Q2 Commentary (2006)
The recently announced action by the Fed saved the month and prevented the quarter from being very unpleasant. Just prior to the June 29th decision on rates, the S&P 500 was solidly negative for the month and the quarterly loss would have essentially offset the 1st quarter’s gain. We are somewhat disappointed by the underperformance in June, although it all occurred in the last few days when the S&;P 500 was particularly strong, but we are gratified by the outperformance during the 2nd quarter.Linking this quarter’s advantage to the 1st quarter’s advantage gives us a reasonable margin of outperformance for the first half.
The quarter was dominated by inflation worries and concerns about how the new Chairman at the Federal Reserve would deal with this problem. Investor angst and volatility were very much on the rise. So, what are the markets telling us and what would the markets like the Fed to do?
One irrefutable observation over the past few weeks is that when the Fed spoke and took a hawkish position on inflation, suggesting that further rates increases were likely, global markets sold off broadly. When they took a softer, more dovish tone, the markets rallied, with last Thursday’s surge being directly related to the Fed’s more benign outlook on inflation. Our market would appear to be saying that Fed Funds are close to where they should be and that the current inflation worries are not a problem. The evidence to support this position would be that the yield on the long end of the yield curve is similar to the yield on the short end. Said another way, the yield curve is not pricing in higher longer term inflation expectations. Ever since the Fed began to raise rates, the slope of the yield curve has become incrementally flatter (see Table 1). If the Fed continues to raise the short end, it is more likely that the curve would invert, which would suggest that a recession is not that far off.
Copyright 2006 Bloomberg L.P.
Moreover, commodities, which have been rising over the past year or so from reasonably benign levels, took a dramatic spike up in April and early May. This clearly unnerved the Fed, but just as rapidly as they rose, they quickly reversed course in late May and have essentially returned to more acceptable levels. We are watching the inflationary pressures caused by rising commodity prices, but as of now, we are not overly concerned and believe that market forces will further dampen the rise in many of these commodities.
A second important question to ask is, what should the Fed do next? Our biased answer is that we would like to see the Fed signal that they are done with further increases and it is quite possible that one could interpret last week’s minutes as such. The ¼ point increases in the Fed Funds rate in May and June marked the sixteenth and seventeenth consecutive ¼ point increases in this rate, which now stands at 5.25%. We believe that this most recent increase will mark the end to the increases and that as the economy slows, so will the inflationary pressures. We are encouraged that the probability of another ¼ point increase in August fell from 90% to about 60% shortly after the most recent minutes were released. Barring a meaningful surge in commodity prices, we believe the Fed will pause at the August meeting. A slowing economy will reduce demand for base metals and energy, lowering their market prices, which in turn will provide a margin cushion for many companies. Thus, when GDP growth slows in the second half of this year, our economy will still show modest growth. Although, we do not expect the Fed to make a such a mistake, if the Fed were to reverse the latest tone on inflation and signal that more increases were in the offing, then we would argue that they are risking a serious policy error and that the likelihood of a recession in 2007 would be dramatically increased.
In closing, we are cautiously optimistic about recent events and the potential for returns in the second half. We remain confident in the portfolio’s positioning and potential. The defensive nature of the portfolio will allow for consistent growth in earnings and dividends, even in a slowing economy. We believe that all but one of our holdings will have year over year growth in their earnings, and all but two will increase their indicated dividend in 2006. Despite the above average dividend yield for the portfolio, these companies continue to increase their dividends at above market rates of growth. So far this year, the average dividend increase for the companies held in the portfolio has been about 15%. This, on top of the fact that the overall portfolio’s P/E for 2006 is less than 15x, gives us confidence that we can continue to create value this year and beyond.
