Overall, the stock market outlook remains volatile, while the bond market outlook could be on the verge of a tantrum. Here’s where to find some comfort food for the soul—and your portfolio. John Stephenson is a portfolio manager and president and CEO of Stephenson & Company Capital Management Inc. in Toronto. Worried about what that comfort food might do to your waist? Mr. Stephenson says it might also do the same for your portfolio’s strategic investment objectives.
Global stock markets have struggled recently with American stocks dropping to a two-month low, led by technology shares. Meanwhile U.S. Treasuries have rallied. But it’s the bond market where the real action has been lately.
Last month, former U.S. Federal Reserve chairman Alan Greenspan predicted that a re-run of the 2013 “taper tantrum” was inevitable. He was referring to the market outlook’s reaction to the Fed’s announcement that it intended to gradually start winding down its “quantitative easing” program at some point. That’s the program under which the Fed had been buying tens of billions of dollars worth of bonds each month. Although this was widely expected, skittish bondholders dumped their holdings on the market, pushing bond prices down (and yields up). At the same time, “risk assets”, such as emerging markets stocks fell on the assumption that there would be less capital available.
Bond market outlook is a roller-coaster
Those events took place two years ago, but you can see why Mr. Greenspan is concerned that the market outlook could be for another tantrum. Bond markets in particular have been anything but boring lately, with a European rout spreading to the U.S. in May. Meanwhile, expectations for when “lift-off” (i.e., a return to rising interest rates) will happen continue to be pushed out. Yields on German bonds, or “Bunds”, have enjoyed a spectacular reverse, giving up five months of gains in a matter of days.
Yields on German Bunds had moved in lockstep with U.S. Treasuries until late in 2012, when Bund yields started to dip lower, pulling U.S. yields down with them. With the European economy slowing and fears of deflation running rampant, investors forced the yields on Bunds into negative territory earlier this year as they surmised that the European Central Bank would not act aggressively enough to stave off deflation. But with Europe’s central bank unveiling a full-blown quantitative easing program of its own, investors decided the deflation scare was over and yields shot back up.
Remember: As yields rise, prices fall
A turn in the dollar, a sharp reversal in German bonds and the market outlook expecting that the Fed will begin raising interest rates later this year have challenged the Treasury market over the past month. The yield on the 10-year note has risen to 2.14 per cent from 1.89 per cent in that time. If the job market outlook continues to improve and inflation readings start to firm up later this year—in line with what economists are forecasting—yields could go higher still.
Uncharted territory ahead
Many economists are convinced the U.S. central bank has the ability to keep the Fed funds rate under control. But this will be the most experimental rate rise in modern history and the side effects are unknowable. One primary area of concern is retail investors who are probably unprepared for losses on supposedly safe fixed income. They are likely to yank money out of funds that will then be forced to dump holdings in already illiquid bond markets, thereby creating a negative feedback loop.
U.S. Treasuries: Wild gyrations, low volumes
The U.S. Treasury market has gyrated wildly on modest volumes in the last few weeks and some doomsayers fear a wave of selling could overwhelm the much more illiquid corporate bond market. The challenge for policymakers is to manage a “Goldilocks” rate rise: just enough turbulence to wipe froth out of financial markets and restore some sobriety to asset prices, but not a full-blown crash that could derail the economic recovery.
Time for dinner?
As for the stock market outlook, an area that remains an investor favourite has been the restaurant sector; shares in this industry have soared recently. Higher disposable incomes from lower gas prices and an increasingly robust economic backdrop are providing meaningful tailwinds to the sector.
The market share of the top 500 chains in the U.S. is now 60 per cent of all dollars spent in restaurants and has increased a total of six per cent in the past decade alone. In part, this represents consumer preference for a consistent offering. Large restaurant chains also have the scale to reduce costs across their network, a significant advantage.
Restaurants, and particularly successful restaurants, generate a lot of cash. In the current environment, with these levels of cash generation, restaurants can fund organic growth at the speed they desire while still retaining enough surplus cash to engage in large-scale capital expenditures.
