LFC Viewpoint: 1Q2013 Economic Commentary


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1Q2013 edition of LFC Viewpoint, Lee Financial's quarterly summary of the economic markets.

Lee Financial is a fee-only wealth management firm in Dallas-Fort Worth, providing investment management and financial planning & advisory services to clients nationwide.

For more information, please call us 1-800-960-1703 and visit us at www.leefin.com.

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LFC Viewpoint: 1Q2013 Economic Commentary

  1. 1. March 31, 2013Lee Financial CorporationLFC ViewpointOutlookWhile bonds struggled to generate real returns for investors in the first quarter of 2013, equity marketscontinued their mostly positive trend despite U.S. sequestration and renewed concerns in Europe. While fiscalchallenges and higher tax rates may yet crimp U.S. economic growth during the latter half of the year, wepresume our managers would continue to find ways to generate favorable risk-adjusted returns for investors.Longer term, we continue to position portfolios defensively towards interest rates and offensively towards bothU.S. and international growth. That being said, we are mindful of the Fed’s commitment to loose monetarypolicy as long as inflation remains low (excluding food and energy) and the unemployment rate remains above6.5%. As such, we would expect interest rates to gradually move higher over time and equity market multiplesto continue to expand over time.In this low interest rate environment, reliable cash flow – whether through areas of the bond market or insegments of the stock market via stock dividend strategies – continues to be a challenge to find, but webelieve cash flow will be a dominant driver of portfolio returns.
  2. 2. ECONOMIC UPDATE1First Quarter RecapStock and bond markets posted varied performance in the first quarter of 2013. Since December, U.S. equity marketshave delivered strong performance, as the S&P 5001has returned over 10%, whereas the bond market struggled toreturn 0.1%2.With profit margins peaking, corporations will need to deliver higher top line growth for earnings to continue to trendhigher. While we note that the primary driver of profit growth since the Great Recession has been through cost-cutting measures, we also see room for price multiple expansion from current levels which should allow equitymarkets to continue to trend higher.The fourth quarter 2012 U.S. GDP previously reported at -0.1% was revised upwards to 0.4%. While not stellar byany recoverys standards, it is positive nonetheless, and we believe that the U.S. continues to be in a long-term, loweconomic growth environment as consumers continue to pay down debt and improve their personal balance sheets.In recent months, we have noticed a breakdown of the “risk-on” and “risk-off” periods characteristic of markets sincethe start of the Great Recession. Correlations across asset classes have begun to shift back to more “normal” times,and portfolio diversification continues to be a dominant theme in portfolios.Exchange Traded Funds (ETFs)As financial market innovation continues, new products and investment structures will likely continue to enter themarketplace. One such investment structure that has garnered a lot of publicity in the last decade is ExchangeTraded Funds (ETFs). According to a recent article in Barron’s, total ETF assets today stand at $1.4 Trillion. Whilethis is substantially below the $10 Trillion in assets in mutual funds, ETFs have clearly made a niche for themselvesas a low cost alternative for investors.Let’s start with a brief definition of what an ETF is3:“A security that tracks an index, a commodity or a basket of assets like an index fund, but trades like a stockon an exchange. ETFs experience price changes throughout the day as they are bought and sold.”While there are situations where we believe ETFs can be effectively utilized to construct investment portfolios, weremain cautious particularly in their use as proxies for bond market exposure. We also see limitations to their abilityto replicate active management.Although their seemingly cost-effective, simple mandates often attract investors, we remain wary of their widespreaduse in bond markets and the potential broad-based impact they may have in a rising interest rate environment. Onesuch disadvantage to the ETF is the lack of ability to evaluate which bond to sell when facing sales. As such, thisbroad-based sell decision – since owning an ETF is likened to owning a basket of the underlying securities inproportion to the benchmark’s allocation – we feel could detract from their long-term performance as compared tomany of the actively managed bond strategies we employ in portfolios.To further illustrate, while bond investors may see temporary impairments in price as similar bonds are marked-to-market, the impact of a decision to sell across all bonds of an index may mean buying opportunities for an activelymanaged strategy to pick up attractively valued bonds as bid-ask spreads widen. We feel that an active approachwhereby the manager can hold the bond to maturity may allow them to add significant value to their investors.1 Source: Bloomberg. As measured by the S&P 500 Index (Ticker: SPX).2 Source: Bloomberg. As measured by the iShares Core Total US Bond Market (Ticker: AGG).3 Source: http://www.investopedia.com/terms/e/etf.asp.
