Spaghetti Westerns and the Economy

We hope everyone is enjoying their Summer.  It always seems to go by so quickly.  But lucky for us there is never a dull moment, financially speaking.  This month we will borrow a well-known movie title from spaghetti-western director Sergio Leone to break down recent economic and political events.  Without further ado, we present the good, the bad and the ugly.

Let’s start with the Good.  As we have continued to write for most of the year, the economic fundamentals have been the star of the show.  One example is employment data. One of the more interesting employment reports looks at both the number of people quitting their job and those being laid off, known as the JOLTS report.  This report shows that the number of people quitting their jobs is at record highs while the number being laid off is at record lows.  This shows that workers have the upper hand and are finding better opportunities.  This is a sign of health for the economy that is supported by strong consumer spending.  But at the same time, it is a perfect set-up for wage inflation.  However, we have not yet seen significant increases in wage, and opinions differ on whether we will.  We talked last month about the “technology effect” as one possible explanation for why it hasn’t appeared.  Another possible reason borne out in employment reports is that younger, less expensive workers are replacing the more expensive retiring boomers.

Continuing to focus on the good, we have several additional positives.  Consumer sentiment continues to show relative strength.  Leading economic indicators hit new highs, driven by new manufacturing orders.  We continue to see the impact of the tax cuts and spending increases as company earnings continue to impress.  And finally, we are seeing a very high level of merger and acquisition (or M&A) activity.  To date we have seen 700 transactions worth an estimated $917 billion.  This also points strongly to the positive economic backdrop and outlook as M&A is very sensitive to economic conditions and market volatility. 

The Bad.  While wage inflation, thus far, is in check, we are seeing increases in most broader measures of inflation to normal levels. The Federal Reserve’s preferred measure of inflation recently hit 2%, its target level. This suggests the Federal Reserve will stay on its course of raising rates this year to keep underlying pressures from pushing it up to unacceptable levels.

With trade tensions at the top of the news cycle, it is understandable that consumer sentiment readings, while still at strong levels, have recently experienced a decline.  There appears to be no end of opinions on what should be done about levelling the playing field for countries trading goods and services.  One effect of these tensions is that China seems to be shifting its agricultural purchases from the US to Brazil.  If trade tensions do nothing else, they are certain to redirect global trade flows.

And now for the Ugly: mid-term elections.  It is anyone’s guess as to what the next several months of campaign and news stories from our nation’s capital will bring.  It is clear that President Trump is continuing to focus on trade and immigration.  This has been extremely polarizing and is having a negative impact on markets.  The House, Senate and media outlets will all look to capitalize on any information or position that is believed to benefit their own agenda.  If the last election cycle was any indication, it is anybody’s guess as to what is in store.  Mark Hulbert from MarketWatch points out, however, that since 1957 returns for the S&P 500 Index have averaged 12% during the 6 months following the mid-term elections.

So, there you have our version of the good, the bad and the ugly.  We can’t overstate enough that we are generally positive in our economic outlook.  We do, however, recognize that there are forces that could derail the recent positive market performance.  Inflation, trade and consumer sentiment are all important factors whose fates are intricately linked, much like the iconic trio in Mr. Leone’s classic 1966 movie.   We are looking for the Good to win out in the end.

News or Noise? How do you tell the difference?

Hard to believe that we are nearly half way through 2018.  School is out, and most people’s thoughts are on a well-earned vacation.  Catchy summertime songs fill our heads with thoughts of simple, care-free days.  Then, as providence would have it, a few well-placed, albeit ill-timed news stories hit to bring us crashing back to reality.  As we wrote last month, investors still seem to be in search of the “other shoe”, waiting anxiously for it to drop.  The latest culprit of market volatility appears to be Italy.  With its new government now in place, Italy has begun to talk of tax reform, deportation of illegal immigrants, and exiting the European Union.  Think Greece from a few years ago, only Italy is the 3rd largest economy in the EU, and as we all know, Italians are far better dressers.  Equity markets wavered around the Memorial Day holiday, as markets digested the potential effects of an Italian exit from the EU, but since then US equities have resumed their recent upward trend.

Here at home, trade negotiations and tariffs continue to dominate the headlines.  China appears to be the main target, although Mexico, Canada and the EU are also feeling the pressure.  All parties involved have threated retaliatory sanctions in kind, which has certainly kept investors busy trying to determine the consequences.

So, are the “Tariff Talks” news or noise?  Are these simply negotiation tactics between the global government heavy-weights that are being played out through the media?  Only time will tell.  We certainly see markets react to the news of the day, especially if the news is negative.  For the year there have been more outflows from equity funds than inflows, as investor are trying to stay ahead of any significant downturn.  But recent downward moves, while troublesome, continue to be short lived and have usually reversed in short order.  

Regardless of whether it is news or noise, it is hard to overlook that the economics continue to be largely positive.   Employment data is robust.  Consumer confidence is near a 17 ½ year high.  Corporate earnings are good with positive outlooks.  Both the retail and technology sectors have been strong performers.  At the time of this writing, the NASDAQ was to an all-time high.  Only housing starts have appeared to slow.  We believe this data continues to support our narrative of a US economy on very sound footing, which bodes well for equities. 

On the bond front, the spike in interest rates, or yields, we saw earlier has reversed for now.  At the time of this writing, the yield on the 10-year government bond is once again below 2.95%.  More importantly, inflation continues to remain quiet.  In recent Notes we have mentioned the return of newly inspired job seekers to the labor market as one possible reason for this absence of inflation, since they help keep wage growth down.  Another possible reason could be something referred to as the “technology effect”.  This is the idea that technology is improving efficiencies at such a pace that costs to the end user are not rising.  Not only are companies doing more with less, but they are also delivering the goods to the end user with little to no change in cost.  This gap between cost savings from technology and what the consumer pays provides an inflationary buffer. 

Looking at the data, we continue to believe that the positives are outweighing the negatives.  And as a result, we continue to maintain our globally diversified allocations keeping our clients invested.  There is no denying that news, especially in the geopolitical realm, has an impact on markets.  It does appear that patience has been rewarded recently over immediate reaction.  Perhaps as summer gets into full swing, economic events may find themselves in a lull, allowing everyone to take a breather.   As the Italians say, “Nulla Nuova, Buona Nuova.” Translated, “No news is good news.”  But we are not counting on it.

A Head Scratcher

Once again, we are scratching our heads as we observe the financial markets as 1st quarter earnings roll in.  Over 75% of the companies that have reported earnings at the time of this writing have significantly beat their estimates.  ISM numbers are well above 50 (indications of economic expansion).  Housing is solid.  These are usually all good things for the stock market.  However, the year-to-date return through April for the S&P 500® Index was slightly negative.  What is driving stocks?  Is it economics? Is it policies and politics?  What are markets telling us?  This conundrum reminded us of a quote from Robert McCloskey, a writer and illustrator of children’s books from the 40’s and 50’s.  The quote goes, "I know that you believe you understand what you think I said, but I'm not sure you realize that what you heard is not what I meant."  We think that just about sums it up.

Outside of the excellent earnings reports, there seems to exist a preponderance of items that are having a negative impact on markets.  Continued concerns over employment, labor markets, inflation data, Fed rate hikes, oil prices, geopolitics, just to name a few, are definitely outweighing the earnings and global growth data that drove markets to new highs earlier this year.  Through the first few days of May, both stock and bond returns were negative, with the brunt of the decline actually being felt in the bond market.

Yes, market volatility has returned.  The combination of one of the longest bull markets on record and some “interesting” global and political developments has many investors looking for the proverbial “other shoe” to drop.  One possible “shoe” could be higher gas prices.  We are beginning to feel the effects of higher gas prices at the pump, making consumers feel a little less optimistic.  We have written in the past about the importance of consumers and their pocket books for market performance.  Oil and gasoline prices have increased on concerns of economic sanctions levied on Iran and problems in Venezuela.  But we believe that the US and Russia will increase production at these higher prices, which will help offset the effects of these geopolitical issues.  This will effectively keep prices capped. 

