October 2014 Investment Update

October 2014 INVESTMENT UPDATE Executive Summary  After averaging only +2.2% real growth since the end of the recessi...

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October 2014

INVESTMENT UPDATE Executive Summary 

After averaging only +2.2% real growth since the end of the recession in 2009, the U.S. economy is finally starting to pick up speed as the headwinds of lower government spending, consumer deleveraging and conservative corporate capital spending are subsiding.



The strengthening U.S. economy will force the Federal Reserve to begin to gradually raise interest rates in 2015. Although equity investors may react negatively at first, we believe that the process of normalizing interest rates is long overdue and will have a minimal long-term impact on the economy and equity markets. We remain cautious on bonds however, as rising shortterm interest rates would likely have a negative impact on fixed income investments.



Despite the strengthening U.S. economy, the broader equity markets weakened in the third quarter as fears surrounding the wind down of the Fed’s bond buying program, Russia’s incursion into Ukraine, the rise of ISIS in Iraq and Syria, and the threat of the Ebola virus resulted in negative returns from small capitalization stocks (-7.4%) and foreign equities (-5.8%).



With the underlying strength of the U.S. economy becoming more apparent and with corporate profits poised to continue to grow from record levels, stocks appear reasonably valued, trading in-line with the long-term average of 15.5x forward earnings.



Emerging market equities appear to offer attractive relative value given the faster growth rates of emerging economies and valuations at just 10.4x forward earnings compared to 13.7x for the more developed foreign markets and 15.5x for the S&P 500 Index.

The U.S. Economy is Gaining Speed After averaging only +2.2% real growth since the end of the recession in 2009, the U.S. economy is starting to pick up speed to a more normal rate of +3.0-3.5%. After the extremely cold winter stalled growth in the first quarter, second quarter GDP came in at a strong +4.6%. In three out of the past four quarters, GDP has grown by over +3.5% and phone: (920) 729-7900

nominal GDP has grown by over +5.0%. Economic growth appears likely to continue above +3.0% for the remainder of 2014 and into next year as the headwinds of lower government spending, consumer deleveraging and conservative corporate capital spending begin to subside. Following years of excess government spending, and outof-control fiscal deficits, gridlock in congress resulted in government spending declines during the past two years. While these spending reductions were necessary to get the fiscal deficit under control and positive for long-term economic growth, they did act as a headwind to GDP growth, masking the relatively healthy +3-4% growth experienced in the private sector (See Chart 1). With the deficit now back to a sustainable level of approximately 3% of GDP, the government is starting to modestly increase expenditures. As government spending swings from a drag of -1% to a neutral or even a positive contributor to GDP, the stronger growth that has been occurring in the private sector will become more obvious. Chart 1: Private Sector GDP Growth Has Been Solid

In addition, we believe the rate of growth in the private sector has the potential to accelerate. Consumers are well positioned to increase spending after reducing debt and building net worth back to record levels during the past five years. Meanwhile, corporations have been very cautious with their investment spending despite generating record profits and free cash flow. With the economy starting to gain more traction and capacity utilization getting tight, we believe corporations will have the cash, confidence, and

59 Racine Street, Suite A, Menasha, WI 54952 fax: (920) 729-7904 website: www.northstarinvestments.com

necessity to increase their investment in employees, equipment, and facilities. This should add an element to economic growth that has been missing from the recovery during the past five years. The Sooner the Fed Raises Rates, the Better The Federal Reserve has been extremely stimulative with its monetary policy since the recession started in 2008. However, this has had a limited impact on the economy due to the reduction in bank lending from 2008-2013. (The banking system is the conduit through which the Fed injects money into the economy.) This is starting to change as lending has finally exceeded the peak level reached before the recession and continues to grow rapidly. We do not believe that it is just a coincidence that the economy has strengthened as bank lending has surpassed previous record levels. Considering the strengthening economy, tightening labor market conditions, rebounding wages, and higher capacity utilization rates, the Federal Reserve will need to start increasing short-term interest rates in 2015 or it will face the risks of overheating the economy and increasing inflation in the years ahead. While some investors are concerned that rising interest rates could act as a damper on stock valuations, we believe that the Fed’s very gradual approach to raising rates will result in a relatively accommodative monetary policy during the next few years (See Chart 2). Therefore, the process of normalizing interest rates should have a minimal impact on the economy and the stock market. In fact, with economic growth strengthening, corporate profits should continue their ascent, helping to drive stock prices higher. Chart 2: Real Interest Rates to Remain Accommodative

interest rates lower in efforts to jumpstart their economies. However, as the Fed moves closer to starting the gradual normalization of its extremely accommodative monetary policy and as the U.S. economy continues to strengthen, we expect interest rates to move higher. We continue to recommend a more defensive bond strategy with relatively low durations until this normalization process has been completed. Significant Divergence in Equity Returns Despite the strengthening U.S. economy, the broader equity markets weakened in the third quarter as fears surrounding the wind down of the Fed’s bond buying program, Russia’s incursion into Ukraine, the rise of ISIS in Iraq and Syria, and the threat of the Ebola virus resulted in negative returns from small capitalization and foreign equities. Although large capitalization stocks, represented by the S&P 500 Index, moved slightly higher during the third quarter (+1.1% return) and are up +8.3% through the first nine months of the year, most other equity markets declined, creating significant divergence in investment returns. Foreign (MSCI EAFE) and small capitalization (Russell 2000) stocks fared far worse than the S&P 500 during the quarter with negative returns of -5.8% and -7.4% respectively. In addition, their year-to-date returns have also lagged, with international equities down -0.8% and small cap companies down -4.4%. With the underlying strength of the U.S. economy becoming more apparent and with corporate profits poised to continue to grow from record levels, stocks appear reasonably valued, trading in-line with the long-term average of 15.5x forward earnings. We continue to recommend investors maintain equity ratios near the middle of one’s targeted range. The Emerging Markets Offer Attractive Relative Value The emerging markets represent attractive value relative to their more developed country peers. With a rapidly expanding middle class poised to drive economic growth at a rate 2-3x faster than that of the developed markets and with emerging market stocks currently trading at a 10.4x multiple to forward earnings compared to around 13.7x for the developed foreign markets and 15.5x for the S&P 500, we believe that investing a portion of one’s portfolio in this asset class will add incremental return over the long-term.

Through the first three quarters of the year, the yield on the 10-year U.S. Treasury Bond declined by 53 basis points to 2.50%. We attribute this decline to increased demand for U.S. debt as European countries and Japan continue to push

phone: (920) 729-7900

In accordance with SEC Rule 204-3(b), our Form ADV is available upon request. Please call or write to Susan C. Beaver, North Star Asset Management, Inc, 59 Racine St., Suite A, Menasha, WI 54952.

59 Racine Street, Suite A, Menasha, WI 54952 fax: (920) 729-7904 website: www.northstarinvestments.com

phone: (920) 729-7900

59 Racine Street, Suite A, Menasha, WI 54952 fax: (920) 729-7904 website: www.northstarinvestments.com