The market outlook for restaurants isn’t all rosy, though, with restaurants reporting tightening labour markets as a source of cost pressure. South of the border, some 26 states are planning to raise the minimum wages over the next two years. As well, the U.S. dollar has been appreciating lately, which is acting as a headwind for many restaurant chains that have large overseas exposure, such as McDonald’s Corp., Starbucks Corp. and Yum! Brands, Inc. (KFC, Pizza Hut, Taco Bell).
But with the restaurant sector trading at a forward price to earnings multiple of 26.5 times—a decade high—finding value is becoming increasingly difficult for investors. However, these high restaurant valuations can be explained in part by the spectacular growth in the overall industry, which has grown at twice the rate of retail sales in the U.S.
What I Recommend
The strong economic environment in the United States is translating into strong restaurant sales. Falling unemployment and lower gas prices, coupled with rising wages, particularly among those with lower incomes, encourages increased discretionary spending directed towards eating out.
Dunkin’ Brands: Record margins and profits, a new loyalty program
One stock I really like is Dunkin’ Brands Group, Inc. (Nasdaq─DNKN), which is a franchisor of quick service restaurants that serve hot and cold coffee and baked goods, as well as ice cream. It franchises restaurants under its Dunkin’ Donuts and Baskin-Robbins brands. The company has 19,000 retail outlets worldwide. Dunkin’s franchise profits and margins hit all-time highs in 2014. As well, it is in the early stages of rolling out a loyalty program that should help drive traffic and profit in the years ahead. I have a buy recommendation on the stock and a 12-month target price of $64.
Panera Bread: Laying the groundwork for above-average earnings growth
Another restaurant stock I like is Panera Bread Company (Nasdaq─PNRA), a national bakery-café concept with 1,880 company-owned and franchise-operated bakery-cafés in 45 states, the District of Columbia and Ontario. It operates under two banners: Panera Bread and Saint Louis Bread. The company also owns fresh dough facilities that deliver dough and other produce to the café system. It offers breakfast, lunch, snacking, dinner, and take-home options through both on-premise sales and off-premise catering.
I believe that Panera could see an above-average earnings trajectory in coming years as recent margin investments bear fruit. I have a buy recommendation on the stock and a 12-month target price on the shares of $226.
Chipotle Mexican Grill: Best combination of growth, individual store returns in U.S.
One stock that is right in the sweet spot in terms of consumer trends is Chipotle Mexican Grill Inc. (NYSE─CMG), whose restaurants serve a menu of burritos, tacos, burrito bowls (a burrito without the tortilla) and salads. It operates roughly 1,784 restaurants throughout the United States, Canada, England, France and Germany. The company also owns two other concepts: ShopHouse (an Asian-themed chain with a layout similar to Chipotle) and Pizzeria Locale (a specialty pizza chain).
Chipotle offers the best combination of growth and store-level returns in the U.S. restaurant industry. Its stock market outlook is for a continuation of a healthy growth rate even 10 years in the future given the penetration opportunity for the core concept, as well as contributions from new concepts. I have a buy recommendation on the stock and a 12-month target price on the shares of $770.
Bond market outlook is for turbulence rooted in reviving economy
The economy’s weakness in the first quarter is widely seen as transitory; not many people expect an economic downturn anytime soon. Indeed, the reason the U.S. Federal Reserve is looking to start raising interest rates later this year is that it believes the economy has reached the point at which rates can rise without damaging it. In other words, the economy is getting stronger.
So the latest turbulence in the bond market outlook has been driven, at least partly, by better economic growth, which should be good news for the stock market outlook. Bond prices plunge if investors fear stronger economies will push inflation higher, but that same improvement in economic activity boosts corporate earnings.
Comfort food for a time of transition
I for one remain convinced that while the eventual transition to higher interest rates in the United States may indeed be rocky, investors’ best long term investment strategy is to buy high quality U.S. stocks, such as the restaurant stocks noted above, on any pullback.
The MoneyLetter, MPL Communications Inc.
133 Richmond St. W., Toronto, On, M5H 3M8, 1-800-804-8846