Is it possible for markets to experience a near term correction, similar to February?  Sure, it’s possible.  We are after all moving into the seasonal summer period when history suggests corrections are more likely to occur.  While we introduced several potential causes of concern in the second paragraph above, we think negative surprises are more likely to come out of the political arena.  While sanctions and trade talks have been in the news long enough for markets to price in some level of probability, overly aggressive or protectionist policies would have a negative impact on global growth and could ultimately hurt stocks further.  And with mid-term elections on the horizon, it is anybody’s guess as to what other “issues” may arise.

We are not trying to portray all doom and gloom or suggest that a recession is looming. Quite the contrary.  The economy appears in good shape with corporate investment in equipment in an uptrend, consumer and business confidence remaining high, and the unemployment rate (3.9%) at an 18-year low.  While such strength has caused concern about the rate of inflation and the Fed’s ability to keep it under control, measures of wage inflation suggest there is still slack in the labor market.  One measure of wage inflation suggests we still could be years away from peak employment.  This should give the Fed room to continue raising rates at a measured pace and keep any negative market surprises to a minimum.  Our own indicators have yet to give us a cautionary signal on equity markets, and long term technical indicators (think trends) are still positive, despite the recent correction. More importantly, underlying conditions in the equity markets of supply and demand have been steadily improving since this correction began in February.  All of this suggests continued support for equities moving forward.

A "Town Hall" recap

Recently, we held our first “Town Hall” event where folks had the opportunity to ask questions about current market conditions and recent geopolitical events. In light of recent market declines, the return of volatility, talks of trade tariffs, Federal Reserve and inflation concerns— we thought that having an opportunity for an open and straight forward discussion between clients and friends was not a bad idea.  Even though these topics are multi layered and complex and, dare we say boring, we did our very best to keep it entertaining.  We were somewhere between a reputable business publication and a game show.  The turnout was great, and, more importantly, some very thoughtful questions were asked.  It was fun for us as well, and it was not the last time for us to do an event like this.

After some opening remarks, we began with the idea that investing is about more than just risk and return—it is about understanding what you, the investor, are trying to accomplish…your objectives, if you will. With clear objectives, a plan can be developed to reach those objectives.  One part of that plan is determining how the assets should be invested, which includes a consideration of your tolerance for risk and need for return.  There is no “one” right way to invest, since investing is ultimately a deeply personal journey.  But having a skilled advisory team to take that journey with you is typically a good thing.  And at Stone Bridge, our investment process combines a global portfolio of diverse assets with the use of our “financial risk” indicator to actively manage our clients’ exposure to stock market risk.  In spite of the recent downtown in stocks, our indicator has so far kept us in our core allocations.

As we opened the floor to questions, the first one was simply, “What caused the recent market correction?”  We summed it up this way: on January 26th the markets hit all-time highs on the back of continued positive global growth and controlled inflation.  Markets were then surprised by a jump in domestic wage growth, sparking concerns that inflation might surprise markets as well. The back-story is that unemployment has finally come back down to normal levels, and it continues to move lower.  As fewer people are looking for jobs, employers are forced to raise wages, which ultimately creates inflation pressures. This is not a bad thing, because it means the economy is growing, people have jobs, and their standard of living is rising! This is what the Fed has been waiting for. The bond market responded, as one would expect, with higher rates in order to compensate for the effect of potentially higher inflation.  And the Fed itself has already said it intends to raise rates this year and next in sync with its inflation projections, so this just confirms what it has been saying.

Getting back to the current correction, the market responded to the surprise in wage growth with fear that rate hikes by the Fed might come even quicker than previously expected, and as stocks and bonds began to pull back, stock market volatility jumped from very low levels. Now add to that the President’s “tweets” of tariffs against our major trading partners—tweets that threaten the global growth story about which we have recently reported—and you have the recipe for a market correction.  While we expect interest rates and geopolitical risk (such as tariffs and other threats to trade and global productivity) to continue to dominate the market cycle for the foreseeable future, we don’t see any sign of recession in the near term. 

One participant asked for our opinion on “crypto currencies”, like Bitcoin.  Crypto currencies are still a bit of a mystery to us.  We believe the jury is still out on whether they can fulfill their role as a currency. One such role is to be a store of value, which suggests some stability in price or value. Crypto currencies have recently experienced wild swings in valuation and even claims of fraud. We believe that both of these things mean government regulations are coming soon for the crypto world. Another role is to act as a means of payment, which is still very limited. We are definitely taking a wait and see approach on “crypto currencies” but recognize that the technology behind them is likely to find a purpose, whether currency related or not.

We certainly covered a lot in our first “Town Hall” event with many smart questions by our clients and friends.  Hopefully, we provided a little clarity into, or at least some educated guesses about current market conditions. More importantly, we highlighted the importance of having a plan and a process around one’s investment goals.  See you at the next event!

A "Tale" Part 2

Last month we wrote about the best and worst of times, taking liberties with Dickens’ masterwork, A Tale of Two Cities.  Fast forward one month, and we find ourselves taking liberties again with Dickens’ work.  Although this time the opening line might read, “it was the worst of times, no wait, it was the best of times, or at least it is back to ‘business as usual’.”  Here is what we mean.  At the beginning of February, markets were very concerned about inflation, tariffs and trade wars, volatility and political turmoil.  All bad things.  But by the end of February and first few days of March, the economic sentiment and equity sell off had reversed course.  We had a strong market rebound, excellent employment numbers, subdued inflation data and potential historical developments on the geopolitical front. All good things.

After plunging by over 9% in early February, US equity markets strongly rebounded +8% from mid-February to present.  Early inflation fears have been replaced by strong job growth that is having little impact on wage and inflation indicators.  Former Federal Reserve Chair Janet Yellen often argued that wages won’t shoot up because there are still plenty of folks who haven’t been working or looking for jobs but are getting back into the work force because of the abundance of opportunities.  This is important because rising wages are typically one of the key drivers of inflation and potential threats to economic growth going forward. 

Other major threats to economic growth are protectionist US trade policies. In mid-February the Trump administration began discussing ideas for protecting US steel and aluminum manufacturers. You can’t get much more protectionist than that. President Trump then announced his idea for broad sanctions on the first of March. The countries that would be hit the hardest were Canada, Mexico, and the European Union.  China was not on that list because most of its steel exports to the US are already subject to sanctions.  The announcement was criticized by many experts and was met with extreme negative sentiment in the markets.  Gary Cohn, the President’s chief economic advisor and director of the National Economic Council, disagreed so strongly with the plans that he resigned from his position. Several countries reacted with threats of counter sanctions on exported US goods.  Early March certainly had the look of a trade war in the making.  But as the dust settled, a more tailored approach landed on Trump’s desk and he signed an executive order that provided loopholes for certain countries.  Both Canada and Mexico were specifically mentioned as excluded from the tariffs with the understanding that future negotiations over NAFTA would address this topic.  Equity markets responded very favorably to these developments.

The final and most unexpected favorable bit of news might have been inspired by the Olympic games recently held in PyeongChang, South Korea.  It was the first time since the 1950’s that leaders from North and South Korea were able / willing to meet.  There was a healthy skepticism, however, toward North Korea’s true intentions and many thought this Korean show of unity was mainly for the cameras, especially after all the harsh language and military posturing between the US and North Korea.  Perhaps it was more than just a show.  It would seem that there is a willingness between the two Koreas and the US to at least discuss the North’s denuclearization.  A letter delivered in early March to President Trump by South Korean diplomats expressed Kim Jong-un’s (North Korea’s Supreme Leader) desire to meet with Trump specifically to discuss the North’s nuclear weapons program.  This meeting is tentatively set for May and could provide significant geopolitical stability for the region. 

Whether it is the best, the worst, or perhaps just the most ordinary of times, we are not quite ready to put this bull market out to pasture.  We still believe the majority of the economic data coming out is more positive than negative.  We are also very interested in seeing the impact of the tax reforms on 1st quarter corporate earnings.  Inflation and global growth remain the keys to both market sentiment and direction.   Inflation at the present appears to be subdued.  Impacts on global growth will require our full attention as trade policies and reforms continue to develop.   

