Julie Jackson<br /> Portfolio Manager
Julie Jackson
Portfolio Manager

We are forward-looking investors, seeking opportunities that are sustainable over the long term.

Investment Review & Outlook - 3Q 2014

Introduction

After rising in tandem in the second quarter, the returns of different asset classes diverged in the third. Optimism about US economic growth benefited large cap US stocks, while small cap stocks and stock markets of economies outside of the US actually declined sharply. Bonds were up slightly, adding to advances earlier in 2014 while, at the same time, commodities gave up all earlier positive returns and are now down for the year.

For the seventh consecutive quarter, the S&P 500 index had a positive return, up 1.1%, resulting in a year-to-date return of 8.3%. The top performing sector for the quarter and the year is Healthcare while the worst performing this quarter is Energy, reflecting the steep drop in crude oil prices. All sectors now have posted positive returns for 2014, although Consumer Discretionary stocks continue to lag all others, as was the case last quarter. The recent trend of small cap stocks underperforming large cap ones worsened over the period, with small caps dropping 7.4% in the quarter, resulting in a -4.4% year-to-date return. The MSCI-EAFE index of developed international stocks followed that same pattern, with a quarterly decline of 5.8%, erasing any gain from earlier in the year. These markets were negatively impacted by signs of slower economic growth, particularly in Europe and China, as well as from increased political tension between Russia and Europe. Although stocks of emerging market countries dropped 3.4% in the quarter, they still are up 2.7% for the year due to strong returns in the second quarter. The Barclays US Aggregate Bond Index, a proxy for the overall bond market, added a slight 0.2% this quarter, bringing the annual return to 4.1%. After rebounding this year, following three consecutive years of declines, the Bloomberg Commodity Index dropped significantly in the period, down 11.8%, resulting in a negative return of 6.2% for the year.

Heading into the last quarter of 2014, we are encouraged by continued signs of economic growth in the US, despite the imminent end of the Federal Reserve’s bond buying program. Interest rates likely will move higher throughout the next year but not sharply enough to choke off growth in a meaningful way. Inflation should remain subdued as energy costs come down and there is no meaningful growth in wages. We believe that the outlook for stocks remains better than for bonds, mostly due to valuation and lack of return potential for the latter. However, uncertainty due to the speed and impact of Fed rate increases, as well as concerns about stalled growth outside of the US, may weigh on investors in the short run, resulting in increased volatility and a possible pullback in the markets during the fourth quarter.

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Performance Summary

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Total Returns & Values for Selected Assets as of 9/30/14

Source: FactSet, Legg Mason Investment Counsel
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Economy

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The economy continued to perform well during the third quarter, likely growing at an annual pace in excess of 3%, following a strong upward revision of 4.6% for the second quarter. Employment continued to be the bright spot, with average monthly job increases approaching 225,000 during the period. For the year through September, over two million jobs have been created, the best showing since 1999, while the unemployment rate fell below 6% for the first time in six years. In addition, weekly data on initial claims for unemployment insurance continues to reside near recent lows, while JOLTs data on job openings rose to the highest level in 13 years. While jobs clearly are being created, wages failed to advance past the stubbornly subdued 2% annual rate of growth that has persisted for the past few years. Despite lackluster compensation, rapidly falling gas and energy prices bolstered disposable incomes nonetheless, resulting in a relatively healthy spending environment. Auto sales surged in August to the fastest annual rate since 2006, while retail sales excluding autos and gasoline also showed strength. The increase in auto sales continued to support manufacturing activity, which hovered near three-year highs for most of the quarter, and strength in new manufacturing orders foreshadowed further advances in the months to come.

We are optimistic about the prospects for the consumer and the economy for the balance of the year. The orderly slowdown in China’s economy combined with continued strength in the dollar should keep a lid on commodity prices and inflation overall, supporting recent advances in disposable income. We expect the Fed will be raising interest rates next year, but we do not believe they will do so at a pace that would be damaging to the growth prospects of the US economy. A corresponding rise in mortgage rates will not be beneficial to the housing market, but the improving labor market likely will be a more important factor in better activity in coming months. Home price appreciation slowed of late as credit availability remained tight. However, we deem the double-digit annual price moves in the run-up to 2014 as unsustainable and view the recent pause as healthy. As price appreciation moderates, even a modest rise in mortgage rates should not compromise the attractive affordability of homes for those that qualify. In time we expect banks will loosen lending standards in sympathy with the improvement in the labor markets, providing an additional tailwind for an economy already benefitting from healthy consumption and manufacturing activity.

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Equities

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The US equity markets began the quarter supported by great optimism as positive job growth and persistent low rates drove the Dow Jones Industrial Average to a new all-time high of 17,000. This positive outlook was reinforced by strong second quarter profit reports from US companies and a very healthy rebound in US GDP to 4.6% for the second quarter. The bull market entered its 66th month in September and has recorded 34 all-time highs so far in 2014.

