What does a Weaker U.S. Dollar Mean for Companies & Consumers?

Earlier this year the U.S. dollar reached a 10-year high compared to the currencies of its major trading partners*.  However, the greenback has declined about 8% year-to-date through July.  In this email we’ll explore what drove the U.S. dollar to record levels, how dollar weakness or strength impacts corporations and consumers, and what may lie ahead for the world’s most widely-held currency.

Many factors affect a currency’s strength or weakness.  Some of these include interest rate levels, inflation, central bank policy, investor sentiment and the health of the economy.  The U.S. dollar is unique in that it is the largest foreign exchange reserve, accounting for over 60% of global reserves.  As a result, other countries’ need for reserves and investors’ fears or confidence also affect how much the dollar appreciates or depreciates.

Following the financial crisis, the U.S. dollar appreciated versus many other currencies due to its perceived safety and ultimately, a quicker U.S. economic recovery compared to its peers.  This happened despite the Federal Reserve’s ultra-accommodative monetary policy in which it pumped trillions of dollars into the economy – an action that might normally depreciate the dollar due to an increased currency supply.  Instead, the Fed’s actions helped lead the U.S. economy out of the financial crisis which helped support corporate earnings and sales growth.  This in turn led to increased foreign demand for U.S. stocks and bonds.  As U.S. dollars are required to purchase our stocks and bonds, growing foreign investment in U.S. securities led to greater demand for the greenback, and subsequent dollar appreciation.

During the last ten years of dollar appreciation, we’ve experienced both positive and negative effects.  On the positive side, a strong dollar makes traveling abroad more affordable for U.S. citizens and effectively lowers the prices consumers pay for imports.  As consumers account for roughly two-thirds of U.S. GDP growth, the savings gained on lower-cost imports due to a strong dollar can lead to significant gains in disposable income, all else being equal.

On the downside, a strong dollar may hinder tourism in the U.S. and could result in weakened demand for U.S. exports as those goods become relatively more expensive for foreigners.  Another drawback is negative foreign currency translation for U.S. multinational companies.  U.S.-based firms that earn revenues abroad will have to exchange foreign currencies back to U.S. dollars at a less favorable rate.  This acts as a headwind to sales and earnings growth, and contributed to the recent “earnings recession” we saw among companies in the S&P 500 Index in 2015 and 2016.

In contrast, recent U.S. dollar weakness has started to help boost corporate earnings growth and could be a support for stocks going forward.  While it’s impossible to know if the dollar’s strength will continue to moderate, a few factors suggest it might.  One is an improving global economic outlook relative to the U.S.  The U.S. economy was a bright spot in the early years following the last recession, but emerging market economic growth is gaining ground and European GDP growth recently outpaced U.S. GDP growth.  Another factor is that the Federal Reserve has shifted to a less accommodative monetary policy stance.  Ordinarily this would support further U.S. dollar appreciation (via a reduced supply of dollars and higher interest rates attracting foreign investors); however, investor concerns that restrictive monetary policy could slow down the current economic expansion are outweighing the shift in the Fed’s policy stance.

Considering the above factors and given several years of strong gains, recent U.S. dollar weakness could continue.  While there are pros and cons to a depreciating dollar, we would welcome the shift as this would help reduce import costs for consumers and businesses, while supporting sales and earnings growth for U.S. multi-national corporations.

*Powershares DB US Dollar Index Bullish Fund (UUP) – compares US dollar to euro, yen, pound, loonie, Swedish krona and Swiss franc

The Parsec Team

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Value Stocks May be Poised to Outperform

Since Parsec’s founding in 1980, we’ve touted the benefits of long-only equity investing.  This includes owning individual stocks, mutual funds, and exchange traded funds (ETFs).  We’ve also maintained the same investment style over the last thirty-seven years.  Regarding funds, Parsec’s investment policy committee (IPC) focuses on low fees, higher-quality holdings, and managers with long track records of outperformance.  When researching individual stocks, we take a value approach, favoring higher-quality companies that trade at a discount to history or peers.

While history shows that value stocks have outperformed growth stocks over most market periods, in recent years growth stocks have delivered higher returns.  In this email we’ll discuss what we mean by value versus growth investing and why we believe value stocks are poised to outperform going forward.

Different stock investors define “value investing” differently.  However, most agree on a few basic principles.  In general, value investors prefer stocks that trade at discounts to their intrinsic values.  Often this happens when a stock’s valuation falls below its long-term historical average or that of its peers.  Another tenet of value investing is margin of safety.  This means selecting stocks that can deliver healthy total returns even if current growth assumptions fall short of expectations.  While we consider ourselves value investors, we will add select growth stocks to the Parsec buy list when expectations look reasonable and a company has a competitive advantage.  In other words, when we think a stock has a reasonable margin of safety.