  3. 3. ECONOMIC UPDATE2Domestic OutlookWhile spending cuts and “sequestration” continue to appear in the news as headwinds for the U.S. economy in 2013,we are seeing two potential tailwinds that could allow our economy to pick up steam: glimmers of a recovering U.S.housing market and U.S. energy improvements give us reason to believe that 2013 may see a growth surprise on theupside despite previously low growth forecasts.As interest rates continue to hover at historical lows, it is not surprising that home ownership is now more affordablethan it has been in decades. As supplies have returned to historical averages, housing starts have rebounded andprices and rental rates for single family and multifamily establishments are trending higher. In fact, the recent rise inrental rates has made rent in many cities higher than comparable home ownership rates. Since housing remains thesingle largest contributor to individual net worth, we believe a more favorable housing environment will haveadvantageous spillover effects for consumer confidence and the economy as a whole as peripheral industries benefitfrom the renewed activity.We also believe that the U.S. could potentially meet all of its energy consumption needs through North Americanproduction by 2020. This could be a major driver of economic growth for the US over the next several years. Whilethe industry itself is creating jobs, the ramp up in oil production from areas such as the Permian basin, Eagle Ford,and Bakken has created a growing need for infrastructure development. Increased supplies should also lower pricesfor oil and natural gas, and it constitutes a great competitive advantage for the U.S. manufacturing and chemicalindustries.Interest RatesIn anticipation of a rising interest rate environment, we have continued to take a defensive position with interest rates.Going forward, we believe macro factors will be a headwind to fixed income returns. As such, we continue to steadilyshift allocations to more flexible core bond alternatives and toward more credit sensitive parts of the fixed incomemarket. We are also looking beyond traditional income sources towards investments that can potentially provide non-correlated returns.We have included the chart below to illustrate two different interest rate regimes since 1950; a rising interest rateenvironment characteristic of the 1950s through the early 1980s followed by a steadily declining interest rateenvironment to the present. Rising (or declining) interest rate movements often have multi-decade long cycles.
  4. 4. ECONOMIC UPDATE3International OutlookStruggles in Europe continue to remain top of mind, particularly with the discussions of Cyprus of late. While Cyprusis just one of their many continued struggles, it’s worth noting that the entire GDP of Cyprus is similar in size to that ofVermont’s economy - the smallest state economy in the U.S. We see less concern in the monetary implications of thisevent – particularly U.S. banks’ exposure – but more of the political precedence it sets for the European Union. WithEurope struggling to keep the European Union alive, we continue to see short-term patches to long-term fundamentaldisconnects. As such, we imagine growth for much of the EU will remain low in the coming decade.While emerging economies have had a weak start to the year, we continue to believe in their long-term fundamentalsand their ability to help deliver above average growth. As such, we continue to find attractive opportunities in both thebond and stock parts of the portfolio. Additionally, it is worth noting that economic growth from emerging economiescan have positive implications for multinational U.S.-based companies with an ability to drive revenue growth fromexpanding markets in emerging economies with millions of citizens in local countries becoming a part of a newemerging middle-class.For any questions regarding the content discussed or for any other matters pertaining to your portfolios, pleasecontact your Lee Financial investment representative.From all of us at Lee Financial, we thank you for your loyal business!DisclaimerThe information provided herein is provided for informational purposes only, and does not constitute an offer, solicitation or recommendation to sell oran offer to buy securities, investment products or investment advisory services. It has been prepared without regard to the circumstances andobjectives of those who received it. Research prepared by Lee Financial personnel is based on public information. Lee Financial makes every effort touse reliable comprehensive information but we do not represent that it is accurate or complete. All information, views, opinions and estimates aresubject to change or correction without notice.Any use of estimates contains forward-looking opinions by the Investment Analyst which may differ from the views of Lee Financial. All estimates arebased on assumptions that may not be realized and actual results can be meaningfully different. Actual events in the markets, company or stock maycause adjustments in expectations from those currently expressed within.All securities are subject to actual known and unknown risks, uncertainties and other factors that could cause actual results to differ materially fromthose projected, including potential of significant losses. These forward-looking statements speak only as of the date of the communication, and do notinclude transaction fees. Prices, values, interest rates, indicated are based on best current information at the close of the date indicated, and willchange.Nothing contained herein constitutes financial, legal, tax, or other advice. The appropriateness of an investment or strategy will depend on an investor’scircumstances and objectives. These opinions may not fit to your financial status, risk and return preferences. Investment recommendations maychange and readers are urged to check with their investment advisors before making any investment decisions. Estimates of future performance arebased on assumptions that may not be realized. Past performance is not necessarily indicative of future returns.