article 04-25-2016

The Economy's Journey into Uncharted Waters

With negative yields and financial experimentation ongoing and the world still dependent on monetary stimulus, Portfolio Manager Charlie Dreifus sees high-quality, inexpensive, and dividend-growing businesses as the best choice in a still challenging environment.

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Cyclical Rotation, Slow Growth
The fears of a recession, or something even worse, which sank the markets in early 2016, have subsided. In fact, there has been a rotation towards more cyclical names despite little evidence yet that growth has accelerated.

The realization has also begun to sink in that there may be better places to put money to work (such as equities) than the 1.6% yield for 10-year U.S. Treasury notes. Indeed, these low-yield alternatives, which could remain relatively low longer, remain the valuation safety valve that could push asset prices higher.

People (in my view correctly) are looking for stocks that resemble bonds. Yield repression continues, as does the TINA Principle, which holds that "There Is No Alternative" to equities. If one can find reasonably priced stocks with solid, stable outlooks, a yield that's competitive with the 10-year U.S. Treasury, and the likelihood of annual dividend increases – why not?

With negative yields in some parts of the world and financial experimentation continuing, those kinds of companies look like a safe bet for now. Surely within the 50% of S&P 500 companies that yield more than the 10-year U.S. Treasury, there are enough names to construct an attractive portfolio.

Less Monetary Stimulus, More Fiscal Initiatives
It is clear that inflation, though still tepid, is accelerating. Wages are climbing, the core PCE ("Personal Consumption Expenditure") deflator is accelerating, and energy and gasoline prices are higher.

A flat to weaker dollar, subsequent flat to stronger prices for oil and other commodity prices, and lower rates, particularly in junk bonds, have until recently signaled a "risk on" environment that has allowed many companies with what we would view as undesirable attributes (little-to-no earnings, highly leveraged balance sheets, etc.) to do well.

At the height of the recent commodity recovery, one wag quite indelicately said, "Forget about FANG [Facebook, Amazon, Netflix, and Google] – it's all about BARF (BHP, Anglo, Rio, and Freeport)." This only goes to show how wild the market's swings can be.

One need only know that Ireland (the "I" in the "PIGS" group of European nations that were in trouble just a few years ago) issued a 100-year bond with a yield below the current rate for the 30-year U.S. Treasury bond. Is it any wonder that buying reasonably priced equities with competitive and growing dividends looks to us like a sound strategy?

We have depended on monetary stimulus for too long, and it is questionable whether similar efforts can jump start an economy that has not been responsive. We need more fiscal initiatives, and hopefully when the Presidential campaign begins in earnest the contenders will focus on that.

The Self-Governing Device
On Tuesday March 29th I joined around one thousand other attendees at a presentation by Federal Reserve Board Chair Janet Yellen at the Economic Club of New York. Chair Yellen is most interesting and informative when challenged with good questions. Professor Glenn Hubbard, Dean of the Columbia Business School, aided in that effort.

The message, well reported in the press, was an argument for a slower path to normalization, if for no other reason than an abundance of caution. She all but ruled out the possibility of a policy error, such as the premature tightening on the part of the Fed in 1937-8 during the Great Depression.

She also made it clear that the Fed, along with other central banks, are not getting enough help from their national governments in providing enough fiscal stimulus. The world remains too dependent – and therefore too focused – on monetary stimulus.

In addition, she stated front and center that the Fed needed to proceed cautiously (i.e., moderate and slow tightening to avoid policy errors) in adjusting policy given the risks to the overall outlook. If things get too strong, the Fed has many tools at its disposal; but if things get worse, the arsenal is much more limited.

She wants–indeed, needs–more inflation. The Fed will err on the side of providing it even while they are mindful of the negative impact of too much inflation, as was the case in the 1970s.

There appears to be a self-governing device at work. Less favorable financial and economic conditions are neutralized by the almost immediate and offsetting declines in market yields. This automatic stabilizer effect kicks in when bond yields decline, providing a buffer when economic data points disappoint and expectations are lowered.

In terms of specific risks, Chair Yellen touched on concerns regarding China's transition from exports to domestic growth as well as further declines in oil prices and their potential impact on the global economy. Her dovish tone pushed the U.S. dollar lower; it is supportive of commodity prices, emerging markets, and cyclical shares.

Janet Yellen was not the only prominent financial figure to recently express caution. IMF Managing Director Christine Lagarde echoed Yellen's concerns in a more global context, arguing that we have not yet arrived at a point where the economy is growing fast enough on its own (escape velocity).

U.S. Recovery Remains Resilient
We continue to see the need for monetary and or fiscal policy. Obviously, the U.S. is still in better shape than other countries, though we will likely post very modest GDP growth for the first quarter of 2016.

All this notwithstanding, the U.S. recovery remains remarkably resilient. Despite weakness in energy and mining, employment figures remain strong while Main Street is feeling good and has the capacity to spend.

U.S. initial unemployment claims divided by U.S. payroll employment recently fell to a record low. People are working–the March employment report was essentially perfect. Solid job growth, decent wage growth, and an ongoing increase in the work force participation rate which reveals more Americans entering the work force.