A Tale of Two Perspectives

“It was the best of times, it was the worst of times”, wrote Charles Dickens as the opening words of his historical novel “A Tale of Two Cities”. Using his characters and historical events, Dickens examines the contrast of good and bad, and weaves in a specific story line of redemption in the midst of rebellion. We believe the current economic and investment environment reflects a similar story of disruption and redemption. We begin our tale at the start of the new year, with stock markets on a tear and without so much as a hint of a correction.  Here in the US, unemployment is at or near decade lows, GDP is improving, and we are seeing a slight uptick in wages. All good things. As a matter of fact, things are looking solid enough that President Trump made an appearance at a gathering of international business and political leaders in Davos, Switzerland, to promote America as an attractive destination for foreign investment. The sighting of a sitting US President in Davos is a rare thing.  (The last sitting President to appear at Davos was President Bill Clinton.)  And somewhere along the way an interesting thing happened. 

Disruption:  Secretary of the Treasury Steve Mnuchin, who accompanied President Trump to Davos, was quoted as saying that America was not concerned about the recent decline in the value of the dollar.  The dollar had already declined 10% in 2017 and was down an additional 2% for the month of January.  That seemed like a pretty innocent statement, right?  What’s the harm of a weak dollar?  Well that depends on what side of the dollar your interests lie.  A weak dollar gives US companies cost advantages as they sell their products in other countries. For example, a European consumer would see prices for American products fall in Euro-terms.  And foreign companies find that their goods become more expensive in the US as their currencies strengthen against the weak dollar, helping American companies that compete against them.  Essentially, the weak dollar acts like a tariff or tax to our trading partners. 

Mnuchin’s comment sent shock waves throughout markets as it increased concerns that the Trump administration would pursue protectionist policies through a weak dollar and that this could damage the recent improvements we have seen in global growth.  Not long after this comment, Mr. Mnuchin had the opportunity to walk back his statement and ease the fears of the investing public.  Unfortunately, it was to no avail. Now add to that the market’s new-found inflation concerns. Recently reported wage increases raised fears that the Federal Reserve and its new Chairman Jay Powell may have to raise rates faster than previously thought. The combination of these things generated a giant spike in market volatility, and over the next 15 days equity markets fell nearly 10%.  This all came off the heels of a very strong start that found markets up over 6.5%.  Fears over inflation, concerns about volatility, and US global policies sent the markets tumbling.  But, had anything really changed? 

Redemption: In our view this is not all bad. The Federal Reserve has been trying to generate inflation since the Financial Crisis, and yet it still sits below the Fed’s target almost 10 years later. The recent wage data suggests some success in that effort, and growing wage income is generally seen as a positive in that it helps stimulate the economy. An important driver of the wage data is the rebound in the global economy that began in the summer of 2016, which has also helped bring down the dollar’s value. And we have not even mentioned the economic tailwind created by recent corporate tax cuts and the potential for US global companies to bring home profits held abroad.

Inflation is certainly something we have been talking about for a while. Investors’ fear of inflation might be early, but the fear is not misplaced. Inflation leads to higher interest rates, and higher interest rates lead to recessions. But we think we are a long way from a rate-induced recession. We believe that renewed fears of rising inflation are disrupting the status quo, and with that disruption comes opportunity. And in our “Tale of Two Cities” we still look for the redemption of the markets.  We still believe that the tailwinds of global growth, and the aforementioned stimuli will support equity markets over the next few quarters.  And the bumps along the way will provide the opportunity to move from the “winter of despair” to the “spring of hope”.

The Road Goes on Forever

The start to 2018 means one thing for us—prediction time is here.  Once again, we are excited about the opportunity to completely whiff (note the humor!) on several themes we believe may play out over the course of the 2018 investment year.  As many of you know, this is an annual “event” for us at Stone Bridge, and we do love our traditions.

Let’s recap our three predictions from 2017:  1) US equity markets break the trend of negative returns during the first year of a new US Presidential Term and finish positive.  Massive understatement with this one.  Markets hit all-time highs, market volatility hit and remains near historical lows, and this is the longest period in the history of markets without so much as a 3% correction.  2)  Emerging market stocks have solid performance.  This was another understatement. EM stocks were one of the top performing asset classes for 2017.  3)  The Federal Reserve raises rates twice in 2017.  We missed this one.  Global synchronous growth gave the Fed confidence to push rates higher three separate times in 2017.   It seems that while we were very positive for the 2017 investment climate, we did not anticipate or even consider the possibility of historical returns. 

So, as we cruise on down the economic highway with 2017 in the rearview mirror we can faintly hear the lyrics of Robert Earl Keen’s song drifting from the radio, “…the road goes on forever and the party never ends.”  If the first few trading days of 2018 have anything to say about how 2018 turns out, they would want us to believe that the party is still going strong. 

Here are our predictions for 2018:

1)    Continued market strength for Q1 and Q2 fueled by synchronous global growth, accommodative monetary policy from Japan and Europe, and strong US corporate earnings benefitting from both global growth and the newly minted tax reform.  Only the threat of wage inflation and an inverted yield curve sometime near the 3rd quarter will give the market a reason for concern (and we stress threat, not actual occurrence).  We think this might be cause for a pullback in the second half of the year, but not a recession.

2)    Geopolitical risks shift from North Korea and missile testing to trade reform and NAFTA negotiations, Brexit issues and Syrian and Libyan refugees in Western Europe.  These are potentially the real risks to the continuation of the global economic growth story in 2018.  On the home front our mid-term elections will also do their fair share to contribute to mid-year market volatility. 

3)    The Fed says three interest rate moves and we finally take it at its word.  We don’t expect any shift in current Fed policies as Jay Powell takes over as Chairman from Janet Yellen.  With the markets continuing to push to higher highs, the Fed effectively has a free pass to continue on its path of measured interest rate hikes.  We will be looking for the Fed to announce 0.25% increases at the March and June meetings, followed by a pause during the Summer, and then for it to deliver one more 0.25% hike in December.  Powell and the other Fed governors will be keeping a close eye on the shape of the yield curve (as we discussed last month). 

4)    We all will know what a BITCOIN is by the end of 2018.  More importantly, we will begin to understand the value of blockchain.

We realize that we are a little more granular than previous guesstimates (combination of guess and estimates), but we do believe that conditions and sentiment warrant the details.  While we are currently enjoying the economic “drive” and want to stay on this “road” for as long as we can, we firmly have two hands on the steering wheel looking out for possible “pot holes”.  We continue to remain positive for many reasons.  The economic fundamentals are strong and market technical indicators are currently pointing to positive territory.  However, most investors are not asking what areas of opportunity are out there, but instead are asking the more conservative question of when this “party” will end.  Ironically, this is a bullish indicator.

2017 looks like one for the record books

With 2017 largely in the rear-view mirror, we can say that it has been a year of history in the making, putting it in the category of the mid-1960s and mid-1990s.  We continue to see “all-time” highs in equity markets (not unusual in bull markets), and we remain at or near historical lows for the volatility market.  In November, the S&P 500 Index broke its previous record for the number of days without a 3% pull-back (over one or multiple days). As for low volatility in terms of pullbacks, 2017 ranks with 1995, 1965, and 1964, according to brokerage firm LPL. 

These are very impressive results but also very unexpected. If you would have asked any market expert at the beginning of the year, few if any would have predicted this kind of market performance.  While the historical highs and lows are noteworthy, there are other developments which were widely “expected” at the beginning of the year. Global economic growth was in an upswing at the beginning of the year and was expected to continue through 2017. Confidence in Europe was confirmed as national elections rejected xenophobic candidates in favor of largely pro-European leaders. Brexit talks have proceeded in an up and down fashion, with both sides making declarations that contradict each other, and the thorniest issues being pushed off into the future. Some market observers feared that US trade policy under the Trump administration might turn protectionist and disrupt global growth, while others expected a variety of pro-growth policies to boost growth.  The closest we have come to seeing any major economic policy enacted is a Republic-supported plan to cut taxes, which may be passed in some form prior to this note reaching your hands. With a deal so close, the market is pricing in the positive impact on stock values, since large corporations would be among the biggest beneficiaries of this plan. With all these things considered, we still believe that equity markets are favorable, that bond markets are stable, and that any correction would represent more of a buying opportunity than much of a larger concern.

