View
From A Mile Up
SECOND QUARTER | July 2014
QUARTERLY STRATEGY AND OBSERVATIONS
Halftime is typically time to review what worked and what didn’t, strategize and regroup.
During the recently concluded World Cup, halftime was the only break in the action
and allowed for much needed energy replenishment for the players. If things are going
well for your team, the break can’t end soon enough. The corollary also rings true–you
don’t want halftime to end if you are on the losing end of a campaign. Halfway through
2014 the break is over quickly for stock and bond markets and this has surprised many
observers on the upside.
Market Index
Q2 2014 YTD 2014
S&P 500® Index
5.2%
7.1%
Russell Midcap® Index
4.9
8.7
MSCI EAFE
4.1
7.1
Dow Jones Industrial Average
2.8
2.7
Russell 2000 Index
2.1
3.2
®
Markets defied widespread calls for a correction and forged ahead, with mid-cap stocks
leading the way. Foreign stock markets generally lagged the broad U.S. markets as our
economy looks to be picking up steam relative to other developed nations. From a sector
standpoint, the energy, utilities and healthcare sectors led the way in the second quarter,
while telecom, consumer discretionary and financials were the worst performers for the
past three months.
The “American Job Machine” is Back
The much watched unemployment number dropped in May to slightly above 6%. However,
if we look past the unemployment report, we see strength in job creation coming from a
number of areas. For the first half of the year, the American Job Machine added almost
250,000 jobs per month, according to recent data. That pace is more than double that of
VIEW FROM A MILE UP
2013, even with the harsh winter weather. More importantly, we are seeing the number
of full-time workers increase while part-time workers decrease. For example, May
saw an increase of 312,000 full-time workers while the number of part-time workers
declined by 78,000. Employment trends continue to strengthen since the end of the
recession in June 2009. This defies predictions that firms would eschew hiring full-time
workers for part-time workers in light of the Affordable Care Act’s insurance coverage
requirements for full-time workers.
Millions of Workers
Millions of Workers
Number of Part-Time and Full-Time Workers in U.S.
Source: Bureau of Labor Statistics
Meanwhile, unemployment claims are at an 8-month low. When adjusted for the
“... unemployment
increased size of the labor force, unemployment claims are at their lowest level
since 2007. It is not just the payroll surveys of large businesses (from which the
claims are at
unemployment numbers come) showing strength. ADP payroll data show that small
their lowest level
large business hiring coming out of the recession, small– and mid-sized companies
since 2007.”
companies. Importantly, small– and mid-sized businesses make up half of the private
businesses are increasing hiring at an accelerating rate. In fact, after years of lagging
(1-49 employees = “small” and 50-499 employees = “mid”) are hiring faster than large
sector jobs in the U.S.
PAGE 2
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
m/m change thousands
ADP Monthly Job Gains Since Recession End by Company Size
Source: ADP, Bloomberg
Lastly, the early signs of wage increases in some industries (think construction, energy
and manufacturing) will lure additional participants back into the labor force. The U.S.
labor force has been increasing by 126,000 workers per month in 2014, a stark contrast
to the declines of 46,000 every month seen in 2013. While wage gains remain subdued,
growing at a tepid 2.0% year-over-year, we are seeing accelerating wage gains in
multiple industries. Over the past year, wage gains in manufacturing have accelerated
from 1.6% to 2%, energy from 2.7% to 4.9%, transportation from 1.2% to 2.9% and
construction from 1.5% to 2.2%. These four areas account for one-third of the country’s
total private work force. In the last two economic recoveries, wage gains didn’t begin to
meaningfully accelerate until unemployment hit 5.5%.
Consumer Net Worth
Not only is the U.S. Job Machine back, but with it the financial health of U.S. consumers.
According to the Federal Reserve’s recently released Flow of Funds report, household
“In the last
two economic
recoveries, wage
gains didn’t begin
to meaningfully
accelerate until
unemployment hit
5.5%."
net worth in the U.S. is now $81.8 trillion. Prior to the last recession, net worth peaked
at $68.9 trillion in the second quarter of 2007, then fell to $55.6 trillion by the beginning
of 2009 as both housing and stock values collapsed. While the value of household real
estate is still below its peak in early 2006, stock market gains have fueled the new
record. Viewed as a percentage of U.S. Gross Domestic Product, we see household
PAGE 3
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
net worth is slightly below its prior peak but still healthy. (GDP has grown faster than
“The health
household net worth since 2005.) The health of the U.S. consumer implies underlying
strength for the economy.
of the U.S.
