2nd Quarter 2015

July 15, 2015

Dear Client:

Midyear Review

2015 has been eventful thus far as American Pharaoh triumphed to become the first Triple Crown winner since 1978, official U.S. diplomatic contact has taken place with Cuba for the first time since 1961, and David Letterman retired from late-night television after 22 years.

As for stock markets, global returns were up marginally for the first-half of 2015, though it hardly arrived in a straight line.

YTD Price Returns (%) in Local Currency and U.S. Dollar terms

(Through 6/30/2015)



Local Currency


S&P 500 Large Cap



Dow Jones Industrial Average



S&P 600 Small Cap



MSCI EAFE (Europe, Australasia, Far East)



MSCI Europe ex-U.K.



Japan (Nikkei 225)



MSCI Emerging Markets






Shanghai Stock Exchange Composite




All major indices had posted gains through May, before suffering a setback in June. Much of the selloff has been attributed to Greece’s debt troubles, higher interest rates, and a resurgent U.S. Dollar. The S&P Small-Cap Index stands out as the exception, gaining 1% in June. Conversely, some Chinese exchanges dropped in excess of 20% on profit-taking following very strong gains. China and Japan remain the best year-to-date performers, helped by accommodative monetary and regulatory policy. Brazil and Indonesia were among the worst performing countries. Growth has trumped Value thus far as the S&P 500/Citi Growth Index gained 2.85%, while the S&P Value lost 0.45%. It is notable that the Dow Jones Industrial Average closed lower for two consecutive quarters for the first time since 2008-2009.

Perhaps the biggest surprise to everyone, except to the Atlanta Federal Reserve, was the dismal U.S. economic conditions during the first three months. GDP was essentially flat, declining by 0.2%. This compares to the first quarter of 2014, when GDP was also essentially flat, growing by


0.1%. Even after expectations were lowered throughout the quarter, the consensus of Wall Street economists was for GDP to grow by 1%. The Atlanta Fed model, on the other hand, forecast a rise of only 0.1%. As we wait for second quarter GDP results, consensus forecast according to Bloomberg is for 2.5% growth, while the Atlanta Fed is predicting 0.7%. Other than Existing Home Sales increasing 5.1% during May, most other economic indicators are tepid at best. Consumer Confidence has fallen, manufacturing activity has weakened and Industrial Production has declined for six consecutive months through May. Personal Income and Personal Spending remain low and are not improving. The current conditions do not compare favorably to mid-year 2014, when GDP rebounded to 4.6% and 5.0% growth in the second and third quarters, respectively. It is against that backdrop, the Fed determined that it is best to maintain current interest rates in its latest meeting. At the beginning of the year, the Fed anticipated the U.S. economy would grow in a range of 3 – 3.2% and some economists were calling for 4%. Since then the Fed has reduced its estimates twice, and now looks for GDP to grow 1.8 – 2% over the course of the calendar year. Heavy betting among traders currently is that the Fed will raise rates in December 2015. For perspective, when the Fed ended its quantitative easing program in October 2014 the bet was a rate hike would come five months later, at the March 2015 meeting.

What was not a surprise is that Greece missed its debt payment to the IMF, due on June 30th, becoming the first developed nation to do so. Greece joins economic stalwarts Zimbabwe, Haiti and Afghanistan in the club of nations who have defaulted on an IMF loan. On Sunday July 5th, Greek citizens voted not to agree to new austerity measures in their national referendum. Following the 1.5 billion Euro default to the IMF, the next event is the 3.5 billion Euro loan payment due to the European Central Bank on July 20th. We look for continued market dislocation around the negotiations for debt relief. Public institutions – primarily the Eurozone member-states, ECB and the IMF, hold the vast majority of Greek debt. While the debt holders are capable of writing off the bonds, the critical issue for Greece is its banking system needs additional liquidity to function and the struggle now is to find another lender. Greece represents 1.6% of the Eurozone economy and 0.3% of the global economy. Ultimately, this story has limited impact on our investment horizon of diversified holdings over 3 – 5 years.


