Broker Check

Investor Letter April 12, 2014

The 1st quarter of 2014 ended with both stocks & bonds relatively flat vs the end of 2013. The S&P returned 1.8%, and bonds, measured by the Barclays Aggregate Bond Index, the same. Foreign stock market returns were as usual widely dispersed, with China continuing its multi-year decline down 5% and EM down 1%. Europe fared a bit better and was up 2% or so for the quarter. Gold returned 6.5% on the quarter while WTI crude was up 4%.

The lackluster performance thus far for risk markets suggest that a much needed consolidation is taking place after a very good year in 2013. Volatility has picked up dramatically and the last half of the quarter saw high P/E growth stocks being sold while deep value stocks were bought. Rumors abound that some large hedge funds were caught long developed markets and short emerging markets. They’ve certainly been trading that way the last few weeks.

While markets are flattish for the year the fundamentals are still favorable for a continuation of the bull market once this consolidation is over.

Global Monetary Policy & Inflation - global central banks remain accommodative with the BOJ/ECB still very much in easing mode. Inflation, or lack thereof, is beginning to concern central bankers. If one considers the enormous deleveraging that’s taken place since the financial crisis it seems that monetary policy has only worked to offset that, but has not gone far enough to actually generate inflation.

As every central bank has an inflation target (not a deflation target) and all the world’s major economies currently have inflation well below their respective targets, it seems clear there is more work to do. China, for instance, reported a -2.3% PPI for March14, the 25th consecutive month of negative readings. In Europe the strong Euro adds to deflationary pressures and the ECB is now teeing up its own version of QE. (Europe’s year over year CPI is now very close to zero.)

Here in the states the FED continues throttling back on its asset purchases, but money supply continues to grow in double digits. The Yellen FED has changed the focus of monetary policy to inflation (from employment) suggesting FED Funds rates will remain low for some while yet as the FED’s favorite inflation measure is just +1.1% YOY.

Indeed the biggest surprise this far in 2014 is that interest rates have not gone up, but down. For both stock & gold investors lower rates are (on balance) good news.

Deflation & Gold - if deflation does indeed gain the upper hand policy makers have only to devalue their currencies against gold to create inflation. This is a time honored practice, and one that has never failed to work. We are not there yet, but a major shock to the global economy at this point could very well mean outright deflation for much of the world. This in turn could lead to talk in policy circles of a revaluation of gold. HarborView Capital recommends that all our clients have a 5% exposure to gold. While we have had no exposure to gold for the last couple years due to our outlook for the metal, we are watching gold and the various factors that impact gold prices for signs it’s time to get reinvested once more.

Economic growth is expected to pick up here in the states to a 3% annual pace as the weather improves. Our labor markets continue to improve. While China is struggling to hit their annual 7.5% growth target they will be close. Copper and other economically sensitive commodities are trading quite well in 2014, suggesting China (the marginal buyer for this sector), is not in danger of a major crisis. Europe’s economy is actually growing again (not just Germany!) while Japan’s growth should be around 2% for 2014. The bottom line is the world’s major economies are now growing together, something we’ve not seen for many years. This is good for earnings and confidence.

Valuations, especially after the latest bloodletting in high PE growth sectors, remain friendly. The S&P is now trading at around 15 time’s forward earnings, an undemanding valuation given the outlook for economic growth, interest rates and inflation expectations. As we are in earnings season now the market is pricing in negative earnings growth for the 1st quarter here in the states. The bar is low, and it is quite likely that the majority of companies will be able to surprise on the upside. Valuations in Europe are lower than here in the states, while in China and Japan they are lower still. No signs of any bubbles in global stock prices. We would suggest the only "bubble" currently is in peripheral European debt where the Spanish can now borrow for 5 years at lower rates of interest than the United States can.

Russia & the Ukraine - as Gore Vidal once said "patriotism is the last refuge of a scoundrel". As Russia’s domestic growth has soured while inflation remains elevated Putin has wrapped himself in the flag, annexed the Crimea and is currently threatening eastern Ukraine. Russia is likely to remain in the headlines for quite some time to come. Putin needs this, but Obama is right, this is not a sign of strength, but of weakness. Dealing with Russia as a regional power is correct and using sanctions will hurt Russia significantly without directly engaging Putin. We don’t see this as being a major headwind for the markets barring an outbreak of major regional hostilities that are in no one’s best interest.

AAA Strategy - our quantitative strategy returned +2.4% for the 1st quarter of 2014 outperforming the S&P500TR. After a strong start the first couple months of 2014 March was unkind, and the AAA strategy saw a negative return due to weakness in biotech. Our algorithm rotated out of biotech and into technology at the end of March, as it was designed to do, and we remain fully invested in risk.

There continue to be many risks to the global markets and economies. But for the rest of 2014 we see the odds of major tail events lower than in any time in the last 5 years. We reiterate our outlook for an 8-10% return for the S&P500 for 2014, which would bring us to the 2000 level.

As always any questions or comments, regarding the markets or your account, please contact us. Happy spring!

Best Regards,
Paul Brian Gibson
HarborView Capital Management LLC
Partner, Portfolio Manager