Geopolitical concerns quickly began to dominate investor sentiment as a ground war commenced in Gaza, a commercial airliner was shot down over eastern Ukraine, and the extremist group ISIL advanced across Syria and Iraq. US equity markets proved quite resilient and each decline was met with bargain hunters seeking to build out their equity exposure.

Investor sentiment was subject to a tug of war. Profits for companies in the S&P 500, and domestic economic indicators generally were positive which then led investors to worry once again about the Fed’s future interest rate policy and the ongoing tapering of bond purchases. Market pundits refer to this as a “taper tantrum.” With the combination of geopolitical concerns and Fed path uncertainty, shareholder preferences moved towards the “risk-off” position, and the S&P 500 declined 3% by the first week in August.

Evidence of continued stagnation in Europe became apparent during the quarter. Germany’s business confidence indicator fell to a 17-month low in September, and both German and Italian GDP shrank. This weakness was exacerbated by the expansion of EU- and US-imposed sanctions against Russia for its attacks on Ukraine. When these conditions are combined with poor productivity, a recovering banking system, and an aged work force, Europe is put in the very difficult position of needing significant reforms. These economic challenges frustrate many workers across Europe and have spawned a strong and growing populist movement evidenced by the recent Scottish independence vote and the growing popularity of Marine Le Pen in France. This trend can make it increasingly difficult for the EU to develop comprehensive and effective banking and fiscal reforms that would combat the structural obstacles to productivity and investment. The ECB is taking a more aggressive stance and, in a surprise move, it cut rates in September, lowering a key refinancing level from 0.15% to 0.05%. Further aggressive actions likely will be instituted by the ECB. The impact of a weakened euro will make exports more competitive, but the road to meaningful improvement for Europe seems quite long and convoluted.

As a result of this slowdown in Europe along with a moderation in Chinese growth, and growing supply from shale formations, oil prices in US dollar terms declined by almost 15% during the quarter. This sharp decline has both positive and negative effects for corporate profits depending on the company’s consumption or production of the commodity. While providing a healthy lift to personal disposable income, the price weakness adds to a growing concern over deflation in areas such as Europe and Japan.

Markets are driven in significant part by emotion, and the pendulum can swing from risk-on to risk-off with relative ease. When a new unsettling factor makes its way into the investor psyche, it is easy for the new source of alarm to dominate market attention. The Ebola outbreak and its recent expansion into developed countries is such a factor. While it is likely that additional infections will develop outside of Africa, polls indicate that a disproportionate part of the US population is concerned with the risk of infection. This fear is likely to add to market volatility.

We continue to subscribe to the paradigm of a protracted and gradual economic recovery in the US which supports a longer-than-average market recovery and expansion. The operating profit per share for S&P 500 companies grew at 11.3% year-over-year in the second quarter. This was driven by revenue per share growth of almost 6% and a record profit margin of 10.07%. While we are not convinced that such a lofty margin can be sustained if companies invest in expansion and some degree of wage pressure is experienced as the economy improves, we do believe that high single-digit profit growth can be realized in the coming 12 months.

With emerging evidence of improving capacity utilization and the ensuing capital expenditure to grow capacity, we maintain a positive outlook on parts of the industrial sector and look for continued opportunities to invest in innovations within healthcare and information technology. We favor companies who have demonstrated an ability to grow cash flows and earnings at this point in the economic cycle and believe these companies will be highly valued by investors. Given the challenges across Europe, we are mindful of the headwinds to corporate profit growth that these may present. We prefer businesses that will benefit from the continuation of the protracted and improving US recovery.

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Taxable Bonds

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Despite two out of three months of negative performance, the US taxable bond market managed to eke out another quarter of positive returns with the Barclays Aggregate Index posting 0.17%. A flight to safety into the long end of the curve kept the index in positive territory. Risk assets were negatively impacted by factors outside of the US such as slower growth in Europe and China and geopolitical risks in the Middle East and Ukraine. Within the US, Fed uncertainty and a lack of liquidity created more headwinds. As such, AAA securities generated returns of 0.25% vs. -0.20% for lower rated ones. Outflows associated with a large mutual fund appeared to pressure intermediate Treasuries, which fell 0.19%, while strong global demand for longer Treasuries resulted in a respectable 3.33% return for the period. This remarkable rally in Treasuries has been the primary driver of performance in 2014.

As investors shifted to a risk-off perspective due to the aforementioned reasons, credit spreads widened despite persistently solid fundamentals. Exacerbating the skittish environment was a lack of liquidity, which was more pronounced in September. Mutual fund redemptions highlighted this liquidity issue and provided a preview of what could happen if fund outflows pick up in reaction to rising rates. On the supply side, September was a busy month for new deals, which logged in the fifth busiest month since 1998. With the significant increase in M&A volume this year, October could set up for heavy issuance where normally it starts to taper into year-end. Regardless, we continue to believe that there will be robust demand for corporates supported by positive GDP growth and the global search for yield. We are anticipating a gradual increase in yields between now and year-end, rather than a dramatic rise. Therefore, we plan to maintain a barbell structure, one heavily weighted to both the long end and the very short end, but with a duration stance shorter than the benchmark.