While we pointed out some weak economic indicators through May, the preliminary June numbers give us reason for cautious optimism and we expect the economy to return to its pattern of low growth over the balance of the year. The outline given in our January letter for a continued strong dollar, elevated market volatility, low inflation, attractive earnings growth, and P/E expansion remains intact. Volatility certainly spiked in June, and in some cases we were slow to reinvest cash based on possibility of a mid-year correction. Beyond the near-term fallout between Greek and its creditors, we look for equities to resume their uptrend this year as moderate economic data puts the Fed on-hold indefinitely. In spite of domestic earnings muted by dollar strength, those companies that are able to grow revenue and earnings are sought after as illustrated by the relative performance of the S&P Growth Index, in addition to mid-cap and smaller stocks. Excess global liquidity continues to drive financial markets as evidenced by the returns in China and Japan. Given that all major central banks are pursuing an accommodative monetary policy, we anticipate this macro tailwind to carry through year-end.

Fixed Income

In the low-yielding environment of past years, fixed income investors are faced with the challenge to find yield alternatives without taking too much risk of principal. Besides the credit risk, rising interest rates are becoming increasingly a concern with the imminent interest rate hike. As previously discussed, we are using high-dividend paying equities supported by sustainable growth potential, investments in niche sectors such as master limited partnerships, and structured securities based on companies with solid fundamentals. In today’s letter we want to focus more on these structured securities and share our approach with you. While their construction can be complex and technical, we want to emphasis their application in our investment process.

Structured Securities

While structured securities encompass a wide range of investments, up to now we are only using a certain type called reverse convertible note with an underlying single stock. Technically this note consists of holding a zero coupon bond and selling barrier put options (Down-and-In puts) on the underlying stock. The premium from selling these options delivers the majority of the coupon we are earning. Should the underlying stock decline more than the agreed percentage and not recover back to its initial price before maturity, we will own the stock as a result of the option contract.


We are taking equity risk with these reverse convertible notes and have to carefully select the underlying stock. We first and foremost look for high quality companies that we are willing to own in the long run. This is the reason why most of the underlying names are part of our core holdings. As the commonly used name “hybrid” securities implies, we can use them tactically from equity or fixed income perspective. A company might offer limited up- and downside in the near-term while we still believe in its long-term merits. Instead of selling and taking the risk of missing the right timing to re-enter, we can invest in a note and get paid for our patience – a yield-enhancement strategy for our equity portfolios. Another scenario could be where we buy a note instead of the underlying company due to valuation concerns. Should the stock price decline during the holding period, we have a certain amount of downside protection from the barrier, while the company’s valuation might reach a more attractive level. Thus, we collect coupons while waiting for a better entry point. From a fixed-income viewpoint we can select less volatile stocks with higher barriers for the notes resulting in lower coupons but higher downside protections. The different motivations for buying each note will determine the appropriateness for the individual client portfolio.


We are aware that the opaqueness of structured products has the potential for high fees and we are minimizing any implicit costs by using a simple, plain-vanilla structure and not buying notes in the secondary market. We screen for potential candidates by their implied option value and look for the best risk/reward ratio, then we approach the main issuing banks directly for a customized note with our preferred terms. The banks bid against each other for our business and by comparing half a dozen or more offers, we gain a good overview of the most favorable terms which usually means the highest coupon rate for a given structure.

Baxter – Baxalta spin-off

On July 1st Baxter (BAX) completed the spin-off of its bioscience business into a separate company named Baxalta (BXLT). The remaining Baxter develops medical products for hospitals and renal dialysis while Baxalta will focus on plasma and biotech business in the therapeutic areas hematology and immunology. Shareholders received one share of Baxalta stock for each of their Baxter stock and according to company information the spin-off will be treated as a tax-free transaction.


Cyber Security is an important ongoing point of discussion at Noesis, and we take it very seriously.  We have implemented encryption capability on our email systems, allowing us to properly protect critical information when we email our clients.  Some of our clients may have already received sensitive information in this manner.  We also encourage our clients to encrypt any sensitive information you send to Noesis.  If you need assistance in doing this, please feel free to contact our IT Specialist Adriana any time.



We look forward to hearing your views and addressing any questions that you may have.


Research Team