One issue that was thought to be a potential concern for markets was whether President Trump would reappoint Janet Yellen as the Federal Reserve’s Chairwoman. He chose to replace her with a colleague of hers from the Federal Reserve’s Board of Governors, Jerome “Jay” Powell. In the end, this announcement did not cause markets too much concern, as Powell has voted in agreement with Chair Yellen since his joining the Board in 2012 and is expected to follow the path she has laid out. As a former investment banker, he has supported the idea of giving banks more freedom in their investment decisions.

As we think about the future, one place to look is interest rates, especially the difference between 2-year lending rates and 10-year lending rates. This difference between short-term rates and longer-term rates is called a “yield curve”, because interest rates (or yields) tend to rise the farther into the future one looks, creating an upward rising curve. Looking at this curve can give us a glimpse of what investors in aggregate are expecting. And interestingly, at the time of this writing the curve is fairly flat, with the difference between the 2-year and 10-year US government bond yield being a mere 0.53%. This suggests that investors don’t expect much growth or inflation over the next 10 years. The problem with this measure currently is that central banks around the globe have “muddied the waters” by artificially pushing down long term rates. With that caveat in mind, we still pay attention to the yield curve, especially looking for an “inverted” curve where short-term rates are higher than long-term rates, making the curve “fall” instead of rise. We believe it would take some aggressive and very unexpected moves from the Fed and from inflation for the yield curve to invert.  It’s hard to see something like that happening any time soon.

We look toward the remainder of the year with optimism.  It will be interesting to see how the last month of 2017 plays out from the perspective of volatility.  As we stated previously, volatility is at an historical low.  Is there enough “stuff” out there to cause volatility to pick up and the markets to correct?  We are not sure.  We don’t necessarily believe that increases in market volatility will be a bad thing.  It just may be later in January that conditions for corrections and volatility become more apparent

The tax debate continues: House v Senate

Last month, with tongue firmly planted in cheek, we called for an “all aboard” onto the tax reform train.  We hope you read between the lines to understand that we felt any form of tax cut / reform would be no easy task in the current political environment.  After much publicized and often heated debate, we now have tax cut proposals from both (Republican controlled) chambers of Congress. Based on recent market and political reaction, our skepticism was and continues to remain warranted.  Let’s take a quick look at the two bills.

First, let’s recognize that reforming the tax code is politically difficult.  The House version attempts some level of reform by, among other things, eliminating most itemized deductions and popular expense deductions (such as those for medical expenses and student loan interest) and offsetting the impact with a higher standard deduction.  The Senate version also doubles the standard deduction, but leaves the expense deductions alone.  In another effort at reform, the House version reduces the number of tax brackets from 7 to 4, with the awkward result that some tax brackets see their tax rates rise. The Senate bill avoids raising anyone’s marginal rate, although they do leave a few the same.

As for the wealthiest taxpayers, even the House plan, which leaves their marginal rate unchanged, offers them the potential for lower tax payments.  We say “potential” because it can depend on other items as well, such as SALT!  Remember the discussion of “state and local taxes” from last month?  Despite the negative media coverage, both versions throw out the deductions for SALT, with the House’s version maintaining property tax deductions.  We still see the elimination of SALT deductions as a critical stumbling block to both plans.

Much to our relief, the bills leave the treatment of contributions to 401k plans and retirement accounts alone. Other issues that affect your investments include: no change to capital gains rates; the mortgage interest deduction stays, although the House version caps it to $500,000 of mortgage debt and limits it to the first home; and the estate tax exemption is doubled (the House plans to eliminate the estate tax itself after 2024). 

For businesses, the two main items are a proposed 20% corporate tax rate and a change to the treatment of offshore earnings.  For accumulated earnings already held in foreign subsidiaries, a one-time tax would be applied at a rate of between 5%-14%.  The House bill would implement the 20% tax rate next year, while the Senate bill would wait till 2019.

Economic commentary suggests the economic impact of the House bill would be limited.  This was reflected in the action of stock markets, which met the announcement of the House proposal with little change.  While stocks fell on the announcement of the Senate version, they simply went back to the levels they closed following the House announcement. Both versions reflect a $1.5 trillion tax cut over ten years, but the House version aims to be deficit neutral after the 10-year window.  Because it alone meets both these conditions (at the time of writing), only the House version can pass the Senate with a simple majority (meaning, with only Republican votes) using the budget reconciliation process. 

We at Stone Bridge continue to believe that the possibility of a tax cut is not the primary driver behind current market conditions, but that the primary drivers are corporate earnings and global demand.  We see both having continued strength.  As an example, 73% of companies reported 3rd quarter earnings better than expected.  We still believe that the biggest risk to equity markets is an unexpected increase in inflation.  With the long-term interest rate below 3% and using the yield curve as our guide, it appears that there is little evidence of inflation risk any time soon.

Tax Reform and lessons from Reagan

All aboard the Tax Reform express!  We are hearing quite a bit concerning tax reform, tax cuts, tax brackets and SALT (we explain this later).  This appears to be the last big push for the Trump administration to get a victory in 2017.  Some folks believe that there is a chance this reform could get done before the year end.  Hey, Reagan did it, right?  Oh, by the way, Reagan’s reform was accomplished with the help of a key Democratic senator, Ted Kennedy, and let’s not forget the small, often overlooked fact that Reagan won 49 states in his re-election campaign (come on, Minnesota!)  While we are not political analysts, we are pretty sure that the current political environment is not as favorable for President Trump.  If you need some evidence, just look at the recent war of words between our own Republican Senator from Tennessee, Bob Corker, and President Trump.

One of the key sticking points of the tax-reform debate—highlighted by Senator Corker—is whether the proposal increases the budget deficit (which would be labelled a “tax cut”) or is deficit neutral, meaning every dollar of tax cut is offset with a dollar of spending cut, so the budget deficit stays the same (which would earn the more acceptable label of “tax reform”).  Moving from tax cut to tax reform is where SALT comes in. Currently, tax payers can reduce their federal taxes by the amount of state and local taxes (or SALT) they owe.  Eliminating this deduction is one way to maintain a deficit neutral approach. In the Southeastern portion of Tennessee alone, roughly 20% of all tax filers claim the SALT deduction.  90% of those filers are households making less than $200,000 per year.  Eliminating the SALT deduction, as proposed in one version of the White House’s tax reform, may very-well increase taxes on the middle class.  Ouch, “tax reform” doesn’t sound so pleasant anymore, and as you can see, this can be as “politically” complicated as health care reform.

Then what is going on with stocks?  Isn’t all the recent positive activity in the market based on expectations for tax reform? Maybe not.  We believe that current market conditions have discounted much if not all policy reforms for the remainder of 2017.  If it’s not tax reform driving the market, then what is?  The continuing story of global growth is the dominant market driver (see our August “Notes”).  The recent catastrophic weather has depressed the most recent jobs data, but it is not missed on economists that new manufacturing and housing developments are needed to replace / rebuild the estimated 100,000 homes and 500,000 autos damaged by Harvey alone.  The US economy appears to be strong enough to handle the political discourse and economic data so much so that Janet Yellen and the Federal Reserve are widely expected to increase short term rates another 0.25% during their upcoming December meeting.  It is this vote of confidence from the Fed, not the idea of lower taxes, that continues to push stock markets to new highs.

When will the good times end?  What could derail the global stock market rally?  We believe that the primary culprit would be a large and unexpected uptick in inflation.  With unemployment in the low 4% range, history tells us that wages should be experiencing pressure to rise, giving us inflation.  While such pressures are not yet visible, we should note that this is what the Fed wants to happen, only they want it to occur gradually and not be a surprise to anyone. We believe that the current mix of employment, sentiment, and growth favors the equity market.  While market corrections are possible, we do not anticipate a recession anytime soon.  It is common to measure bull markets by their length, but they do not end because they’ve reached a certain age.  Another popular recession indicator is when short-term interest rates are higher than comparable long-term rates, ie. when the yield curve is inverted.  Looking at the current yield curve, it seems the Fed can raise rates several more times before the curve inverts (and that’s assuming that long-term rates don’t move up as well, which they often do).