Household Net Worth as a % of GDP
consumer
implies
underlying
strength for the
economy.”
Source: Federal Reserve
Inflation Watch
Last quarter (View From A Mile Up, April 2014), we wrote about “lowflation,” the term
characterizing a sustained period of ultra-low, albeit rising prices, as part of our
ongoing inflation watch. This quarter, we look at another indicator of inflation, the
Personal Consumption Expenditures Index (PCE). Often overlooked in favor of the
Consumer Price Index, or CPI, the PCE Index (also referred to as the PCE deflator or
PCE price deflator) is another measure of the prices paid for goods and services by U.S.
individuals.
The PCE varies from the CPI in calculation methodology in ways that assume
consumers make allowances for changes in relative prices – i.e., that consumers will
substitute (buy) goods whose prices are stable or falling for those whose prices are
rising. Also, the PCE basket of goods and services is much broader than those included
in the CPI. Both series offer “headline” or overall measure and a “core” measure which
strips out energy and food costs. While the CPI is calculated by the Bureau of Labor
Statistics, the PCE is calculated by the Bureau of Economic Analysis, prompting the
PAGE 4
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
question of why two different government agencies are calculating price changes of
goods and services.
% Change
% Change
Consumer Price Index vs. Personal Consumption Expenditure Index
Source: Bureau of Labor Statistics, Bureau of Economic Analysis
We do know that the Federal Reserve prefers the PCE measure of inflation for some
of the reasons stated above (substitution effects and more comprehensive coverage of
goods and services). For that reason alone, we feel the PCE bears watching as well as
the CPI. As the chart above shows, both measures of inflation generally move together,
albeit with different nuances.
So what are the inflation indices telling us? They both point to a modest uptick in inflation
here in the United States. If the current inflation trends continue, we may have seen the
low point for inflation. More time will give clarity to whether the recent increases are
indeed an inflection point, but we continue to carefully watch for signs of inflation, such
as companies exhibiting increased pricing power.
Social Security – A look at the File and Suspend Strategy
We are often asked about the “best time to apply for Social Security.” It is a question that
often arises as people begin thinking about retirement. An important step in answering
the “when” is a review of spending and saving needs. Such an assessment will help to
calculate the sustainability of resources into the next phase of one's life. Although Social
Security income is a supplement to other income sources, it may be worth
“So what are the
inflation indices
telling us? They
both point to a
modest uptick
in inflation here
in the United
States."
PAGE 5
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
exploring how best to maximize the benefits that might be available. The solution may be
different for various families based on the difference in the ages of spouses, the earnings
of each spouse throughout their lifetimes, and life expectancy assumptions. We often
help clients construct a pathway to better understand the possible amounts they may
receive if they choose among various payment options.
One strategy for maximizing Social Security benefits is file and suspend. How does it
work? A person files for retirement benefits with the Social Security Administration,
but suspends payment. This strategy can allow you to earn delayed retirement credits,
which can increase the future payments you receive by as much as 8% per year. Once you
reach age 70, there is no advantage to delaying the receipt of Social Security income. File
and suspend is only relevant for people who have reached full retirement age under the
Social Security terminology. For example, if you were born in 1954, your full retirement
age is 66. If your monthly benefit amount would have been $2,000, you file with Social
Security and begin earning delayed credits. At age 70, the monthly benefit would have
compounded to be over $2,720 throughout the remainder of your life.
Married couples can benefit because the filing allows for a spouse who earned lower
lifetime wages to begin receiving spousal Social Security benefits including a monthly
income (usually at 50% of the spouse who filed). Therefore, it is not necessary for both
spouses to delay receiving income to achieve the desired increase in income based on
the primary wage earner. In the example from the previous paragraph, the spouse who
delayed receiving his or her $2,000 per month (with the intention of later earning a larger
amount) could still have a spouse who is at full retirement age eligible to start receiving
$1,000 per month without waiting until age 70. If both spouses have been high earners
throughout their lives, it will not always make sense to file and suspend. If one spouse
has been a much higher earner than the other spouse, then we would need to determine
the cash flows based on life expectancies, but file and suspend may still be a viable
strategy.
For single people, file and suspend can also be a practical part of your financial plan. An
unmarried individual can still gain by receiving the up to 8% per year increase in annual
income when benefits begin. Furthermore, single and married people have an option to
receive the benefits retroactively from the time of filing (and suspension of payments).
