Third Quarter Highlights
Global equity and fixed income markets were mixed in the third quarter, although most major averages edged higher. Precious metals rose, while other commodities fell, despite events such as the drone attack on Saudi oil facilities in early September. The U.S. dollar continued to defy skeptics, posting a gain for the period.
A Continuation of Cross Currents
Similar to the second quarter, stocks initially rallied on earnings that beat lowered expectations. But early August saw a market drop as new Administration tweets threatened a 10% tariff on the remaining $300 billion of Chinese imports. Optimism returned, however, as the two sides agreed to restart formal talks on October 10th.
Currently, expectations hinge on hope for a “mini-deal” which would involve more of China’s agricultural imports such as pork and soybeans. More contentious items such as intellectual property rights and national security concerns will probably be addressed over time. At quarter’s end, the initiation of impeachment proceedings against the President also adds to the mix of uncertainties.
During this quarter, Europe was very much in the news. The possibility of a hard Brexit was reduced as British PM Boris Johnson’s attempts to force a Halloween deadline were stymied. Meanwhile, the European Central Bank (ECB) delivered one last bout of monetary easing under outgoing leader Draghi, while hopes for a German fiscal stimulus faded as government officials cooled towards the idea. All the while, economic data from the Eurozone was weak as Germany likely heads into an economic recession.
The Federal Reserve figured prominently during the summer by lowering interest rates for the first time in a decade. Though many had hoped for a more aggressive easing, the U.S. central bank did lower the Federal Funds Rate by 25 basis points (0.25%) twice during the quarter. It should be remembered that Chairman Jerome Powell must try to formulate a consensus among the voting members, a task that has proven to be more difficult in recent months. The September meeting featured three dissents: two voters opted for no rate cuts while one wanted a 50-basis point decrease.
A Tale of Two Economies
The current dichotomy in the American economy is major part of the dilemma among
Fed members. The consumer sector is doing well, with confidence surveys moderate but still strong and unemployment near 50-year lows. The average hourly wage is growing and the quits ratio, a measure of worker confidence in finding better paying jobs, is near multiyear highs. Also, people have money to spend — the savings rate is over 8% and home equity is steadily building for the average homeowner.
The manufacturing sector, on the other hand, is weakening rapidly due to a slumping global economy. Trade tensions, chiefly between the U.S. and China, are a major source of angst for exporters of industrial goods. The effects extend down the supply chain, with many other manufacturing companies involved in the slowdown. A strong U.S. dollar has also not helped the situation.
Fortunately, the consumer makes up close to 70% of the U.S. economy, while manufacturing composes most of the rest. The key question is the spillover effect of manufacturing to the consumer sector. If unemployment picks up significantly and consumer confidence falls precipitously, a recession will become a real possibility. However, if some progress is made on the trade front, especially with China, the global economy may trough soon after and the deterioration in U.S. manufacturing may be halted.
The Yield Curve and Negative Interest Rates
The yield curve is still partially inverted, but now positively sloped past the one-year maturity. At the risk of saying it might be different this time, due to this the yield curve’s predictive accuracy of a future recession may be muddled this time around. Also, there is the new phenomenon of negative interest rates in many countries. Both the ECB and the Bank of Japan (BOJ) have formally instituted this policy and over $15 trillion in global debt is now negative yielding. Foreign investors in search of a positive yield have bought massive amounts of American debt, depressing yields on longer maturity instruments.
The implications for the pricing of assets due to negative interest rates are wide ranging. Many mathematically-based pricing formulas, such as the Black-Scholes model used to price financial instruments, break down when negative numbers are part of the calculation. Negative interest rates also provide little incentive for banks to extend credit, a necessary condition for economic growth. Indeed, the recent decision of the BOJ not to buy longer maturity debt may be an admission that negative interest rates are too low and could actually hinder economic growth.
The Outlook for Year end
- Our neutral asset allocation remains unchanged.
- It is too soon to know how impeachment proceedings in Washington will evolve, although ultimately, the economy is the key to the markets.
- Trade talks with China, along with continued Fed accommodation, will be the most important thing to watch in the months ahead. If the trade situation does not improve over the next several months, an eventual recession is a distinct possibility.
- If there is some progress with trade, economic growth should trend higher again, an environment very positive for the markets.
“There are two kinds of forecasters: those who don’t know, and those who don’t know they don’t know.”
— John Kenneth Galbraith
Fourth Quarter Recap
As they had done throughout most of the year, financial markets finished in a rally mode. Economic growth has been steady, coupled with the passage of sweeping individual and corporate tax reform legislation. Although some form of tax overhaul was anticipated, the timing and scope was a positive surprise for most. Bond yields rose slightly, as the Federal Reserve Bank fulfilled its earlier promise to raise short term rates for the third time in 2017. Oil prices rose to the highest levels since mid-2015 as production quotas reduced inventories, raising demand.
The phenomenon of political volatility not translating into general market volatility continued both here and abroad. Global equity markets also displayed a remarkable steady ascent. This reflects an improving economic outlook, not just in developed countries but emerging ones, as well.
In spite of an absence of volatility, there was a clear delineation of individual winners and losers. Equities such as FANG (Facebook, Amazon, Netflix and Google), aerospace and transportation stocks ended very strong while most traditional (brick and mortar) retailers plummeted. Money managers have had to be extremely vigilant in investing in winners while avoiding the “landmines”. This investing dynamic is expected to continue, with many disruptive new technologies displacing companies with vulnerable business models.