If any tax reform is passed, we will be paying attention to its potential impact on inflation and interest rates.  In the meantime, we continue to stay the course with our portfolios. So, sit back and enjoy the slow, steady train ride that we believe should carry us through the final quarter of 2017.

What's been "going on" with Stone Bridge

We are taking a slight departure this month from our usual overview of the global markets and political “goings-on” to focus on a few specific items that will impact on our clients' portfolios.  So, let’s put global growth rates, tax reform, ballistic missile tests and such on hold for now and discuss some upcoming allocation alterations. 

If you are our client, you may have noticed an increase in your cash position lately.  This is not a function of some fear that we have reached a market top or that we feel a correction is imminent.  (While recognizing that September and October historically tend to be the weakest months for stock markets, we feel the market is suggesting strength rather than weakness for the rest of the year.)  Instead, it is simply due to two portfolio positions that many of our clients have been or are exposed to.  First, we have recently moved clients out of their exposure to reinsurance, and second, our volatility strategy is pointing to cash.  This combination is responsible for the bulk of the cash in many client portfolios.

Reinsurance has been getting a bit of attention in the wake of hurricanes Harvey and Irma. While exposure to reinsurance has been profitable over the past few years, events such as hurricanes can lead to losses.  Our clients avoided the losses inflicted by these two disasters, in what we refer to as a fortunate "act of God", as they were in cash well before Harvey made landfall.  It was not because we predicted a bad hurricane season. Our reasoning for our decision was two-fold: we have an opportunity to invest client portfolios in "real assets" (different from traditional real-estate), like timberland and farmland, and the timing of this new investment corresponded with a restructuring of the reinsurance portfolio that caused our exit.  We plan to give you more information on this new investment over the coming weeks.

As for our volatility strategy, our expectation is that it will remain in cash for the near term. Under ideal circumstances, where the equity market faces typical seasonal weakness in September and October, then rallies through the rest of the year, we would expect the strategy to enter a trade as the weakness turns into strength, offering the potential for upside through the end of 2017.  This assumes that the markets do not ignore seasonality and do something different from here on out. 

We are also excited about some changes to our core broader markets holdings.  For many of our clients, we will be using Globalt Investments (a firm out of Atlanta, Georgia) to provide market research and assistance with modeling portfolios.  In the past, we have used firms like Blackrock and Versus through their mutual fund offerings to provide active allocation and tactical portfolio rebalancing.  But, we are always looking to improve our process.  We believe the combination of Globalt's models and our volatility strategy will provide improved processes.  Our clients will be receiving more information on Globalt in the very near future. 

Our final change is coming from our planning side of the house.  Through a company called eMoney, we are introducing Stone Bridge Connect.  This is a budgeting and planning software/ tool that allows our clients to organize their financial lives and see all their accounts in one place or dashboard.  You can aggregate all of your investment holdings as well as mortgages, insurance, loans and credit cards, to name a few, so that you can get a complete picture of your financial health.  It can be used to run scenarios that help determine if a client is on track for specific long-term goals or it can drill all the way down to how much one spends on coffee a month.  For our clients, we will be sending a separate email that will provide you with your own link to Stone Bridge Connect at no cost to you.  Over time we hope your Connect portal will be the only place you go for all things pertaining to your financial life. 

As you can see, we have been busy this summer with our own brand of “goings-on”.  We are definitely excited about these portfolio changes and look forward to seeing how Stone Bridge Connect can work for you.

The Capital Hill Cafe, open 24/7

If you are watching the news on a regular basis, you are being fed a steady diet of all things political.  We have found ourselves at a never-ending media buffet with all flavors of concern such as healthcare, Russia, tax reform, immigration, debt ceiling, political firings, Korea, internal investigations, political appointments and on and on and on.  We can’t swear to it, but we believe a few of these items are gluten-free. 

Many of our clients are asking what negative impact Washington is having on the markets.  Just how much attention is Wall Street paying to the political uncertainty?  We believe that markets are paying about as much attention to politics as your teenage son or daughter pays to the advice you so lovingly provide.  That is to say, not much.  By and large, the markets are ignoring all shapes and sizes of political news, both the “minor inconvenience” and the “catastrophic calamity”.  We believe instead that markets are being driven by two things, corporate earnings and global growth.

It is very easy to get caught up in the emotion, hype, and “stress eat”, if you will, and ignore the financial information right in front of you. So, let’s take a break from the politics and look at some key factors that are contributing to the strong earnings and global growth picture. 

A recent Fidelity Investments economic update noted the following as having contributed to growth seen in both US and international stock markets: a synchronized global expansion, low inflation, extremely low market volatility and a weaker US dollar.  Despite what one might fear when listening to the news, global trade is at its highest level since 2011 and nearly 90% of countries are reporting higher export orders than a year ago.  European economies are experiencing growth as political risk eases, China’s economy is steady, and the US economy benefits from this global improvement.  The weaker US dollar has also contributed to corporate earnings growth for many global companies. 

On the home front, even after the Federal Reserve has raised short-term interest rates two times this year, long-term interest rates are lower now than where they began the year.  Both US stocks and bonds have performed well, apart from energy and telecom.  Strong corporate earnings and low inflation are providing a stable backdrop for the Fed to seriously discuss the unwinding of their balance sheet.  If you remember back to the financial crisis, “The balance sheets of the four-major advanced-economy central banks—the U.S. Federal Reserve (Fed), European Central Bank, Bank of Japan, and Bank of England—have more than quadrupled since the global financial crisis due to trillions of dollars of quantitative-easing asset purchases.”  That was then—central banks rapidly buying bonds.  This is now—central banks slowly getting rid of bonds. This “unwinding” will effectively tighten monetary policy, or take money out of the system.  We will have to pay close attention as this move by the Fed could increase market volatility.

So, despite the steady diet of political media reporting, it appears that financial markets are more focused on how companies and countries alike are showing continued growth.  With a low volatility environment, inflation in check and global demand at relatively high levels, we believe our clients are being rewarded for maintaining their current portfolio allocations. 

We realize that emotions do play a large part in one’s outlook and that it is easy to forget the basics while focusing on the sensational.  Washington will eventually get its act together.  In the meantime, earnings and global growth can be the two main ingredients that merit our attention, and the rest can be left to the politics of the day.

The Neverending Search for Value

For this month’s “Notes” we once again return to the heartland of Omaha, Nebraska, home of Mr. Warren Buffet.  We wanted to focus on a specific statement that Warren made when he was addressing his shareholders in his annual letter to shareholders.  This letter typically arrives a few weeks prior to the actual shareholder meeting in Omaha and serves as a guide for many of the questions.  This letter is usually scrutinized by public and press alike and often makes headlines.  This year’s letter was no exception.

In this year’s letter, Buffet argued that all investors, no matter their size, should invest in index funds.  This is commonly referred to as “passive investing”, because index funds do not try to outperform the index through stock-picking or any other investment approach, but “passively” hold the index.  This is significant in that Buffet and all the long-time Berkshire Hathaway investors made their fortune not from passive investing but from active investing.  This appears to be a major shift in Buffet’s investment philosophy.  As you might imagine, his advice was broadly covered by the financial media and used to villainize most financial professionals, to whom he referred as “Wall Streeters”. His basic assumption is that financial professionals almost guarantee “poor investment performance accompanied by high fees.”

During the annual meeting, Warren was asked to give some color to his statements about “Wall Streeters” and passive index investing.   As Buffet began to explain, it became quickly evident that the basis for the comments were his family’s unique situation: his family has more money than it could spend over multiple generations, giving his family an infinite time horizon and an ability to ride through stock-market ups and downs with ease.  This is not the case for most families.

Most families need their savings to enhance their retirement income and are afraid of outliving their money.  Unlike the Buffets, typical families face several basic limitations, among them: 1) the size of their investment portfolio, 2) their expected lifespan, and 3) their ability or desire to bear risk—all of which impact the “income” they can sustainably withdraw from their savings.  These limitations force them to balance competing objectives, which often include their desire to maximize returns, on the one hand, and their need to survive the ups and downs of their investment portfolio, on the other.  Most of us are very mindful of the impact a significant market downturn can have on our lifestyle.  That’s why many people turn to financial professionals for advice.