In addition to a value-based stock selection approach, Parsec’s investment philosophy also has a quality bias.  This means we prefer companies with strong cash flows, consistent earnings growth, a long history of dividends, and above average returns on invested capital.  We also favor companies with strong balance sheets that can withstand different market environments and even gain market share during difficult economic periods.

Looking back over the market’s history, value stocks have outperformed growth stocks by an average of 4.4% annually from 1926 to 2016 (Bank of America/Merrill Lynch).  More recently from 1990 to 2015, value stocks outperformed growth stocks by just 0.43% annually.  The spread has since reversed and in the last ten years value stocks have lagged growth stocks by 3% annually through the second quarter of 2017*.

The shift in leadership from value to growth stocks coincided with the start and continuation of the Federal Reserve’s massive monetary accommodation programs known collectively as quantitative easing (QE I, II, and III).  Those programs put additional downward pressure on interest rates.  In the face of low or no yields and the slowest economic expansion after a deep recession in over 120 years, investors demonstrated a preference for growth stocks over value stocks.  They were willing to pay up for companies delivering higher growth in a world where growth had become scarce.  Throughout the last ten years value stocks have occasionally outperformed, but usually in tandem with a steepening Treasury yield curve and thus improving growth expectations.

Because asset prices and interest rates are inversely correlated, very low interest rates over the last decade have led to above-average asset valuation levels.  This has been even more pronounced among growth stocks as investors have been willing to pay a premium to own them in a slow growth environment.  As a result, typically higher-priced growth stocks are even more expensive today.

Sticking to our value- and quality-biased investment approach has admittedly been a headwind in recent years.  However, we believe higher-quality stocks trading at a discount are poised to outperform.  Growth stocks currently trading at premium valuation levels will have further to fall in the event of a market downturn.  As well, low interest rates have prompted corporations to take out record debt levels.  As rates begin to rise, higher-quality companies or those with strong balance sheets and robust cash flows will be better able to service their debt levels, even during an economic downturn.  While maintaining our investment approach through the current environment has been challenging, we feel confident that investing in higher-quality companies trading at discounted valuations will reward clients over the long-term.

*References the Russell 3000 Growth Index and the Russell 3000 Value Index

The Parsec Team

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What’s Ahead for Fixed Income?

After more than thirty years of falling interest rates and thus rising bond prices, yields may be moving higher.  While trends are often short-lived, this new trajectory could persist into 2017 and beyond given recent changes in the political landscape as well as a less accommodative Federal Reserve (Fed).  We’ll take a look at what this new monetary and political environment may mean for bonds and how to best-position your fixed income portfolio for the long-term.

A proxy for the bond market, the 10-year Treasury note yield hit an historical low of 1.36% in July 2016 only to jump 100 basis points (or 1%) by the end of November.  The move came as investors responded favorably to the surprise U.S. Presidential and Congressional election results, in anticipation of higher growth levels in the years to come.

Part of the optimism stemmed from the new administration’s promise to cut consumer and corporate taxes and spend on infrastructure projects.  This picture presents a mixed bag for bonds, however.  Increased fiscal spending and lower taxes are positive for economic growth and a healthy economy is generally good for lending and credit activity.  But stronger economic growth would push yields higher and thus bond prices lower.  On the other hand, higher yields would provide investors with higher current income, acting as a partial offset to lower bond prices.  Rising interest rates or yields would also allow investors to reinvest into higher-yielding bonds.

Duration is an important characteristic to consider when reinvesting at higher yields.  A bond’s duration is the length of time it takes an investor to recoup his or her investment.  It also determines how much a bond’s price will fall when yields rise.  Longer duration bonds such as Treasury or corporate bonds with long maturities experience sharper price declines when yields rise.  Likewise, shorter duration bonds are less volatile and will exhibit smaller price declines, all else being equal.  Because we can’t predict the exact direction or speed of interest rate changes, it’s important to have exposure to bonds with a mix of durations.  In this way an investor is able to respond to any given environment.  For example, when yields are rising, an investor can sell her shorter-duration bonds, which are less susceptible to prices changes, and reinvest into longer-duration bonds with higher rates.

Another factor that affects bond prices is inflation.  Inflation expectations have started to heat up in light of low unemployment, wage growth, and expectations for increased government stimulus.  Higher inflation could also put upward pressure on interest rates and thus downward pressure on bond prices.  While inflation can erode the real returns of many bonds, some bonds, such as Treasury Inflation-Protected Securities (TIPS), stand to benefit.  TIPS are indexed to inflation and backed by the U.S. government.  Whenever inflation rises, the principal amount of TIPS gets adjusted higher.  This in turn leads to a higher interest payment because a TIPS coupon is calculated based on the principal amount.

Finally, the Federal Reserve’s shift away from accommodative monetary policy will have an impact on bond prices.  Although higher interest rates from the Fed will likely pressure fixed income prices, overall we view this change favorably.  This is because a return to more normal interest rate levels is critical to the functioning of large institutions like insurance companies and banks, which play a key role in our society.  Likewise, higher interest rates will provide more income to the millions of Baby Boomers starting to retire and would help stabilize struggling pension plans at many companies.

