April 2014 Market Commentary
Over the last few years we have witnessed the U.S. economy move in “fits and starts”. Are we in for another repeat? The last quarter of 2013 was revised up from 2.4% growth to 2.6%. However the first quarter of 2014 is running at about a 1.4% rate. Some of this is due to the extremely cold weather. Exactly how much, as spring arrives, we shall see. Consumers slowed their spending in the first quarter causing economists to lower their estimates for the quarter. The picture is not entirely bleak; personal income was up in February on top of the gain in January. The slow down in consumer spending did not effect the entire economy as spending on physical goods increased last month as well as spending in the services sector. Consumer confidence rose to 82.3 in March from 78.3 in February. The Case-Shiller home price index also climbed, up 13.2% January 2014 over January 2013. All of these items indicate an uptick in the economy as we move into spring. In a related real estate sector, the U.S. office market added space in the first quarter at a pace not seen since 2007. As with the growth in other areas, this rise is slow by historical standards, but it does show improvement.
Another strong indication of economic growth is that the Institute for Supply Management’s Purchasing Managers Index (PMI) rose to 53.7 in March, up from 53.2 in February. Two leading components that helped this index expand was the Index of New Orders, which increased again to 55.1 from 54.5 in February and Production which also increased from a reading of 48.2 to 55.9 in March. Another positive indication was the Commerce Department release of construction spending which was up 0.1% in February. Although this index peaked at 57.3 last November, a reading of 53.7 is a very good number. These are improving numbers but they are still relatively slow by historical standards.
Also, last Thursday the Commerce Department released data showing that business profits are growing faster than GDP. A closely watched measure of after-tax corporate profits increased to 11.1% of GDP, or $1.9 Trillion dollars for the fourth quarter. Economists expect corporate profits to expand or grow by 7.4% this year. One aspect that has helped corporations is the very low interest rates. Companies have refinanced their debt at very low rates, saving billions of dollars. This should allow for increased future capital expansion.
The world seems to lurch from one geopolitical event to another. Russia is still adding uncertainty to global fears over the Ukraine. This adds to the uncertainty in European. Last month the European Central Bank (ECB) announced they would leave interest rates unchanged. It seems that inflation in Europe has slowed to a point where fear of deflation is being considered. Spanish consumer prices were lower year over year and Germany’s inflation rate was under 1%. Germany and Spain are ranked first and third based on the size of their economies in the European Union. Rumors have started to circulate that the ECB will consider Quantitative Easing to bolster their economies. .
In previous Market Comments I have discussed the tremendous benefits to manufacturing as a result of lower natural gas and Natural Gas Liquids (NGL’s) prices. As natural gas prices have dropped by more than half in the last decade and ethane prices even more, capacity increases in the chemical industry are surging. Producers are adding approximately 105 million metric tons of capacity, led by ethane and methanol production, along the Gulf Coast. Current estimates are for growth to peak in 2017 with the addition of another 23 million tons of capacity. This increased production along with the tremendous cost advantage should result in a 500% increase in earnings from ethylene alone. Global demand for ethylene is estimated to grow by 150% from 2010 to 2040. This is being driven by the expanding middle class in the developing world. There has been a rapid globalization of world wide chemical markets. This growth in demand comes at a very opportune time for the United States as we expand production coupled with our advantage of lower costs. At a meeting of the HIS World Petrochemical Conference here in Houston, it was announced that U. S. exports of polyethylene, polypropylene and para-xylene could double in the next ten years due to our cost advantage. For these reasons we continue to add to our positions in Westlake Chemicals (WLK) and LyondellBasell (LYB). They are both adding capacity which will be coming online this year thru 2016. They have shown very nice profit increases year over year and this should continue.
Additionally, refiners are adding capacity. Phillip’s Petroleum (PSX) is adding refining capacity as well as increasing capacity in there chemical division. As a result, we are adding to our position in PSX, partly due to the chemical influence but also due to the tremendous increase in light sweet crude production from the Bakken and Eagle Ford shale formations. Their capability to process this ultra light Eagle Ford crude into near gas which can then be exported to Central and South America where they can be further refined.
With rising sales prices for natural gas and NGL’s, we are seeing increased profits for the players in the Bakken and Eagle Ford shale. We believe their fourth quarter profits will reflect a dramatic increase over the year before. As these companies better understand the reservoirs they are drilling in, they are able to decrease their drilling cost and timeframe, which increases production faster and improves their margins. Several names we recommend in this area are Continental Resources (CLR), EOG Resources (EOG), Oasis Petroleum (OAS) and Whiting Petroleum (WLL). For a play on the Marcellus shale, Gastar Exploration (GST) and Range Resources (RRC) are where we are putting our money.
The mid stream sector is adding capacity as well. Most of the new shale finds are in areas that did not have a lot of infrastructure. Pipelines, gas liquids separation facilities, fractionators, storage capacity and export terminals are being added at a very rapid rate. Our favorites in the sector are Kinder Morgan Partners (KMP), Enterprise Products (EPD), and Breitburn Energy Partners (BBET). They have nice dividends that are very tax efficient and they are also experiencing increases in their distributions as well as providing share price increases.
In the pure industrial space, our holdings in Emerson Electric (EMR), Honeywell International (HON) and United Technology (UTX) are at or near 52 week highs. United Technology has several long cycle businesses that allow them to maintain good growth in share price and dividends over long periods of time.
We are emphasizing investments in companies with good cash flow, good cash distributions and companies that operate in areas where they have a competitive advantage due to much lower energy costs and raw material input costs. We prefer companies that generate good, after-tax returns. Their price earnings ratios are at levels that are attractive compared to the low interest rates on investment grade bonds. With interest rates at historic lows, even as dividend taxes go up, the after-tax returns are still higher than most investment grade debt. There is a growing shift from very low yield bonds into equity. BSG&L is a long term investor and we believe that if you are patient, build cash and buy good companies on pull backs, your portfolio will have good growth over the long term.
Ben Dickey CFP/MBA/CHFC
BSG&L Financial Services LLC