Unlike the typical family, the Buffets are able to ignore the limitations faced by others. With an income from their investment portfolio that far exceeds their lifestyle, they can afford to ignore the risk of an equity market crash, because it won’t impact their lifestyle or that of their heirs.  With this in mind, we understand why the solution, according to Mr. Buffet, is to buy a stock market index and never worry about the portfolio again.  Because he literally doesn’t have to.

And despite his apparent disdain for financial professionals, he has served as his family’s financial advisor, overseeing not only investment management, but also the planning of wealth transfer, philanthropic giving, tax minimization, etc., around the central issue of “what is the money for,” and we are certain he did so with the help of attorneys and accountants. For a normal family with financial limitations and competing objectives, this role would be filled by its trusted financial advisor.

Wouldn’t this make the case for Warren Buffet to encourage every family to identify and work with an advisor they trust to assist them in establishing and implementing a plan around the important question of “what is the money for”?  We believe so.

When Buffet was asked if he would have paid a management fee for the advice of his business partner, Charlie Munger, Buffet replied that he would gladly pays fees when they deliver such value as Charlie.  So, there are obviously situations that would warrant paying fees, and there is value that can be gained from paying for expert advice.  Here’s to our belief that Charlie, who is 93, is not the last financial professional who is worth paying for his advice. 

A Saturday with Warren and Charlie

As you know from last month’s notes, we recently traveled to Omaha, Nebraska to attend the Berkshire Hathaway annual meeting.  It was our first opportunity to sit in a very “intimate” setting with +20,000 of our new best friends and listen to Warren Buffet and Charlie Munger, two of the most legendary investors of our time. Buffet and Munger run the Berkshire Hathaway company, which as a “holding company” owns other companies, such as GEICO insurance, Dairy Queen, Clayton Homes, Shaw Industries, Helzberg Diamond, and See Candies, just to name a few.  Investing since the early 60’s, Buffet and Munger made names for themselves as value investors.  By actively identifying and buying well run companies at attractive prices, they have delivered significant long term value for their shareholders.  If an investor had bought Berkshire shares in 1965 when Buffet took over the company and held them through 2016, (s)he would have enjoyed compounded annual returns of 19% over those 52 years (almost twice the return of the S&P 500 over the same period).

Any reference to a specific security is for informational purposes only and is not an offer to buy or sell securities.  Past performance is not indicative of future results.

Now in their late 80’s and early 90’s, respectively, both Warren and Charlie offer answers to shareholders’ questions at each annual meeting. Running on a steady diet of coke (for Warren), diet coke (for Charlie), candy, and peanut brittle, the duo answers questions for roughly 8 hours with only a lunch break in between. One of the shareholders jokingly complimented them before the entire 20,000-person crowd on their seemingly iron bladders. 

The discussion covered everything from the investment process, the persistence of returns, the current investing environment, technology, energy, philanthropy, the Asian investing culture, succession planning, the widespread lack of planning, fees and more. Nothing seemed off limits.  There is so much worth sharing, that we decided to spread it over multiple Notes. Today we will touch on some of the highlights. 

When asked about what they look for in a company, both Warren and Charlie agreed that they seek out companies with a sustainable competitive advantage in their respective industries.  They also spoke of the importance of corporate culture. While some value investors prefer buying troubled companies at low prices—hoping that their stock prices will rebound as they work out their difficulties, Warren and Charlie warned of falling into the trap of trying to “fix” the “unfixable”.  This was a lesson learned early on by Buffet following his purchase of a controlling stake in a struggling textile mill known as…Berkshire Hathaway!  His investing success ultimately came from getting out of the textile business, rather than trying to “fix it”.  The lesson is that even for value investors, value is found in the quality of what’s being bought more than in the price being paid. 

Closely related to this is their advice that people should invest in what they understand.  During the 1990s, Buffet didn’t invest in tech companies because he didn’t understand them.  While he was roundly criticized in 1999 for missing the dot-com-boom, he was vindicated when he subsequently avoided the tech crash.  Munger might say that those chasing the dot-com stocks were trying to be brilliant, while he and Buffet were just being rational…investing the way they always had and in things they understood.  As Munger often says, “Fish where the fish are.”

In a more sobering moment Warren warned investors to have realistic expectations for the future returns of Berkshire Hathaway stock. Citing changes in the investing landscape such as the increase in both the availability of information and the competition for good deals, they warned investors to expect mid-single digit returns going forward.  “It used to be easy”, said Munger.  While Berkshire’s outperformance since 1965 is impressive, it’s return for the last 15 years (at just above 8%) has barely exceeded that of the S&P 500.  It is very telling that two extremely successful, long term, investors are trying to lower shareholder’s future expectations. 

So, where are the “fish”? What are our investment expectations?  What do we do with the money we have? These questions hit every investor every day, and they are as important to our individual clients as they are to firms like Berkshire Hathaway. As advisors, our goal is to help our clients answer these questions, to match the answers with an appropriate investment portfolio, and to pursue their goals with rationale rather than with brilliance.

Always the Optimist, for now

In the International Monetary Fund’s World Economic Update for April 2017, their version of our “Notes”, the IMF announced that “global activity is picking up with long awaited cyclical recovery in investment, manufacturing and trade,” and that global growth is expected to rise from 3.1% for 2016 to 3.5% for 2017.  Sounds great, right?  While optimism is high, there remains a “but” in the report: “significant structural impediments and a balance of risks [that are] tilted to the downside”.  The IMF is concerned about the individualistic approach global leaders are taking in addressing economic problems which the IMF describes as “common challenges in an integrated global economy.”  As we look at the current global scene, we had to agree (with a touch of humor) that nothing suggests a willingness to cooperate with neighbors on mutually beneficial solutions quite like building a wall, shooting off ballistic missiles, or exiting one’s regional economic union.  Global leaders around the world appear to have a slight more nationalistic view than the IMF’s recommended globalist view. Right or wrong, each world leader is optimistic about the his or her own position.

Economically speaking, optimism is measured by sentiment or “soft” data.  Answers to questions like, “How do you feel about … ?”, are collected from businesses and individuals to gauge if business leaders and consumers are feeling positive about their current or future situations.  And as previously discussed, the soft data jumped significantly following the election of President Trump.   Sentiment is very good and folks are optimistic that “things will improve”, but…there’s that word again…the “hard” data (numbers taken from the economy itself, like car sales, exports, new hires, etc.) is not quite keeping pace.  US GDP growth for the first quarter was less than stellar at about 0.7%.  This is the slowest growth number reported in the last 3 years.  Much of the blame falls on stalled growth in consumer spending and retail sales compared to the fourth quarter.  This divergence between the “hard” and “soft” data is raising questions.  If folks are feeling optimistic, shouldn’t their optimism show up in stronger retail and consumer numbers?

Since we are on the subject of numbers and hard data, we continue to see strong earnings from US companies.  These company-specific earnings reports, as well as the strong sentiment data, continue to support the stock market.  Geopolitical concerns, political policies and foreign elections seem to be having little impact on current market valuations.  The IMF’s warning of downside risk doesn’t appear to have impacted market participants. But it’s advice regarding global cooperation might have resonated with Secretary of State Rex Tillerson, who recently suggested that he is at least considering how US policies impact our global partners.

In a speech to State Department employees, Secretary Tillerson laid out President Trump’s “America First” foreign policy.  While he was clear in stating that America’s interest is in promoting our own national security and economic prosperity, he understood the necessity of working with our partners and competitors around the globe to accomplish these goals.  He referred to this as a “balanced” policy.  Our cooperation with China and Russia, for example, would be necessary to work toward a denuclearized Korean peninsula, a peaceful outcome in Syria, and the defeat of ISIS—top national security goals.  But he also noted areas of our relations with these two countries that lacked balance—our trading relationship with China, and Russia’s aggressions toward Ukraine.  How can he get their cooperation on the topics of North Korea and Syria/ISIS while also addressing the “imbalances” he sees in the other areas?  It seems that “values” will be sacrificed; Tillerson argues that foreign policy should be used to promote our national security and economic prosperity first and foremost, and that the promotion of American values (human dignity, personal freedom, democracy) are secondary and optional.  While we have our doubts about the wisdom of subordinating values to pragmatism, we think the governments of China and Russia would be pleased.

