings growth. Sales and earnings in 2015 were flat to down for S&P 500 companies, but are set to rise 5 to 10 percent according to the consensus. That might be aggressive, as profit margins may narrow owing to nascent wage pressures. Still, we expect modest gains in stocks. We expect developed equity markets outside the U.S., (Europe, for example) to do better. Easy money, more fiscal stimulus, an expanding economy, and weaker currencies should give corporate profits a boost. And valuations are better than in the U.S. While it’s a much tougher call, hope springs eternal with respect to the emerging equity markets. They have been trashed, but perhaps not enough to jump in yet. Valuations are better of course, but there is still considerable uncertainty. The plunge in commodities is worrisome because it is so broad based. It not just oil and gas, which we might chalk up to a supply glut, it’s everything! It is suggestive of weak global demand. We will maintain our underweight to this asset class and not try and catch the proverbial falling knife. It’s hard for us to get excited about foreign government debt boasting negative yields. In general we view bonds as expensive insurance in diversified portfolios. They will probably remain so given a dearth of safe haven assets. Within separately managed bond portfolios we remain underweight corporate bonds but are watching for an entry point as spreads have widened making these bonds more attractive. While non-financial leverage has increased (fueled in part by stock buybacks), the banks have shored up their balance sheets and are quite healthy. We expect the yield curve to flatten as the year progresses although don’t expect much of a sell-off in the intermediate and long end of the market. The Federal Reserve will be cautious and likely hike rates only twice this year keeping the federal funds rate below 1 percent. Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.

Eye on Wall Street: Markets move sideways in November

Last month proved to be quiet compared to the big October rebound in equities. The S&P 500 gained 0.3 percent and is up 3 percent year-to-date, or YTD. Foreign equities lost a bit of ground mainly due to a strong U.S. dollar, which was up 3 percent on FX markets. U.S. interest rates climbed anywhere from 5 to 20 basis points, or bps, across the yield curve. Investors expect the Federal Reserve to hike rates on Dec. 16. The two-year Treasury jumped the most; it was up 20 bps to yield 0.93 percent at month end. The Barclays Aggregate Bond Index lost 0.3 percent. Commodities continued to take it on the chin. Oil fell over 10 percent and finished under $42 a barrel. Gold had its worst month since 2007, declining 6.8 percent to $1,065 an ounce. The Bloomberg Commodity Index lost 7.3 percent and is down 22.3 percent YTD. We’ll have much more about the economic and financial market outlook next month when we review 2015 and peer ahead to 2016. Antiques Road Show My wife and I have been watching this PBS mainstay for years. From time to time you’ll hear us yelling at the TV, “How much? Sell it! Hit the bid! Don’t keep it at that inflated price!” My pet peeve is when someone reports buying something for say $1,000 20 years ago and it’s now worth $2,000. The appraiser often comments, “not a bad return.” Actually, using the Rule of 72 (i.e. divide 72 by the growth rate to estimate how many years before an investment would double) the annual rate of return would be 3.6 percent — not particularly attractive. Really though, how have collectibles faired as investments? A recent comment by an analyst at ISI Evergreen got me thinking. He said: “Coin prices are dropping again and antique furniture prices are some 18 percent below the 2006 peak. Auction prices of classic restored automobiles are down 11 percent from their 2007 peak. Silver set prices are slipping lower as silver prices fall. High-end art prices, however, are starting to rebound from robust overseas demand. But most collectible prices are down from the 2007 peak.” More analytically, a recent article in the Financial Analysts Journal takes a look at collectibles, noting that by some estimates the average high net worth individual has almost 10 percent of their wealth in artworks, antiques, jewelry, fine wines and other luxuries. The authors quote the annual returns from 1900 to 2012 for stocks (9.4 percent) and bonds (5.5 percent) compared to art (6.4 percent), stamps (6.9 percent) and violins (6.5 percent). However, they caution that these numbers exclude transaction costs. Dealer markups and fees for collectibles can be high. For example, auction houses typically charge a “premium” to the buyer and a “commission” to the seller, which together can be 25 percent of the asset’s price! So you better have a long holding period in mind before taking the plunge. Furthermore, collectibles are very illiquid and often require insurance and storage fees. There is the danger of forgery and fraud, not to mention fads and bubbles. The standard indices also underestimate the true volatility of collectible prices. The actual return volatility is probably closer to that of equities. The authors note that diversification within collectibles is important. Yet for a variety of reasons (the difficulty of day-to-day pricing for example) they can find few examples of successful collectible mutual funds. Bottom line? The authors conclude that the, “after-cost, risk adjusted financial returns are low, which can be seen as an indication that the ‘psychic return’ on holding unique and aesthetically pleasing objects must be substantial indeed.” My advice? As an investment, collectibles leave much to be desired. From that perspective it is probably better to get your satisfaction vicariously by tuning into the Antiques Road Show. I’ll bring the popcorn! Jeff Pantages, CFA, is the chief investment officer for Alaska Permanent Capital Management, a $3.5 billion investment management and advisory firm located Anchorage.
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