The biggest surprise to us thus far in 2014 has been the magnitude of the U.S. Treasury rally. Yields on 10 year U.S. Treasury Note have fallen from 3.0% in January to as low as 2.3%, before settling into a current range of 2.35% – 2.45%. We attribute this to disinflation and slowing global economic growth. Economic sanctions placed on Russia are weighing on the already fragile recovery in the Eurozone. Germany’s GDP has fallen from 0.7% in the first quarter to -0.2% in the second quarter, and Industrial Orders fell 5.7% in August, indicating future economic weakness. As a result of deflation fears, yields on the 10 year German Treasury have collapsed from 1.9% in January to a low of 0.9% currently. The ongoing malaise prompted Mario Draghi, President of the European Central Bank, to cut interest rates to 0.05% versus 0.50% a year ago, and to announce a quantitative easing program of 600 billion to 1 trillion Euro increase in the ECB balance sheet over the next two years through purchases of asset-backed securities and covered bonds.

In September 2012, the Federal Reserve announced its plan to purchase $85 billion per month of U.S. Treasury and Federal agency-issued mortgage backed securities. This was the Fed’s latest effort to print money and place it into circulation, in hopes the added liquidity would further reduce borrowing costs and stimulate demand. Last December, the Fed indicated it would decrease its monthly purchases by $10 billion at each subsequent meeting and confirmed in the September meeting, the quantitative-easing program will end in October. We anticipated dollar strengthening in 2014 based on the effect of the expiry of Fed easing, coupled with the need for many other central banks to continue their respective stimulus. The Euro currency has fallen 8.8% relative to the U.S. dollar this year, while the Japanese Yen and British Pound Sterling are also weaker. The dollar index is currently trading near a 4-year high. Given the stronger dollar and continued global disinflation, gold has fallen 13% since its peak in March, while West Texas Intermediate crude oil has dropped almost 16% since its peak in mid-June. Likewise, prices of industrial metals and many agricultural commodities have fallen over the course of the year, as indicated by weakness in the CRB index.

The Federal Reserve

The Fed has a dual-mandate from Congress to foster full-employment and maintain stable prices by keeping inflation in check. On October 3, the U.S. Labor Department released September employment data, reporting a stronger-than-forecast increase in non-farm payrolls of 248,000, versus a consensus estimate of 215,000. This positive headline report reduced the unemployment rate from 6.1% to 5.9%, and the broader underemployment gauge from 12% to 11.8%. The U.S. economy has added in excess of 200,000 jobs each month except for January and August, suggesting steady improvement. In terms of the total number of jobs, the pre-recession peak was surpassed in April. Two trends the Fed is watching closely are wage growth, and the labor participation rate. Looking more closely at the trends, 45% of the jobs created since the Great Recession are in lower-wage service industries, while 16% are temporary positions. The average salary of jobs lost during the recession was $64,000, while the average of new jobs is 20% less, at $51,000. During September, retail sector and temporary hires combined for 55,000 of the new jobs. Wages are up 2% year-over-year, and have risen only 1.9% annually since 2010. Furthermore, the labor force dropped by 97,000 during August, with labor participation falling to a 36 year-low of 62.7%. While labor shortages exist for specific skilled labor (e.g. oilfield workers in North Dakota and West Texas), there is no wage inflation in the broad-based economy.

The Fed uses Personal Consumption Expenditures (PCE) as its primary inflation gauge. Inflation has not been an issue during the economic recovery dating back to mid-2009. Through August, the PCE is up 1.5% on an annual basis. The Fed’s target is 2% based on the decision that some level of inflation is necessary for the economy to resume its historic long-term growth rate of 3.2%. Other popular inflation gauges confirm the low-level of price increases. The Consumer Price Index and core Producer Prices are up 1.7% and 1.8%, respectively. This has prompted some economists to refer to this period as a “Goldilocks economy” that is growing slowly with little inflation. As such, we do not foresee the need for the Fed to aggressively increase interest rates in the coming year.

Outlook

Going forward, we feel there are two important themes for us to focus on. Earnings growth remains strong for many U.S. companies. Revenue growth coupled with cost-containment and efficiency continues in 2014. Consensus estimates, according to Bloomberg, are for S&P operating earnings to grow 12.7% this calendar year to $120.4. Secondly, we are all familiar with the sage advice of “don’t-fight-the-Fed.” In-line with the Fed’s outlook, we don’t believe it is necessary to take near-term action to begin a series of rate hikes, as inflation and employment remain below their stated targets. As we enter the fourth quarter, geopolitical tensions such as the Ukraine/Russia conflict, fighting in the Middle East region, and democracy movements in Hong Kong continue to dominate the headlines. Nevertheless, we continue to look beyond the transient news items to invest in sound companies that generate solid operating earnings.

As always, we appreciate your trust in us and the opportunity to serve you. Please contact us if you have any questions or comments.

Sincerely,

Noesis Research Team