Beyond the Great Divide: Investment Commentary from Hutchens Investment Management

CONCORD, N.H. - Oct. 1, 2013 - PRLog -- As the headline news dwells on political brinkmanship, the potential “disruption” is a non-event for US securities markets. Looking out beyond this short-term consideration for US equity investments, the outlook for stocks decidedly outweighs the alternatives, US credit and government bonds, European stocks, emerging market securities, and at least for now, China and Japan investments. Recent economic data show improved underlying health of the domestic economy, cash heavy corporate balance sheets, increased consumer spending, and energy independence. While rapidly rising rates are cited by many as the biggest risk for a correction, and should it occur, it would be an opportunity rather than a long-term negative. We are entering into a long-term period of economic improvement, more in keeping with a normal economic expansion, with interest rates rising at the long end of the yield curve. As Washington provides further evidence of its dysfunction, 3Q2013 earnings are upon us. Hopefully, the ensuing debt ceiling debate later this month will not adversely impact a favorable market reaction to better-than-expected 3Q revenue and earnings.

Consumer spending, approximately 70% of GDP, is driven by personal income - - primarily wages and salaries. Increases in consumer spending are the catalyst for advances in manufacturing and services. Most important for the extension of the growing economy is the rise of capital spending. Capex follows like clockwork the trend set by production and services which follow consumer expenditures. These three stages of economic activity; consumer spending, industrial production and services, and capital spending represent the core of corporate profits.

The role of employment is often given for low levels of consumer spending. However, it is the rise in consumer spending working its way through the system that produces employment, following rather leading consumer expenditures. The current problems with employment are both cyclical and structural and therefore, will not provide the additional stimulus at levels during previous business cycles. There are a number of new positive underlying developments within the scope of the normal business cycle that will alter the magnitude and duration of the advance in the economy. Among these are:

 Housing – The housing recovery is well underway but given the depression levels reached following the financial crisis we remain below historical averages for housing starts, sales, permits and inventories. Home prices, except for notable exceptions in deeply depressed areas, remain over 20% below the 2007 levels. Since housing is local it will be a longer cycle of recovery than other major purchases, for example, autos.

Housing is rebounding and construction, which has lagged thus far, will cut into cyclical unemployment. According to the National Association of Home Builders (NAHB) “for each new single family home built, three new jobs are created.” Using the NAHB’s conservative estimate of 932,000 housing starts in 2013 and given the long-term trend of 1.7 to 1.8 million starts closing the potential 800,000 housing start gap would add 2.4 million cyclical jobs. Housing today (residential, investment and housing services) accounts for 15-16% of real GDP, well-below the 18-19% historical level.

Among the more interesting aspects of this housing recovery is the role of institutional investors. A number of well-established money management firms, as well as new organizations, have purchased large blocks of residential homes. Initially these funds will rent the properties but with a long-term view of selling as the value increases. This has added additional demand to the already low inventory of distressed housing (foreclosures and short sales). This trend is likely to continue as the housing recovery is in its early stages and rental properties remain at a premium.

 Energy Dividend – The consumer will benefit from energy independence. Already a combination of increased drilling and accessible transport has reduced US oil imports, which in turn shrinks the trade deficit. In June, the petroleum deficit was $17.4 billion down from a record $42.4 billion five years ago. At this pace a surplus of some $100 billion is attainable by 2020. A recent study by IHS Global Insight estimates that increased production from unconventional oil and gas has increased disposable income by an average of $1,200 per household and is predicted to rise to more than $2,700 by 2020. Alternatives such as biofuels, natural gas, efficient electric cars, and higher mileage requirements for new autos will cut further into dependence on the highly volatile Middle East.

 Corporate Spending – As mentioned the increase in capital formation is a necessary ingredient for a normal business cycle. Businesses have been reluctant to commit capital in an environment of political and economic uncertainty. This attitude seems to be changing. By early 2015, assuming real growth of about 2.5%, the employment rate should be closing in on 6% and capacity utilization moving toward 80%. These two factors would suggest that wage pressures increase as capital expenditures rise and tech spending improves productivity (currently near 15 year lows), putting pressure on profit margins.

Our investment strategy remains positive on equities. There is a possibility of a short-term correction in the seasonally-weak October.

Authors:


David Minor

Rebecca Goyette

Editor:

William Hutchens