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Municipal Bonds

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Despite a volatile quarter, tax-free bonds continued to be one of the strongest performing fixed income sectors. The Barclays Municipal Bond Index generated 1.49% for the quarter, boosting year-to-date performance to an impressive 7.58%. Longer-dated bonds continued to outperform as light volume of new issuance and low expectations for future inflation combined with continued inflows into municipal bond funds to support the market. Despite generally positive economic data, geopolitical concerns kept Treasury rates anchored, and municipals reaped the benefits of the flight to quality. Short and intermediate maturities did not fare as well since they are more impacted by expectations of Fed rate increases sometime next year.

Given the hostile tax environment combined with the demographically-driven desire for income, we expect demand for tax-free income to remain robust. While still low, new supply continues to slowly increase. We expect issuance will pick up after the mid-term elections, as it usually does, once elected officials tend to state and local needs. An increase in supply combined with positive economic data and a Fed inching closer to tighter monetary policy could allow rates to finally drift higher. At this time, five-year tax-free bonds yield only 66% of the comparable Treasury while 10-year munis yield nearly 87%, closer to the 90% range that persisted over much of the year. As a result, we favor a more barbelled maturity structure, focusing on intermediate-dated, high-coupon bonds to augment portfolio yield, while balancing these purchases with cash and extremely short maturities to soften the portfolio’s overall duration stance while keeping a small cash reserve to deploy on any meaningful rise in interest rates.

While the headlines have gravitated to the dire credit events in places such as Puerto Rico and Detroit, it is important to note that these are isolated incidents. Overall defaults within the municipal market were running below last year’s pace through September (41 versus 45), and are likely to be the fewest for a calendar year since 2009. That being said, we are becoming somewhat cautious looking forward regarding the prospects for state and local government debt. Tax revenues seem to be in a slowing trend, somewhat exacerbated by the acceleration of income into the 2013 tax year to avoid higher marginal tax rates. This shift inflated income tax and capital gains receipts at the local level to the detriment of this year’s collections. Also, increasing pension liabilities threaten future budgets in certain instances (most acutely in Illinois and New Jersey) and are trends that we continually monitor. In spite of these developments, the municipal market remains a high-quality source of tax-free income for investors. Should risk become re-priced in the form of additional yield, we would welcome the opportunity to utilize our credit resources in a risk-adjusted manner to find value in a yield-starved market.

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Commodities

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After a promising start to the year, commodities, as measured by Bloomberg Commodity Index (formerly the Dow Jones-UBS Commodity Index), now are down 5.6% in 2014, suffering a significant decline of 11.8% this quarter. Among the components, gold declined 8.4% in anticipation of the Fed being closer to raising interest rates, leading to continued strength in the US dollar. Investors often buy gold as a hedge against a weaker currency, and the potential of rising inflationary pressures while increases in interest rates tend to diminish the attraction of gold. In the oil markets, the price of US benchmark light sweet crude now is down 7.4% for the year, at $91.16, after a steep drop of 13.5% in the quarter. This is the lowest price for the commodity since late 2012. Rising supply, both in the US and globally, and lower global energy demand, particularly in China, weighed on prices. Anticipated supply disruptions due to geopolitical risk in the Middle East and Russia did not materialize.

Going forward, significant headwinds for this asset class remain as the Fed ends its bond buying program and is that much closer to increasing interest rates. Subsequent US dollar strength likely will further diminish the appeal of gold, an asset with no income component, as well as most commodities. Of course the role of gold as a safe haven during times of economic or political turmoil remains intact. In addition, a stronger dollar makes commodities more expensive for buyers in emerging market economies, further weighing on demand, since these assets are priced in US dollars. Abundant supplies of oil combined with weak macroeconomic data from the eurozone and China likely should keep a lid on oil prices in the near future as well.

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Conclusion

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We have a modestly positive economic outlook for the next year, with an estimate for annual US growth of 2.3% for 2014 and 3% GDP over the twelve months. Our expectation is for a 10-year Treasury yield in the low- to mid- 3% range by the middle of 2015 due to a subdued inflation outlook and benign wage pressure. We continue to favor stocks over bonds, due to the lack of return potential for the latter as well as our view that economic growth remains positive. Our overweight in stocks is tilted primarily towards large-cap US stocks relative to small caps and those overseas. While the valuations of small cap stocks have come down during the quarter, and they primarily have domestic economic exposure, we remain neutral at this time due to relative valuation versus large caps. Our concern about economic growth outside of the US is why we have gone to an underweight in stocks of developed international markets. We have become more optimistic about emerging market stocks, moving to neutral from underweight, due to reasonable valuation and positive near-term growth prospects. It would not be unexpected to have a moderate correction in stocks, and we would consider a pullback of any significance to be an opportunity to add to equities. With a tapering Fed on the horizon, no catalyst for robust global growth, and tame inflation, we remain underweight commodities.

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The views expressed are subject to change. Any data cited have been obtained from sources believed to be reliable. The accuracy and completeness of data cannot be guaranteed. Past performance is no guarantee of future results.

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