Investors want the best outcomes. Positive, or improving, earnings data in an economy that is not growing so quickly that the Fed will raise rates sooner than expected. The latter seems to be working, the former not so much, at least not yet. Perhaps the upcoming earnings season, helped by an easier currency comparison, among other things, will demonstrate improvement.

To some degree, the rally off the lows on February 11th has been led by the worst of the worst: companies with weak balance sheets, low returns on equity and poor profit trends.

If the Fed remains dovish, this could continue; only when the Fed removes the punch bowl will higher-quality companies with strong balance sheets, no borrowing needs, and stable outlooks outperform on a more sustained basis.

For 2016's first quarter, the biggest percentage gainers on the NYSE included U.S. Steel (+101%), LSB Industries (+75%), and J.C. Penney (+66%). What did they have in common? Closing prices at the end of 2015 that were below $10 per share and questionable futures, prompting the question, is there too much confidence now?

From its June 23, 2015 peak the Russell 2000 Index lost 25.7% to its low on February 11, 2016. This would be viewed as a correction large enough to call it a bear market. The excesses in the small-cap index have been addressed – though arguably not totally eliminated.

Uncertain Prospects for Global Growth
Since the mid-February market bottom, confidence has risen (surprise!) while volatility, as measured by the VIX, has declined. As we get closer to the U.K. referendum on exiting the Eurozone, as well as our presidential conventions, followed by November elections, it will be interesting to see if the mood remains as upbeat.

Call it whatever you like–a cyclical bull market, a bear market rally, or a short squeeze– but the movement post-mid-February shows an increasing appetite for stocks and commodities.

The picture drawn by Chair Yellen at the talk I attended suggests ongoing weakness in global economic growth. If she's correct, which seems probable, then don't count out the rapid revenue growers, those FANG-like names, as investors might once again embrace "dream" stocks.

Companies made 394 dividend reductions in 2015, compared to "only" 295 in 2008. Why did last year see more? As credit grows tighter, for oil and gas companies in particular, payouts fall. (Our focus on internal cash generation provides a potential buffer to such events happening to our holdings.)

Are we now facing permanent uncertainty? Of course not. Yet until there is resolution of the grand experiment in quantitative easing implemented by the Fed and other central banks, uncertainty will prevail.

About one-quarter of global government bonds now trade with yields below zero– a figure that is only likely to grow due to ECB buying. The laws of unintended consequences are just beginning to assert themselves. And so we continue our journey into uncharted waters.

Among the things that could go wrong beyond the obvious geopolitical and terrorist risks are a hard landing in China, a material yuan devaluation, and an earnings decline for the S&P 500.

Another potential negative not much spoken about is the need in June-July to provide debt relief to Greece, which so far has not been progressing well. This deadline occurs around the time of the U.K Eurozone referendum, making it likely that we could see some turbulence at that time.

Dividend growth and the potential power of compounding continue to obsess me. While the initial yield on the S&P 500 was a little over 1.5% in 2004, as of March 2016 the yield on cost was 3.9%, compared to its current yield of 2.1%. It works! Lost perhaps in the overall feel-good experience post February 11th is the fact that yield, irrespective of sector or market cap, has outperformed so far in 2016.

A Still Challenging Environment
We have witnessed 22 consecutive quarters in which the trailing 12 month EPS for the S&P 500 has been up greater than the trailing 12 month's sales.

While we are big believers in being lean and mean and in the power of incremental margins, this trend is growing long in the tooth. Without a pickup in revenues, the earnings improvements will fade out.

For whatever it's worth, I believe some sort of change regarding the foreign profits of U.S. companies will occur after the elections despite (or because of) the recent Treasury inversion ruling. The current structure, which is in place in only five other OECB countries, doubles taxes on foreign-sourced incomes, which result in inversions and leave an estimated $2 trillion offshore. This is not helping the U.S. in any manner.

We continue to see high-quality, inexpensive, dividend-growing businesses as the best bets in this challenging environment.

Important Disclosure Information

Charlie Dreifus is a Portfolio Manager and Principal of Royce & Associates, LP, investment adviser to The Royce funds. Mr. Dreifus's thoughts and opinions expressed in this piece are solely his own and may differ from those of other Royce investment professionals, or the firm as a whole. There can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.

The S&P 500 is an index of U.S. large-cap stocks selected by Standard & Poor's based on market size, liquidity, and industry grouping, among other factors. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

The CBOE Volatility Index (VIX) measures market expectations of near-term volatility conveyed by S&P 500 stock index option prices.

Russell Investment Group is the source and owner of the trademarks, service marks, and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell© is a trademark of Russell Investment Group. The Russell 2000 is an unmanaged, capitalization-weighted index of domestic small-cap stocks. It measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index. The performance of an index does not represent exactly any particular investment, as you cannot invest directly in an index.

This material is not authorized for distribution unless preceded or accompanied by a current prospectus. Please read the prospectus carefully before investing or sending money. Smaller-cap stocks may involve considerably more risk than larger-cap stocks. (Please see "Primary Risks for Fund Investors" in the prospectus.)

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