1) PROFESSIONAL ADVISORS GROUP, LLC Complete Financial Management Greece is the Word Volatility and Uncertainty Continue In March we commented on the volatility in the capital markets and observed that there was no discernible path to a consistent unobstructed high rate of growth in economies both domestic and abroad. We commented on slowing productivity in the United States and the consensus annual GDP rate of growth of 2.5 - 3%. We noted that durable goods orders and capital expenditures were restrained. Although there continued to be some improvement in the rate of employment, wage gains were insubstantial. We also noted that inflation was well below the Federal Reserve’s target of 2%. And although the Federal Reserve declared its inclination to begin raising shortterm interest rates, they reaffirmed that any decision would be data dependent. Abroad, we commented on the decelerating rate of growth experienced by China and the limited impact that stimulus has had on reversing the trend. We were cautious with regard to the European recovery as the European Central Bank’s quantitative easing program commenced. We had not at the time addressed the financial crisis in Greece as discussions between Greece, the IMF, the ECB, other European governments and other creditors were underway and all were hopeful. As of the close of the second quarter of the year, there have been some modest gains in the domestic economy. Economists anticipate that the economy grew in excess of 2.5% in the second quarter of the year, bolstered by increased consumer spending and increased activity in the housing market. Construction spending on both residential and nonresidential projects reached its highest point since 2008, and automobile purchases were strong. The manufacturing sector continued to grow during the second quarter, although the strong dollar remains a limiting factor for exports. Consumer spending was also supported by the “energy dividend” of lower energy prices for consumers. Employment and job growth continue at a modest pace with the unemployment rate coming down to 5.3% at the close of the quarter, notwithstanding the downward revisions in the May and April employment numbers and the decline in the labor participation rate to 62.6%. Second quarter corporate earnings growth should reflect improving economic conditions, although top line revenue growth continues to be challenged with the possible exceptions of the auto industry and the healthcare sector. Even excluding negative year over year earnings growth in the energy sector, many analysts anticipate no EPS growth (and possibly negative EPS growth) for the second quarter. First quarter earnings were similarly depressed as a result of the downturn in energy prices and were also impacted by currency losses relative to the euro. In the second quarter however, notwithstanding the resurfacing of the financial crisis in Greece, the dollar weakened against the euro and therefore these currency gains should be reflected in quarterly earnings (perhaps again reversing as the Greek drama unfolds). 1325 Avenue of the Americas, 14th floor ï‚·New York, NY 10019 t 212.355.0346 f 212.355.0413 www.klsadvisors.com
2) During the second quarter, the price of oil increased from first quarter levels but remained deeply discounted from prior year levels negating EPS growth in other sectors of the S&P 500. Shortly after the close of the quarter, oil prices again declined. We continue to believe that inflation is not a substantial factor as wages have not begun to rise meaningfully and there seems to be excess capacity in manufacturing and service sectors both domestically and in China. We are, however, mindful that the skills mismatch affecting the jobs market may give rise to higher wages and may affect operating margins, but such has not yet been significant. In all, the domestic economy continues to grow at modest rates while wrestling with declining productivity and modest demand that places a ceiling on capital expenditures. Companies have used free cash flow and borrowed (at low interest rates) to buy back shares to support stock price and EPS growth. Internationally, towards the close of the quarter, China and Greece injected more volatility into the capital markets. China’s stock market had experienced extraordinary gains during the first five months of the year followed by sharp declines (approximately 30%) in the last several weeks. Pre-correction valuations in the Chinese equity markets exceeded S&P 500 multiples for its Shanghai Composite Index; its more technology heavy Shenzhen index surpassed U.S. multiples reached in 1999 during the technology bubble era. This at a time of decelerating economic growth and substantial questions regarding corporate governance and reporting. On the final day of the quarter, Greece failed to make a payment of €1.5 billion due the International Monetary Fund. This failure resulted in Greece being in immediate technical default on other debts of far greater magnitude. The ongoing ability of Greece to pay its debts has been and continues to be the subject of a high stakes negotiation as Greece and its creditors seek a possible resolution to the crisis. The ECB has maintained, but not increased, support for Greek banks. European governments who own Greek sovereign debt have thus far been reluctant to compromise or partially write off such debts. As the deadline approached, European and U.S. equity markets were roiled. Greek banks were closed and capital controls were initiated. Investors and Eurozone member states alike were greatly troubled by the uncertainties that surrounded the Greek situation. If Greece were to exit the Eurozone (“Grexit”) and establish its own currency, sovereign debts would not be paid and economic turmoil in Greece would ensue. Equity markets and member states in the Eurozone also feared the potential that other economically challenged members of the Eurozone could be motivated to exit the euro or seek to compromise their own obligations following Greece. Such uncertainty continues to fuel volatility in currency and worldwide capital markets. Because Greece has been especially reliant on imports, the cost of such imports would skyrocket in the event of a “Grexit” relative to a much weakened local currency and there would initially be a severe decline in living standard. Assuming that political stability could be achieved and rule of law maintained sufficient to attract foreign investment, the advantage of a greatly devalued currency could provide the stimulus for future growth. Whether or not there is a “Grexit”, there are still many structural reforms that must be undertaken to right the economy for the long-term. These include reforms to the Greek tax and retirement systems. 2
