Avalon produces a variety of investment commentaries.
Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.
Low-Balling Inflation Puts the Fed at Risk
September 28, 2017
TPP Is Dead. What Now?
January 25, 2017
The Possibilities of Trump's U.S.
December 9, 2016
Reversal Rates Are the Next Big Challenge for Central Banks
November 23, 2016
The Good Ole Days Aren't Coming Back
October 13, 2016
The Federal Reserve's Anti-Volcker Inflation Revolt
August 24, 2016
Why the Fed Needs to Raise its Inflation Target
August 18, 2016
Is the Rest of the World Ditching America to Trade with China?
August 3, 2016
Has the Federal Reserve Become Congress's Golden Goose?
July 20, 2016
The Fed Must Avoid the 'Credibility Trap'
June 21, 2016
Why the Fed Needs to Make a Policy Error
May 18, 2016
The Fed Faces Its 'Anti-Volcker Moment'
May 9, 2016
The Fed's Critical Global Mandate
April 29, 2016
Why the Federal Reserve Is All Talk
April 26, 2016
Is the Global Middle Class Really Here to Stay?
April 12, 2016
Quarterly and Monthly Notes
First Quarter, 2018
Third Quarter, 2017
Second Quarter, 2017
First Quarter, 2017
Fourth Quarter, 2016
Third Quarter, 2016
Second Quarter, 2016
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Avalon Advisors Announces San Antonio Expansion
December 21, 2016
Avalon Advisors Announcement
December 16, 2016
April 11, 2016
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Third Quarter Snapshot:
U.S. equities outperformed international equities in the third quarter, with the S&P 500 returning 1.13% and the MSCI All Country World Index ex U.S. losing 5%. Domestic small cap stocks continued to lag their large cap counterparts, with the Russell 2000 losing 7.4% for the quarter and 4.4% for the year-to date. Health Care and Technology, up 5.5% and 4.8%, respectively, were the best performing sectors in the S&P, while Energy and Utilities, down 8.9% and 4.0%, respectively, were the worst. Although U.S. stocks bounced back from their selloff in July, the rally began to fade towards the end of September, leaving the S&P barely up for the quarter, although still up a strong 8.3% for the first nine months of 2014.
U.S. investors in international stocks were negatively impacted by a rising dollar, which was up almost 8% against a basket of major world currencies. For example, German equities lost 3.6% in euros but this loss translated into an 11.1% loss in dollars. Japan was actually up 7.3% in yen but down 1% in dollars, and Brazil was up 1.8% in real but down 8.4% in dollars. As in the U.S., Health Care and Technology were the strongest performing sectors internationally.
Despite overwhelming predictions to the contrary, U.S. interest rates have continued to decline this year. The 10-year Treasury ended the quarter at 2.52% down from 3.04% at the end of 2013 and the Treasury yield curve continued to flatten in the quarter. Municipal bonds continued their strong year-to-date performance, with Barclay's Municipal Bond Index returning 1.5% in the quarter and 7.6% year-to-date. Municipals have been benefiting from strong demand, improving financial strength of issuers and constrained supply. High yields bonds lost almost 2% in the quarter, but are still up 3.5% year-to-date.
Investors have been expecting rates to rise as our economy continues to improve and as the Fed has tapered (and now ended) its bond-buying program. However, with other economies weakening, particularly Europe, and monetary stimulus increasing in the Eurozone and Japan, the U.S. bond market has experienced an inflow of funds from abroad. In fact, renewed weakness in the Eurozone during the quarter caused European sovereign rates to hit record lows, with the German 10-year falling to 0.88% at the end of September, significantly below comparable rates in the U.S. This increased demand for our bonds is putting downward pressure on rates and, at the same time, driving up the dollar. The rising dollar hurt U.S. investors in foreign bonds. The Barclays Global Aggregate Ex U.S. Dollar Government Bond Index lost 5.4% in the quarter.
Although we may see some rise in rates from today's level, we believe we are likely to remain in a low interest rate environment for some time. In fact, the bond market has recently ratcheted down its expectations for rates and those expectations are now significantly below those of the Fed itself.
