February 2014 Market Commentary
The economic recovery from the “Great Recession” is more than five years old. We have had fits and starts before, with a quarter or two of good growth followed by a lackluster quarter of growth. The first half of 2013 was below the average return of previous recoveries. However growth picked up in the third quarter which came in at a rather robust 4.1%. The forth quarter, which was released on Thursday, January 30th , came in at a better growth rate than I had anticipated of 3.2% which meant 2013 full year growth rate was 1.9%. Although it looks like a 1.75% to 2.25 % first quarter of 2014, our estimate for the full year is a growth rate of 2.5%. The increase in my growth estimate is based on increasing consumer spending as well as in increase in corporate capital spending. These estimates seemed to be confirmed by the increasing consumption of refined products. Although the economy is now growing at an increased rate over the past quarters, it is not close to the growth we need to reduce unemployment. There are several reasons for the increase in growth. Household debt has come down substantially over the last few years. Consumer sentiment has improved and consumers are venturing into the shallow end of the debt pool. Another reason is that state and local governments have improved their fiscal positions by reducing debt and increasing their fund reserves. Many states are experiencing substantial increases in revenue. If these trends continue, growth could pick up even more. Lastly, even though the markets threw a temper tantrum when the Federal Reserve announced they were tapering their bond buys, the bottom line is the Federal Reserve will stay accommodative for a prolonged period of time. This should appease the markets and slow rate increases on the long end of the interest rate curve. That is beneficial for the economy and for equities.
As in the past several years, overseas is a mixed bag. For a change it looks like Europe is improving, but at a slow rate. Spain and Italy recently announced positive growth for the fourth quarter. This is offset however by the problems incurred by the BRIC countries. Brazil is having major currency problems caused by an increase in their trade and capital deficits. India is having the same problems. Russia is declining in output and China is somewhat stable around the 7.5% growth rate. A new area of growth is Sub-Saharan Africa. These nations are working together in ways that should allow a more rapid economic expansion. There is a very large population in this region that is very poor. As their economies improve, you could see a China-like increase in the middle class. These factors, on balance, have prompted the World Bank to increase their estimate of world GDP growth in 2014.
Over the last year, I have mentioned several times the large competitive advantage that lower energy prices have given U. S. manufacturers. Industrial production increased for the fifth straight month in December. The U.S. manufacturing capacity utilization increased in December to the highest level since the summer of 2008. As the utilization of idle capacity increases, companies begin to increase capital spending. This will add to the growth in GDP as well as in hiring. There is over $100 Billion dollars in pipeline expansion underway as well as more than $110 Billion in chemical plant expansions domestically. As midstream companies see rising prices for Liquefied Petroleum Gas (LPG) and an increase in contracts for Liquefied Natural Gas (LPG) for export, they will continue their expansion plans. The mid-stream sector should be the place to be this year. For this reason we are adding to our positions in Enterprise Products Partners (EPD) and Kinder Morgan Partners (KMP).
Another segment of the economy that continues to expand is Petrochemicals. One of our current holdings, Westlake Chemicals (WLK), has seen increases in margins and increases in shipments of specialty chemicals. Their olefins and vinyl production has increased 26% year over year. In previous postings I had mentioned they were adding to their ethylene production in Lake Charles and that they had purchased a PVC pipe producer. These two items greatly contributed to this increase in margins and shipments. Two other companies that we recommend, LyondellBasell (LYB) and Huntsman Chemicals (HUN), are also seeing similar type increases. We are adding to these positions as cash becomes available.
With rising 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), Sanchez Petroleum (SN), Oasis Petroleum (OAS) and Whiting Petroleum (WLL).
We believe the economy is expanding at a slightly faster pace than in the past. That is why 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