Taken altogether and in light of an uncertain environment, we believe a diversified bond portfolio targeted to meet your specific fixed income needs is the best way to weather this changing yield environment.  In addition to considering your specific income objectives, our Investment Policy Committee meets regularly to assess the current economic, fiscal, and monetary environment.  We adjust our asset allocation targets in order to take advantage of attractive opportunities or reduce exposure to higher-risk (over-valued) areas.  While we may over-weight some areas or under-weight others, in the long-run we continue to believe that a well-diversified portfolio is the best way to weather any market environment.

Thank you,

The Parsec Team

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High-Yield Turbulence

You may have read some scary headlines on high-yield bonds recently.  We’d like to take a moment to update you on the situation and provide our perspective.  First a little background.  High-yield bonds are debt securities issued by companies with credit ratings below investment-grade.  These bonds are commonly called “junk bonds” because of the weaker balance sheets and growth prospects of the companies that issue them.  As a result of increased default risk, investors typically demand higher interest rates on these types of bonds to compensate for the additional risk they take on.  When things are going well, high-yield or junk bonds can deliver above-average interest payments and price appreciation.  When things are not going well, investors can experience sharp price declines and some companies may even default on bond payments.  In a nut shell, higher reward comes with higher risk.

Many advisors, including Parsec, include a modest amount of high-yield bonds in client portfolios.  Junk bonds are considered an asset class and can improve the diversification of a portfolio because they have lower correlations to regular bonds and even stocks.  This means when regular bonds are flat or down, high-yield bonds could actually rise.  The same goes for stocks – high-yield bonds and equities do not always move in the same direction, which confers some diversification benefits.

In addition to diversification benefits, junk bonds have historically delivered healthy returns.  The group tends to do well in the early years of an economic expansion when tight credit starts to loosen and company balance sheets improve.  On the flip side, high-yield bond performance becomes more volatile as an economic expansion starts to slow down and the spread between higher-quality bonds and junk bonds widen.  This indicates investors once again require more return to hold these higher-risk assets.

Earlier this year, interest rate spreads – the difference between high quality bond interest rates and low quality or “junk” interest rates – started to widen as energy company profits came under pressure and debt default rates ticked higher.  Since May 2015 through mid-December, high-yield bond prices have fallen over 12%*.  However, on a total return basis, the group is down about 8% as higher coupon payments were a partial offset.  While debt default rates on speculative-grade companies are below the 20-year average of 4.3%, at around 2.8%, they’ve jumped from 1.4% a year ago due to falling commodity prices that negatively affect profits**.

As high-yield returns tumbled over the summer, many investors ran for the exits.  Unfortunately, diminished bond liquidity following the 2008-2009 financial crisis made redeeming shares difficult for some.  Regulations that strengthened the banking and financial systems via higher capital requirements and reduced leverage have had the unintended side-effects of raising costs for banks and primary dealers to hold fixed income inventory.  With lower inventory levels, these critical market makers are less able to provide liquidity in the debt markets.  This was highlighted recently when investment firm Third Avenue froze investor redemptions in its high-yield fund (which is not a Parsec holding) due to liquidity constraints.  The Third Avenue fund was heavily invested in some of the lowest-ranked credit bonds, which exacerbated the management team’s ability to find willing buyers.  In the end, Third Avenue chose to freeze investor redemptions for one month.

The Third Avenue situation is unusual, but does it reflect deeper issues for the high yield space?  Our view is that current U.S. economic expansion is maturing, which suggests higher credit spreads and potentially more volatility (including downside risk) for the group.  At the same time, falling commodity prices and a strong dollar are headwinds for high-yield.  That said, U.S. jobs growth remains robust, the housing market continues to advance, and consumers are the healthiest they’ve been since before the Great Recession.  The recent Federal Reserve interest rate hike echoes our sentiments that the U.S. economy is on healthy footing.

While high-yield may see more downside, we believe investors are becoming more discerning after years of indiscriminate investing across high and low-risk asset classes alike.  This is a good thing.  It means that fundamentals, and not accommodative monetary policy, will once again drive asset returns.  Although high-yield bonds may face more headwinds in the near-term, our focus on higher-quality, higher-liquidity, high-yield debt should help us better weather a difficult environment.

Despite potential high-yield headwinds, we continue to recommend that clients remain fully invested.  This is based on our experience that market timing is a losing game, as asset class leadership can change sharply, and often without warning.  The historical record has shown that through various market cycles, both stocks and bonds have out-paced inflation over the long-term.  As a result, we recommend investors stick with their high-yield holdings.

*The BofA Merrill Lynch US High Yield Index

**S&P 500 data

Carrie A.  Tallman, CFA

Director of Research

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