Recent statistics continue to show a strengthening U.S. economy. September employment growth rebounded from a disappointing August, the unemployment rate continues to fall, and the latest GDP release showed third quarter growth of 3.5%. Jobless claims are close to the lowest level since 2000, and the number of job openings continues to rise. Unfortunately, wage growth continues to be anemic after adjusting for inflation, but we could start to see more upward pressure on wages if the labor market continues to tighten. In the meantime, consumers are benefiting from lower energy prices (again thanks to a slower global economy and a stronger dollar). Oil prices fell almost 12% in the third quarter and have fallen further since then. Overall, the U.S. economy continues to be a bright spot among the developed economies and many of the emerging economies.
The S&P 500 has recovered from its October selloff and is now above its September 19th high. At the end of last year, we pointed out that a large part of the S&P's 2013 return came from P/E expansion and that further returns were more likely to be driven by earnings increases. Despite a weak first quarter (largely weather-induced), earnings growth has been quite strong this year, up 7.7% in the second quarter and estimated to be up over 7% in the third quarter. Consensus earnings for 2015 are forecasted to increase over 10% on an expected 3.7% revenue increase.
Many companies have continued to find ways to expand profit margins and have been benefiting from the lack of wage growth. The strong earnings growth experienced thus far in 2014 is even more impressive given the slower growing global economy. Over 40% of the S&P's earnings come from international sources, with about 20% coming from Europe. Much of the U.S. Industrial sector is heavily exposed to the global economy and a number of these companies have been experiencing slower growth despite an improving domestic economy. Earnings in the Energy sector and parts of the Materials sector have been hurt by the large drop in commodity prices since the beginning of the summer. However, companies more exposed to the U.S. economy, such as many of the Financials, have experienced healthy earnings growth. In addition, earnings in the Health Care sector (particularly the biotechs and pharmaceuticals) have been accelerating, thanks to innovative new drugs and treatments and an aging population. Although this sector has historically performed better when the economy is slowing, recent stock performance has been more earnings driven, with the sector returning almost twice the index return for the first nine months.
The S&P is currently valued at about 16.8 times 12-month forward earnings, above its 10-year average of 14.1. Considering the low inflation and low interest rate environment, this valuation is not unreasonable if companies can continue to deliver or exceed expected earnings growth. Although investors have raised concerns over stretched valuations in a number of internet-related stocks, these stocks continue to comprise only a small part of the S&P, and the Technology sector's average forward P/E at 15.4 is below its 10-year average of 16.0.
European economies, which had been slowly recovering from recession, weakened in the third quarter, causing most European equity markets to decline. The European Central Bank responded with additional stimulus measures towards the end of the quarter and has taken additional easing steps since then. Valuations continue to be modest, with the MSCI Europe Index selling at about 15 times forward earnings. European companies with exposure to the U.S., such as Daimler, have been reporting strong earnings growth. But we have also seen some U.S. companies, such as Nike, experiencing strong earnings growth in their European businesses.
Japan is continuing to increase monetary stimulus, surprising investors in October by announcing yet another increase. Valuations in Japan are higher at 18.6 times forward earnings, but remain significantly below the 10 year average of 22.3, and we continue to find attractive stocks there for our international and global portfolios.
Equity performance in Emerging Markets has been mostly disappointing the last few years, as economic growth has slowed. But in financial markets, changes in expectations are key, as evidenced by the technology boom of the late Nineties. Many technology stocks were growing earnings at rapid rates, but more importantly, these rates of growth often exceeded investors' expectations. As analysts rushed to increase earnings estimates and projected growth rates, the prices of technology stocks soared in the last half of the decade. At their peak in March of 2000, expectations and valuations were simply too high. Similarly, in the early part of the 2000's, economic growth in Emerging Markets was not only very high compared to that of developed markets, but growth continued to exceed expectations. Expectations and valuations rose and, by 2007, Emerging Market valuations were roughly in line with those of the S&P 500. Now after the weak performance of the last few years, Emerging Markets are selling at about 12 times forward earnings, a significant discount to the S&P P/E. At the same time, expectations for economic growth have fallen considerably and now appear to be much more realistic. Moreover, we are starting to see signs of political and economic reform in China. India and Indonesia have recently elected leaders based on promises of reform (although Brazil did not). Finally, rising wages in China are having a positive effect on peripheral countries in Asia, as manufacturing shifts to these countries and Chinese consumers have more to spend, not only in their own country, but in surrounding ones.
The opinions expressed herein are those of Avalon Advisors, LLC investment professionals at the time the comments were made and may not be reflective of their current opinions. Nothing herein shall be construed as investment advice or a solicitation or offer to purchase or sell any securities.