So perhaps Tillerson’s comments were a partial win for the global economy—“balance” is certainly better than “protectionism”, as the spread of global protectionism would be a serious threat to the economic prosperity of America as well as that of our trading partners. 

One additional note: In a few days, we are off to Omaha, Nebraska to attend our first Berkshire Hathaway annual meeting.  We will report back in next month’s “Notes” what the “Oracle of Omaha”, Warren Buffet, has to say about life, the markets and the global condition.

1st Quarter's Rearview Review

With the 1st quarter of 2017 in the books, we wanted to briefly update you on the market movers and shakers.  In general, it was a positive quarter.  Politics and foreign affairs have dominated the media cycle.  And the markets, until recently, have managed to head in only one direction—up.  From a big picture point of view, volatility has been subdued since the US election to a degree rarely seen for such a long period of time.  The 1st quarter experienced the lowest quarterly volatility since 2006.  Is this complacency or are investors correct in extrapolating what the very positive sentiment numbers might mean for the outlook of the economy?  It has been a good start to the 2017 trading year.  Will it continue?  Time will tell.

In the meantime, here are a couple of quick observations on the first quarter of 2017.  During the first three months, the S&P 500 index was up 5.5%, the US aggregate bond index was up 0.7%, and the VIX volatility index fell by 10.2%. The Federal Reserve declared the US economy strong enough to handle a rate increase and raised the short-term benchmark rate by 0.25 percentage points.  This was the first of 3 moves the Fed said it is planning to make this year. 

One thing we found interesting was that Fed members engaged in a coordinated effort to hit the main stream media with talk of potentially raising rates at an even faster pace or starting to “sell back” some of the bonds they previously purchased during their “Quantitative Easing” programs.  This would effectively be “Quantitative Tightening.” It would have a similar effect as raising interest rates and is consistent with the Fed’s change from easing to tightening that began with its first interest rate hike in December 2015.  However, after the Fed seemed to be reassuring equity market for so many years that it was supportive, we find it interesting that the Fed now seems ready to let some of the air out of the life raft and see how both equity and bond markets respond. 

Here are a few highlights and “not-so-high-lights” from the quarter.  The Dow and the S&P reached all-time highs without any real sell-off in bonds, even after the rate increase.  This suggests that equity markets and bond markets are still in disagreement about longer-term growth prospects.  Technology, Healthcare and Emerging Markets experienced a strong quarter, while Energy, Retail, and Commodities struggled.  On the international front, there has been very little fallout from Brexit proceeding and minimal market impact from geo-political tensions with Syria and North Korea.  Trump’s handling of the military attack on Syria, in which he also sent a warning to Putin, seems to have been taken as a positive.  And North Korea’s belligerence seems to have put trade tensions with China on the back burner, at least for now.  On the home-front, however, it would appear that equity markets are pausing for a reality check after President Trump’s failure to repeal or even reform President Obama’s healthcare legacy. 

Some of the shine appears to have faded from the “Trump Bump”.  While the S&P 500 Index was flat in March, it closed the month below its March 1st peak, creating a negative trend line, as concerns increased over President Trump’s ability to implement his pro-growth agenda. 

As the 2nd quarter gets underway we will certainly be listening very closely to the Fed, as well as paying attention to foreign elections and, for that matter, foreign relations.  In the meantime, we continue to maintain our allocations for our clients.

Action and Reaction

Last month we talked about actions speaking louder than words.  Well, this month we are beginning to see an outline of what healthcare reform might look like: a replacement plan for the Affordable Care Act has made its way through the House Ways and Means committee.  Next stop: Congress.  Another “action” is coming from the Federal Reserve.  In a very orchestrated effort the Fed Governors en masse got out the “word” that the US economy is healthy enough for a rate hike.  And by all measures, it appears that the Federal Reserve is set to increase rates during its upcoming March meeting.  The equity markets have taken this in stride, with major US equity indices keeping near their recent historic highs.  As markets were making new highs towards the end of February, we saw volatility start to increase as well.  Let’s focus on a few things that we believe might contribute to future volatility.

As we mentioned previously, Federal Reserve officials are out talking about rate hikes, and this time they apparently mean it.  We realize this sounds like a tagline to a bad movie sequel, but this is the same Fed that promised four rate hikes last year, and delivered only one.  So what is different about the message this time?  To our recollection, this is the first time in a long while we have seen all the Fed officials speaking with such solidarity.  And the message is rate hike.  Futures markets are pricing in a greater-than-95% chance that the Fed will raise rates during their March 14th and 15th meeting (which may have already happened by the time you read this). 

If we can take the Fed at their “word”, this would be the first of three planned rate increases for this year, according to previous Fed comments.  This is coming at a time when Japan and Europe continue to appear committed to keeping their rates low.  This is noteworthy for two reasons.  First, it is a signal from the Fed that the US economy is healthy enough to withstand the ramifications of modest rate increases.  Second, it also creates a scenario for dollar strength.  As rates on US Treasury bonds increase, foreign buyers will find US bonds more attractive than their home-country bonds and will want to buy them.  Their need to sell their own currency and buy dollars in order to purchase our bonds would contribute to dollar strength, provided they don’t hedge currency movements.  A strong dollar potentially hurts US exporters, as well as emerging market entities that have issued debt in US dollars.  If this scenario plays out, we will likely see more volatility.

There is also the GOP’s desire to repeal the Affordable Care Act, cut regulation, and reform taxes…something the equity markets have liked.  We believe that the equity market’s current pause is in part due to investors’ desire to see more than just talk...to see policy catch up with equity markets.  As we write, House Speaker Paul Ryan is out promoting the President’s “A Better Way” healthcare plan as part of the initiative to “repeal and replace” the ACA.  While the proposal is out of committee, there seems to be some dissention in the GOP ranks as to what the best health care plan is for America.  We believe equity markets see this more simply.  They want to see plans that promote sustainable improvements in economic growth.  Without such plans, we will likely see more volatility.

And Finally, we are keeping an eye on Britain.  Let’s not forget our European friends who unexpectedly voted to leave the European Union last June.  As you remember, the vote was just the first step in the process for the British exit, or “Brexit”.  Now it’s up to Parliament.  The English Parliament is widely expected to enact article 50 later in March.  At that point, Brexit will be official. Great Britain will begin the two-year process of negotiating its departure from the European Union, which involves negotiating new trade agreements. If this is in any way seen as disruptive to global markets, we will see volatility increase as a result.

It appears that the Fed, US policy makers, and our friends across the pond are all ready to act.  The goal is to act in ways that are productive and in some cases already predicted.  The current outlines for action certainly bring with them the possibility for market volatility.  And we will continue to pay attention to the words being said and, more importantly, look for and evaluate the actions taken.

The Word of the Day is...

Abraham Lincoln is credited with using the phrase “Actions speak louder than words”.  We all know that it’s easier to say something than it is to follow through.  Some might say that the true measure of the person is one’s doing what they say. So the phrase “Actions speak louder than words” is as true today as it was in 1856, or is it? 

Could it be that, in today’s 24-hour news cycle, words are more important than actions? President Trump moves markets with tweets, executive orders and international relations decisions—or missteps, depending on where you fall on the political spectrum.  The stocks of entire sectors move up or down based on the President’s message of the moment.  In general, stock markets have reacted very favorably to his promises of reform and infrastructure-spending.  Given the time, energy, and “political capital” it will take to get these items through Congress, however, it seems that “words” are speaking louder than actions.  As usual, expectations are driving markets.  The important thing for today’s market is that words are followed up with actions.