In the event you discover an emergency need for a lump sum amount, you can notify the
Social Security Administration. Under the current rules, they will provide you a lump sum
payment on the amount you missed receiving. If you didn’t file at all, Social Security will
only provide retroactive benefits for the prior 6 months after you reach full retirement
age. If you file and suspend, the lump sum calculation goes back to the date you filed for
benefits which means a potentially much larger amount of money.
PAGE 6
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
Although this space is not large enough to discuss all the variables to consider in a
comprehensive way, we encourage you to take a closer look at how this may affect your
lifetime income. For the most accurate assessment, please let us know if you’d like to
discuss any of these points in greater detail.
Our own financial planning expert, Chad McDonnell, CFP®, urges clients to discuss Social
Security strategies with their portfolio manager well before they reach full retirement age.
Following Up – Education at a Crossroads
In View From A Mile Up, October 2013, we quoted our analyst Jennifer Oldland as
predicting “There are many headwinds facing the [college] industry including overcapacity
and online learning competition.” Not only was Jennifer’s message prescient (as we saw
with the recent shutting of Corinthian Colleges), but we think profound as well.
More research has shown that while higher education is big business (despite the nonprofit status of the overwhelming majority of universities and colleges), the business
model of educating our young adults hasn’t changed since Aristotle taught at the Athenian
Lyceum: young students gather at an appointed time and place to hear their elder
scholars impart their wisdom via lecture.
Three headwinds are blowing to reshape the higher education system in the U.S. as we
know it: funding challenges, the changing labor market, and technological revolution.
The first challenge is well-known–tuition costs! Universities increased tuition 1.6% more
than overall inflation every year for the past two decades (while costs for many other
goods and services were in decline). For many students, the price of a higher education
degree remains a good deal, as numerous studies have shown the higher earning value
of a degree-holder over a lifetime. However, for the 47% of U.S. college students who fail
to complete their course of study, the debt accumulated in pursuing, but not achieving a
college degree calls into question the need for that degree they didn’t get.
The second challenge is posed by changes in today’s and tomorrow’s labor markets. The
traditional model of higher education, whereby young high school graduates go to college
in their 20s, earn a degree and enter the workforce is being challenged. A recent Oxford
University study shows nearly half of occupations are at risk of being lost to automation
in the next few decades, requiring retraining for the displaced worker. The new model of
education is one where workers require re-training at multiple points in their working-age
years. The traditional university is ill equipped for these “recharging stations” for later-life
scholars.
Lastly, the educational tech revolution is slow to come, but come it will. So far, Massive
Open Online Courses (MOOCs) have failed to live up to their early and lofty expectations.
That the MOOCs model will be disruptive is not in question. How much that disruption
PAGE 7
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
impacts different providers of higher education remains to be seen. We do know that
many small, private colleges are struggling to balance their budgets, and credit rating
agency Moody’s foresees a “death spiral” of closures of small- and mid-tier colleges.
Like any tidal wave of change, there will be winners as well as losers in the unfolding
education revolution. The universities least likely to lose students will be those elite
institutions with established reputations that can attract top-tier faculty. It is no surprise
that Georgia Institute of Technology, Harvard, Massachusetts Institute of Technology,
and Stanford are all involved in the MOOC model.
Almost 2,500 years after Socrates lectured students, paving the way for formal
educational institutions, we may be on the verge of a revolution in higher education.
These shifts in the educational landscape will undoubtedly produce winners and losers,
the identities of which we don’t yet know. However, recognizing that an important
shift is taking place should allow us to anticipate the changes and to seek investment
opportunities as new models displace old ones–creative destruction at work once again.
THE BOND BOX
Bond Market Review
Comments from our Bond Traders
The bond market continued to rally to lower long-term interest rates in the second
quarter. The strong performance was not confined to the United States as the
decline has been a global phenomenon throughout the first half of 2014. The trend
was most prominent in Europe with the German 10-year approaching its post-crisis
low-yield of 1.2%. Even the weak credit peripheral countries had dramatic yield
declines on their 10-year bonds–Spain down to 2.7%, Italy to 2.8%, Ireland to 2.3%
and even Greece fell to 5.9% a mere two years after its recent default. With these
weaker countries offering yields equal to or even less than the 2.5% available on
U.S. Treasury Notes, our bond market looks like excellent value, particularly with a
backdrop of global tensions percolating in the Ukraine and the Middle East that can
quickly lead to a flight into the safety and quality of U.S. markets.