3) Absent the Greek exit from the Eurozone, a mechanism still must be developed to ensure there is not a repetition of euro-financed trade deficits that eventually lead to local economic decline. It is apparent that ex post facto austerity is an insufficient means of dealing with a crisis of excessive debt relative to GDP (approximately 175% debt to GDP ratio) and high unemployment. The immediate illiquidity in the Greek economy that resulted after the banks were closed and access to cash was limited foreshadows the problems yet to come if Greece were to leave the Eurozone. Individuals could not access their cash, pensioners were limited to a fraction of their monthly pensions, businesses would not accept credit cards, and stores and restaurants had insufficient resources to buy supplies and inventory. Without a currency circuit breaker there is presently no self-enforcing mechanism to adjust trade imbalances to stabilize the individual state economies. After Greece failed to make payment to the IMF, game theory and brinksmanship shifted into high gear. Creditors insisted upon additional austerity and the Greek negotiators resisted. Then, for a brief moment it appeared as if a deal would be struck with Greece capitulating to the demands of the creditors. Shortly thereafter, however, Greece issued a letter asking for certain exceptions with respect to the austerity and tax proposals put forth by the creditors. It then appeared there was no deal to be had. A Greek referendum was held on July 5th to determine whether Greece would capitulate to creditor demands for more austerity and taxes. The vote was a resounding “No!” The International Monetary Fund has gone on record stating that it is not possible for Greece to pay all its debts. The Greek people concur, yet many wish Greece to remain in the Eurozone. Regardless of the outcome of the Greek crisis, Europe is in a position to withstand Greece further defaulting on its debts. The absolute amount of debt that may be written off should not put the European recovery in jeopardy. Greece’s total debt is approximately €323 billion. Its GDP is approximately €184 billion, or approximately 2% of Eurozone GDP. In the aftermath of Greece’s failure to make payment, equity markets declined modestly, seemingly taking the default and subsequent referendum “No vote” in stride. Finally, even if Greece should exit, we note that it is unlikely that the euro will be unwound given international trade benefits and capital markets access that its members enjoy. Nevertheless, Eurozone leaders and investors are concerned by the apparent polarization of some member states. Meanwhile, closer to home, Puerto Rico announced that it could not pay its debts. At the last minute, however, it made payments due on its bonds in July and entered into serious discussions for compromise with creditors. The U.S. territory’s excessive debts relative to its economy were enabled by virtue of its U.S. dollar currency and the exemption from state and federal income taxes for interest paid on Puerto Rico bonds. A problem not all that dissimilar from that of Greece which was enabled by its increased access to the capital markets and its ability to borrow at lower interest rates as a result of its inclusion in the Eurozone. Puerto Rico also has the additional complications of a high cost and U.S. regulatory structure (minimum wage and employer payroll taxes) in the island economy without the long-ago expired U.S. corporate tax incentives to support economic growth. Puerto Rico bonds comprise approximately 2% of the $3.6 trillion municipal bond market. Any default or compromise would not significantly affect the U.S. economy but may add to increased municipal market volatility. 3
4) Domestic equity markets have largely been insulated from the turmoil in Europe, and now in China. It should be expected, however, that the operations and earnings of multinational corporations will be adversely impacted by any additional economic slowdowns abroad and such will be priced into their shares. For the quarter, the Dow Jones Industrial Average declined -.29% (+.03% ytd); the S&P 500 and Russell 1000 Indices gained .28% (+1.23% ytd) and .11% (+1.71% ytd), respectively. The Wilshire 5000 returned .06% (+1.67% ytd). The MSCI EM Index increased .69% (+2.95% ytd). The Russell 2000 Small Cap Index increased .42% (+4.76% ytd) while the S&P 400 Mid Cap Index declined -1.06% (+4.19% ytd). The MSCI EAFE Index gained .62% (+5.52% ytd). The MSCI All Country World Index returned .35% (+2.26% ytd), and the MSCI European Equity Index gained .36% (+3.82% ytd) net of currency losses. Portfolio Construction At quarter close, the price-earnings ratio for the S&P 500 was approximately 18.0x 2015 estimated EPS. Mid- and small-cap shares are valued at approximately 21x and 24x 2015 estimated EPS, respectively, with much greater anticipated growth in 2015 EPS. In most client portfolios we remain modestly underweight large-cap shares and modestly overweight mid- and small-cap shares. With long-term Baa corporate bonds yielding approximately 5.0%, the implied PE ratio for equities is 20x. While PE expansion is possible, it is more likely that interest rates will rise thus lowering the implied equity multiple. As we discussed earlier this year, we continue to believe that the drivers of share price increase going forward will be growth in EPS rather than multiple expansion and continue to anticipate this growth to be modest and gradual. Nevertheless, diversified domestic equities continue to represent a competitive investment on a relative risk/reward basis as compared to other asset classes. We continue to maintain exposure to both growth and value equities and to both passive and active