At the same time, markets have largely ignored news reports that would otherwise leave a stain on the President.  Questions about his conflicts of interest, his connections with Russia, his trade policies, his disorganized administration, his executive orders have all seemed to be downplayed.  It seems that investors are listening to what President Trump wants them to hear, and they are disregarding the rest.  If 2016 was the year of uncertainty, then 2017 must be the year of double, secret uncertainty. 

At least for now, equity markets don’t seem to care about criticism of President Trump.  January experienced the Dow closing above 20,000 for the first time in history.  Is it all based simply on “words”?  We don’t think so.  4th quarter reported earnings for companies was strong, confirming the earnings recovery that began before the election last year.  The unemployment rate continues to stay low, even as more people return to the job market.  Wage growth seems to be in check.  And the Fed’s preferred measure of inflation is still below its target.  While the Fed intends to raise interest rates several times this year, Chair Yellen emphasizes her intent to move only to the extent the economy can handle it.  Global growth, especially in Europe, is better than expected and continues to surprise on the upside.  While there are other things than “words” supporting the stock market, earning could improve further if some of the talked-about reforms are passed.

For our part, we are acting upon our signals and maintaining our clients’ asset allocations.  Our volatility strategy is currently in cash, so those clients with exposure to our volatility strategy have, for now, an extra cash cushion, in case “words” disappoint.

It’s probably true for all of us that we prefer to depend on someone’s actions more than on someone’s word.  But markets move ahead of actions...they try to anticipate the future.  The trick is to know which direction the future is going…which “words” become real actions.  Mark Twain may have said it best when he summed it up this way, “Actions may speak louder than words, but not nearly as often.”  At least for now words trump action.

8 Arms and 3 Educated Guesses

It is that time of the year again when we make some educated guesses as to where financial markets are heading.  While we never miss an opportunity to express our opinion, we are feeling a little like the proverbial eight-armed economist this year.  You know who we’re talking about—“on the one hand…, on the other hand…, but on the other, other hand…”.  You probably spent some time with him or her over the Christmas holidays.  We bring up the eight-armed economist only to say that there seem to be as many possible threats as there are opportunities.  But we’ll jump into that later.

Before we sort through this year’s tea leaves, let’s look back on our 2016 predictions and see how we did.  Prediction #1: “Although Federal Reserve Vice Chair Stanley Fischer has indicated that the Fed will look to raise rates four times in 2016, we, along with many investment professionals, believe that the number of rate increases should be half that.”  We almost had this one. The Fed raised interest rates only once in 2016, and that move came on the heels of the US Presidential election and the promise of increased infrastructure spending.  The Fed cited global economic concerns as the primary reason for not having made four rate increases.  Prediction #2:  High yield bonds will be one of the top performing asset classes in 2016.  We got this one.   Coming off a dreadful 2015, high yield bonds returned more than 17% for 2016 vs. almost 12% for the S&P.  Prediction #3:  The US consumer will continue to shine in 2016.  We were on track with this as well.  Another year of continued growth, low interest rates and benign inflation provided the backdrop for increased consumer confidence.  This was reflected in a recent excerpt from the Conference Board’s most recent Consumer Confidence Survey®: “the post-election surge in optimism for the economy, jobs and income prospects, as well as for stock prices which reached a 13-year high, was most pronounced among older consumers.” 

Okay so that makes us 2 out of 3 for 2016.  What about 2017?  Here is what we are thinking:

1)    US equity markets break the trend of negative returns during the first year of a new US Presidential term and finish positive.

We think the expectation and ultimately implementation of financial and regulatory reform will continue to drive stocks in a positive direction.  Corporate tax reform and the repatriation of overseas dollars held by US companies would boost stock returns: not necessarily from companies reinvesting in capital expenditures, but through enabling these companies to continue buying back their own stocks.  This will buck the trend that has seen markets fall by nearly 3% on average in the first year of a new Republican President’s first term.

2)    Emerging Market (EM) stocks have a solid performance during the 3rd and 4th quarters.

Our expectation that Emerging Markets perform well in the second half of the year is as much about US infrastructure spending as it is anything else.  Many EM countries are exporters of commodities, which are needed for building.  You need building materials to build all the roads, bridges, hospitals and municipal projects that find their way into infrastructure spending bills.  In our improving EM scenario, the US dollar would need to stabilize, as a continually strengthening dollar would have a harmful effect on EM and global growth.

3)    The Fed raises rates twice for 2017, versus their announced intentions to raise rates 3 times. 

We think again that the Fed will only raise rates twice in 2017.  Rising US rates could push the US dollar higher as foreign investors would continue to prefer higher yielding US government bonds over the lower yields offered in Europe and Japan. An overly strong dollar could hurt global growth, ultimately hurting the US economy.  And the Fed proved last year—when they cited economic concern in China as a reason to keep rates unchanged for most of the year—that they absolutely do consider the global impact of their interest rate decisions. 

We make these predictions with the caution of an eight-armed economist, with arms filled with potential positives balanced by arms full of possible negatives.  Year one of the Trump Presidency, the initiation of Brexit, and key European elections could all make for a very eventful investment environment…on the other hand….

Yes Virginia, there is a Trump

Now that one of the most contentious and downright nasty Presidential elections is over, what have we learned?  Here is one take on it: if you are a Trump supporter, his narrative was figurative; whereas if you are a detractor, it was literal.  A figurative Mr. Trump might be understood as follows: “wall” really means “reform”, “replace” equals “revise”, and “jail time” could even mean “patriot”.  Regardless of your take, we all admit that markets have been on a tear since the election. With equity markets now at all-time highs, the market’s “Trump Bump” has continued into a full-on Santa Clause rally. 

However, if we look back at history, we discover that this type of market performance in not unprecedented.  Based on data from Dorsey Wright, a leading research and market index firm, the US equity index has advanced over 4% on average in the month of November when a Republican presidential candidate is elected.  This November’s gain of 5.4% is slightly better than average. While we knew the election results could have injected a bout of volatility, we took our ques from the “Brexit” vote, a time when most investors were rewarded for maintaining their portfolio allocations (see our post-election write up).

So, what does this mean for the markets going forward?  The expectation is that President Elect Trump’s administration will be pro-growth and will lower regulatory burdens.  With that in mind, let’s look at a few areas that we believe merit attention for 2017.

Financial regulation, we believe, will be in the cross hairs of the new administration.  There is some expectation that changes will be taking place to the Dodd-Frank Act, the post-2008 financial reform act which many investors believe has stifled bank-lending.  We believe that this would benefit financial institutions both large and small.  We also believe that the Department of Labor’s fiduciary and overtime rules will come under the same scrutiny.  We believe any changes to these laws could have a meaningful impact for small businesses. 

Recently-implemented SEC rules that require certain money market funds to calculate their daily value will likely change the way institution and individuals think about the safety of their cash positions.  There are now rumblings that these rules could also be revised.  This change would simply revert back to the way it was previously.

The President-Elect is in the midst of announcing his cabinet and other appointed positions.  These appointments are setting the tone for much of what we believe is to come during 2017.  While “Trump and friends” are dominating the news cycle, there are a couple of interesting things that are going on outside of the US that we wanted to point out.  

If Trump were to follow through on his tough trade talk, the resulting protectionism could be destabilizing for global markets…although the people he has named for cabinet positions don’t seem to have the back-ground to favor trade wars.  Another factor is the set of upcoming national elections in France, Germany, and the Netherlands—which, like the recent Italian referendum, are considered yes-or-no votes on the EU. Britain will also be exercising Article 50, which will be the official beginning of the “Brexit” negotiations.  And finally, global monetary policy is becoming less effective, which is one reason there is more talk about fiscal policy, at least here in the US.

Given all of this, and markets being at new all-time-highs, it is no surprise that volatility is likely to increase.  There are lots of things out there to make people nervous.  We continue to hold to our allocations for our clients.  We are still expecting the US to lead the way and are keeping our eye on Europe and Asia.  Trade, reform, and growth will be at the forefront.  We will see how much longer the rally continues. 

As we move closer to inauguration day, we are constantly reminded of Forrest Gump’s box-of-chocolates analogy: “You never know what you are going to get.”  And thanks to a certain someone’s love of Twitter, we are certainly experiencing that first hand.

Merry Christmas,