PAGE 8
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
Muni Land
Municipals enjoyed another strong quarter of performance with the Barclays Municipal
Bond Aggregate Index returning 2.6% and an impressive 6% in the first six months of
the year. Improving credit, lack of issuance and higher taxes drove strong performance
across the tax-exempt sector. The 10-year AAA Municipal Bond closed the month with a
2.3% yield, down 10 basis points from the end of last quarter and an astounding 66 basis
points from the end of last year. If nothing else, the performance of the bond markets
through the first half of the year shows the danger in consensus views, as nearly every
market strategist predicted that rates would drift higher at the close of last year.
Interest Rates: As mentioned previously, at the end of last year sentiment seemed to
have overwhelmingly swung to a view of higher rates. Yet as yields have moved lower
and volatility has hit generational lows, sentiment seems to have broadly swung the
other direction. Once again seeing broad consensus has given us pause and we view the
possibility of higher rates in the second half to be high.
Credit: We remain very positive on the credit fundamentals of the municipal market,
especially in Colorado. Real estate, job creation and GDP have all made stronger
recoveries than national averages. From June 2012—May 2014, Zillow shows home
prices in Colorado and Denver increased 16% and 20% respectfully. Higher real estate
prices are a major tailwind for municipal credit as ad valorem property taxes are a
major source of revenue for local governments. We continue to focus on these tailwinds
to identify which sectors and individual credit names will benefit the most.
Puerto Rico (“PR”): It seems a bit odd to dedicate an entire bullet point to a
small Caribbean island, but there is strong reason to do so. As noted in previous
commentaries, PR is able to issue bonds that are tax exempt in every state and
municipal managers, especially the largest complexes, have found their extra yield
desirable. So desirable in fact that a Morningstar research report showed that nearly
70% of all mutual funds held PR bonds, some with startling high concentrations. We
point this out with added emphasis as the PR credit situation has declined materially in
the last month. On 7/01/2014, PR bonds were downgraded by Moody’s and are now rated
B2, well into junk territory. With over $70 Billion in municipal debt outstanding, PR is
one of the largest issuers. While financial deterioration in PR has not yet had a systemic
effect on the overall market, we would view it to be highly advantageous if that were
to take place. The municipal market is notorious for “throwing the baby out with the
bathwater” and if we are able to buy high–quality municipal bonds for lower prices due
to fiscal problems of a small island in the Caribbean, we certainly will.
PAGE 9
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
Conclusion
While stocks continue to defy calls for a correction, and bonds seemingly wait for higher
interest rates in vain, we are becoming even more attuned to valuations. Five years into
the current stock market rally, the U.S. economy seems to be not only on firm footing,
but experiencing accelerating growth. We do not think it prudent to throw caution to
the wind, and recommend rebalancing portfolios to one’s long-term asset allocation
targets. Where appropriate, we continue to favor an overweighted position to stocks
versus bonds, but are also mindful that short maturity bonds play an important role in
diversified portfolios.
Welcome Tim Rich
Denver Investments would like to welcome the newest addition to our team, Tim Rich,
CFA. Tim joins us after spending the past eleven years working in California in the
wealth management industry as an analyst and portfolio manager. He received his BA
from Duke University and his MBA from UCLA-Anderson School of Management. Tim
is a Chartered Financial Analyst and we are pleased to welcome him back home to
Colorado.
PAGE 10
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
VIEW FROM A MILE UP
This page is intentionally left blank.
PAGE 11
| Wealth Management | p: 303.312.5000 | w w w.denvest.com
Second Quarter 2014
FOR MORE INFORMATION ABOUT OUR WEALTH MANAGEMENT OFFERING, PLEASE CONTACT:
Denver Investments | Wealth Management | 1225 17th Street, 26th Floor | Denver, Colorado 80202
p: 303.312.5000 | f: 303.312.4900 | e: jrober [email protected] | w w w.denvest.com
The views expressed herein are those of the Wealth Management Group and do not pertain to all investment strategies offered by Denver Investments. The Quarterly Strategy and Observations contain
statements that are general in nature and apply to Denver Investments’ model accounts. Investment strategies for client accounts can differ from the model account based on individual client objectives,
guidelines and/or restrictions. In addition, actual events may cause adjustments in portfolio management strategies from those currently expected to be employed. Please contact your portfolio manager
if you have any questions regarding your account. Performance information of certain broad based benchmarks may be included. Past performance does not guarantee future results.
The mountain logo together with “Denver Investments” is a registered service mark of Denver Investments.