BY ERIC STURDZA
At the beginning of November, the level of confidence the market was placing on a December interest rate hike hovered around 80% which seemed broadly correct. Nonetheless, to fully confirm this, several important hurdles still had to be cleared: (1) October’s payroll report, (2) the US election, (3) the OPEC meeting, (4) November’s payroll report, and (5) the Italian referendum.
(1) October’s payroll report: As mentioned in the previous commentary, this hurdle was cleared as the rise in average hourly earnings was solid and pushed the year-over-year pace to 2.8% (the best runrate during this cycle). Even so, the Investment Adviser will be keeping a close eye on the next payroll releases because although the acceleration in average hourly earnings concerned all employees, the run-rate for production and nonsupervisory workers (which accounts for 82%) actually slowed and has been moving sideways in the last year.
(2) The US election: The reality is that Trump has highlighted factors that could enhance economic activity (regulatory change/easing and tax reform) and hurt the backdrop (restricting trade). For now though, the Investment Adviser believes the net result will be positive but, of course, it depends on how much of what has been said will actually be implemented and, more critically, how much common ground can be found between President-elect Trump and Congress.
The post-election expectations of fiscal stimulus (i.e. higher spending on infrastructure and defence, tax reform etc.) resulted in industrial, defence, financial, and healthcare sectors rallying alongside “value” stocks in general. The Investment Adviser believes the defence play has been overdone, whilst financials still have some headroom with healthcare and transport still below historical norms. Therefore, the Fund maintains its overweight in healthcare and will continue increasing exposure to financials and transportation as it did before the election. Based on historical observations, the Investment Adviser believes that the industries which could perform best in a rising rate environment are technology, commodities and energy. However, in the current cycle, financials have had (up until now) the greatest sensitivity to increases in 10-year bond yields.
Furthermore, the Investment Adviser believes that potential changes in tax policy will impact sectors differently. Those sectors with higher current tax rates (i.e. healthcare services, transport, consumer staples, and in some cases financials) have the potential to see a strong earnings boost whilst sectors with lower current tax rates (i.e. energy and technology) could see their multiples become more expensive on a relative basis. Another significant theme that has emerged since Trump’s election is cash repatriation. It is well known that many companies have moved their operations overseas so that they can generate and recognize a large chunk of their earnings in more tax-friendly locations. Generally speaking, technology companies are amongst those which have the highest levels of cash “stuck” overseas and stand to benefit the most from an increased ability to access that cash. Examples of these would be Alphabet and Apple which are currently held in the Fund.
(3) OPEC Meeting: OPEC decided to cut production by 1.2MMbls per day which was at the upper end of expectations. The key aspects being the reduction will take effect on 1st January 2017, the agreement will be valid for six months with a possible extension and the Ministerial Monitoring Committee will be built in as part of the agreement in order to help ensure compliance. The Investment Adviser believes that once the cuts are implemented (and also depending on non-OPEC members such as Russia and Oman) markets will progressively shift from a surplus to a deficit, thereby yielding a significant cut in inventories and pushing oil prices higher. Seeing oil go to $55-60 per barrel wouldn’t be surprising in the short-term. However, compliance remains the key issue/ uncertainty and the Investment Adviser believes that markets will only move once more evidence is seen that producers are actually implementing what has been agreed. For the Fund, the strict process limits direct exposure to companies in this sector, so sector ETFs may be considered if the Investment Adviser believes a sustained rally will occur.
(4) November’s payroll report: A mixed bag but nothing to deter the Fed from raising rates. The decline in the unemployment rate to 4.6% from 4.9% will help support the hawks during the FOMC meeting. Furthermore, despite a slight slowdown in average hourly earnings, which is mostly due to volatility, the job leavers (a strong forward looking indicator) rate has accelerated and this could mean that the rate of slack absorption has accelerated thereby possibly warranting a stronger dot plot outlook (i.e. a faster rate hike profile going forwards).
5) The Italian referendum: There isn’t much to say in terms of overlap with the U.S. as markets had already strongly priced-in a “no” vote.
NOTEWORTHY PORTFOLIO EARNINGS RELEASES
Shire Plc. released 3rd quarter earnings on the 1st November. Revenues missed guidance by 3% due to hematology and immunology which was mainly stated by the company as a result of lighter than expected ordering patterns. Nonetheless, management did reiterate their guidance and affirmed underlying demand trends for both segments which helped the stock price recover somewhat from its initial downside response to the headline results. For the Fund, the pullback provided a good point to further increase exposure to a company the Investment Adviser expects will do well in 2017. In addition to the three points put forward in the previous commentary, the company is better positioned than its peers in terms of their product portfolio over the medium to long term.
Allergan Plc. also released disappointing 3rd quarter results with a revenue miss of 2% and EPS miss of 6%. For revenue, some of their older products such as Namenda XR underperformed. This in itself is not a problem. Gross margin went from 89% to 87.5% and SG&A, which was announced to go under 25%, came out at 27.5% with management not giving clear reasons as to why this happened, which impacted investor confidence. The company has gone through significant transition and management has been unable to handle this perfectly; nonetheless, it remains a good company focused on returning value to shareholders and management has made some great strategic decisions. Taking into account the current level of approximately 11 times 2018 expected EPS, the ongoing buyback program (which is going to swallow 8% of outstanding shares), a dividend in place, and Allergan’s solid clinical pipeline (with over 11 new products in phase 3 trials and more than 10 in phase 2) the Investment Adviser remains positive on the potential upside.
Priceline, which operates as an online travel agency, posted stellar results once again. Despite the headwinds from terrorism and political uncertainty that the travel industry faces as a whole, this is a signal that the company has, for a while now, developed a crucial mass platform, technology advantage, and re-occurring customer base that are increasingly difficult for others to penetrate. Consequently, Priceline’s bookings growth and room night growth stand well above Expedia’s 11% organic growth. The Investment Adviser expects these trends to continue for several years given the low penetration levels, increasing online usage, increasing mobile application usage (where Priceline has a dominant global position), and the fact that the company is continuously strengthening its network effect on both organic and inorganic initiatives.
PERFORMANCE UPDATE AND FORWARD LOOKING THOUGHTS
As the Fund was well positioned in sectors such as healthcare, financials, and consumer staples it yielded a total return for November of +4.3% versus +3.5% for its benchmark. The Fund has also outperformed its benchmark on a three month basis as it yielded +2.12% versus 1.6% for the MSCI USA NR index. Top contributors for November were Bank of the Ozarks (up 31.3%) , a Bank that provides a wide range of retail and commercial banking services to individuals, businesses, and government agencies, and Signature Bank (up +24.3%) which is a full service commercial bank that serves privately owned business clients and their owners and senior managers.
The Fund’s holdings in Alaska Airlines and semiconductor company Skyworks Solutions have now been closed. The reasons being (1) as stated in previous commentaries, it follows the strategy of slowly exiting high beta and lower market capitalization stocks and (2) the stock price on both had recovered well which made the risk/reward less compelling and therefore represented a good time to exit.
Looking forward the Investment Adviser remains confident in the Fund’s strategy, positioning and potential for continued outperformance. Indeed, the sector rotation, which accelerated following Trump’s election, is expected to continue and most importantly, the expected earnings growth of the Fund’s holdings should offer substantially better upside than the market.
The views and statements contained herein are those of the Eric Sturdza Banking Group in their capacity as Investment Advisers to the Fund as of 16/12/2016 and are based on internal research and modelling.