styles of management in most client portfolios. Most client portfolios are underweight foreign equities with much of such foreign equity exposure hedged back to the U.S. dollar to mitigate the impact of currency conversion on client portfolios. We continue to have modest duration exposure in most fixed income portfolios. We are not likely to extend maturities as the Fed has signaled that tightening (or raising interest rates) may commence this year. We continue to invest in high quality municipal bonds held as a risk mitigator in most client portfolios, and anticipate that the Fed will be cautious in raising rates so as not to upset the trend of improving economic conditions. Interest rates rose during the quarter with the 10-year treasury closing at a yield of 2.35% (23 basis points higher than the 2.12% yield at the start of the year). The two-year and five-year treasury yield at quarter end was virtually unchanged from the beginning of the year. 4
5) Outlook Domestically, economists seem encouraged and are forecasting higher economic growth during the second half of the year. Including the slight contraction in the first quarter of the year, consensus outlook is for annual growth of 2.5 - 3% in 2015. This notwithstanding a slower acceleration in employment gains than many previously anticipated. The Organization for Economic Cooperation and Development recently advised that worldwide inflation is well below the 2% annual target of most central banks. While the inflation rate is approximately 2.5% in the G – 20 countries, the OECD expressed concern with regard to the risks of deflation. Fresh stimulus is continuing to be injected into the worldwide economy by central banks in Japan, Europe, India and China, among others, as the Federal Reserve is preparing domestic markets for an eventual increase in interest rates. Pressure on Chinese equities is likely to continue, given high valuations, although the Chinese government is easing margin restrictions and has committed funds to help support share prices. In the first half of the year, mergers and acquisition activity has been robust as companies challenged by organic growth opportunities seek combinations in order to achieve efficiencies and enhance profits. Healthcare, pharmaceutical, technology and media, and insurance companies have led the way. We continue to anticipate a tepid growth environment and some volatility in the capital markets as international macro-economic relationships adjust while central bank polices support recovery. Although surges in share price may occur from time to time, we expect growth based on earnings and economic fundamentals to be modest and anticipate equity returns consistent with this. Finally, there has been much discussion regarding liquidity in the capital markets given the enhanced capital requirements imposed by new regulations on financial institutions. In times of market volatility, price declines could be exacerbated by the absence of institutions willing to buy securities for fear that such would adversely impact their capital and regulatory requirements. Fixed income managers, in particular, have expressed their concerns on this matter. Although this may give rise to additional market volatility, it does not in and of itself affect fundamental valuations. It does, however, underscore the importance of having an appropriate investment time horizon and risk adjusted portfolio. Postscript As we prepared to mail this commentary equity markets in United States and China came under renewed pressure. China equities continued in free fall bringing increased concerns as to the recovery of the Chinese economy, the possible impact this will have on international trade, and the pressure that further slowdown in China may have on commodity prices including oil and on the larger world economy. 5
6) The Bank of England held an emergency meeting at the end of June and has concluded that the outlook for financial instability has worsened as a result of the Greek debt crisis and its polarizing effect on Europe. The OECD is now forecasting a slowdown in the world's major economies including the United States and China. The decline in commodity prices and slowing of world economies has caused concern among some economists that there is a risk of stagflation – i.e., a stagnant or recessionary economy coupled with an increase in consumer prices (the beginnings of which were noted above in the OECD's report). Whether or not this is a valid concern, it is clear that reflating world economies is not consistent with slowdowns, excess capacities, and weakened demand for commodities. We believe that the Federal Reserve will stay attuned to and be sensitized to economic developments worldwide and will accordingly be prudent and cautious before it begins raising interest rates. Finally, Greece has a €3.5 billion payment due on July 20. In a letter issued by the Greek authorities to its Eurozone creditors there was some indication that Greece would agree to some additional austerity measures and softened its demands for debt reduction. European shares rose on the news. We will continue to consider these and future developments as we address appropriate portfolio construction and risk/reward balance for our clients. The above commentary represents the economic and market views of our firm. We remind you, however, that each client’s portfolio is managed individually. Please speak with your KLS advisor with respect to your personal circumstances and individual portfolio performance. July 8, 2015 The material contained herein is intended as a general market commentary. The prices/quotes/statistics referenced herein have been obtained from sources deemed to be reliable, but we do not guarantee their accuracy or completeness; any yield referenced is indicative and subject to change. The views and strategies described herein may not be suitable for all investors. Certain opinions, estimates, investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice. The information contained herein should not be relied upon in isolation for the purpose of making an investment decision. This material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. Past performance is not indicative of future results. 6