Major Things to Consider in 2018
S&P 500 earnings were already slated to rise 10-12% this year, but they now get an additional 6-8% boost from corporate tax rates dropping from 35% to 21%. This does not take into account incremental changes or profit repatriation strategies which could have both positive and negative implications for individual companies in 2018 and future years.
The outlook for individuals is less clear, with numerous winners and losers. There should be a modest bump in paychecks, which will help support consumer spending. Higher wages will also benefit the consumer as the economy nears full employment. Manufacturing is picking up, and the more favorable treatment of depreciation expensing should improve capital spending plans. Corporate sentiment is also improving, with small business optimism at its highest since 1983. Commodity prices are rising, aided by increasing global growth especially in the emerging nations Though crude oil prices will probably trade in a higher range (a ceiling in the mid-60s for West Texas Intermediate, or WTI), as many frackers (shale drillers) are expected to ramp up production.
Not to be overlooked are coming changes from the Fed. In addition to new Chairman Jerome Powell, there are a number of vacancies to be filled during the year. It will be interesting to see if the new appointees take a more hawkish stance (leaning towards higher rates) or dovish stance (leaning towards fewer rate increases). For now, Chairman Powell has indicated a continuation of the gradualist policy begun by his predecessor, Janet Yellen, and this should reassure investors.
Of concern to economists and investors has been the flattening yield curve (a line that plots Treasury rates from shorter to longer maturities), due to the increase in short rates while longer rates have barely budged. While important, it is the inverted yield curve (short rates higher than longer ones throughout the curve) that has historically served as an early warning signal that a recession will occur. Fortunately, we are not at that point yet, and foresee longer rates finally picking up as a decrease of central bank buying both here (the QT, or Quantitative Tightening program) and abroad, particularly in the second half of 2018. We will continue to closely monitor the yield curve for future signals about the economy.
The economy still shows few signs of overheating.
- The job market may be tight, but wage growth at 2.5% is nowhere near a danger point. As a reference, full employment was reached in 1995, but the expansion cycle lasted another six years.
- Capacity utilization remains well below normal.
- Capital spending has lagged but is finally picking up.
- Rising business investment is usually a hallmark of the middle, not the late stages, of an economic cycle.
- Inflation is relatively tame, in part because of a tepid expansion — the cumulative real GDP growth of 20% is well short of the 1960s (52%) or the 1990s (43%) economic expansions.
We remain constructive on U.S. and global equities, realizing that overbought conditions do exist and that a pullback can occur. However, if it happens, we will look at it as a buying opportunity unless the economic outlook deteriorates. Our cautious view on fixed income remains unchanged.
“Time in the market
is more important
than timing the market.”
Third Quarter Recap
The summer of 2017 proved to be a good one for financial markets, especially for equities. In spite of cautionary adages such as “sell in May and go away” and “September is the worst month”, pullbacks proved to be short and shallow. Global stocks also rose, while ten-year Treasury yields ended largely unchanged for the quarter, after dropping to almost 2.00% in early September.
The relative lack of market volatility largely reflected steady economic growth in the U. S. and gradually improving conditions around the world. The Eurozone continued its long-awaited recovery after a favorable outcome in the French elections, and China lent strength to the rest of Asia.
The stability of the markets was somewhat surprising, given such unnerving events as North Korean missile launchings and the domestic rancor from the Charlottesville tragedy, together with the lack of progress in new health care legislation. However, each incident seems to have a shorter shelf life than the previous one, a sign of a market that is more focused on the economy than anything else.
Interesting developments at the Fed
The second half of the quarter included some notable changes on the investment landscape. One change was oil prices finally hitting a temporary bottom. Consumption has been picking up, with the International Energy Agency (IEA) moderately raising demand forecasts and OPEC members adhering to surprisingly high production quotas.
Also, tax reform legislation moved into the spotlight, and global economic reports in the U. S., China and the Eurozone have been largely upbeat. This resulted in a rotation into Value stocks and more economically sensitive stocks in the Financials, Energy and Materials sectors. Small and midcap (SMID) stocks also rose, leading to a broadening of the rally, a positive development. Almost lost in the headlines was the announcement that the $970 billion Norway Sovereign Wealth Fund, the world’s largest, was moving from 60% to 70% equities.
Meanwhile, Fed watchers now have three things to handicap:
- Pace of interest rate increases
- Shrinking of the Fed’s $4.5 trillion balance sheet (also known as QT or quantitative tightening)
- Composition of next year’s Board of Governors
At this point, it appears that a third rate increase will occur in December. The monthly QT runoff will initially be $10 billion, with the monthly total increasing by $10 billion each quarter over the next year. This amount represents less than 7% of the total and appears manageable, at least for now.
The big question is who will be nominated to be on the Board, especially the Chairman. Current head Janet Yellen, Governor Jerome Powell, former Governor Kevin Warsh and Stanford professor John Taylor are on the short list of candidates. The announcement, due soon, could cause some short-term volatility in the markets, though both Yellen and Powell would likely continue to pursue a gradual pace of monetary tightening next year.
Though tax reform is not a certainty and would likely be a 2018 event, we feel that a watered down package will eventually pass Congress. If the bill contains a lowering of the corporate tax rate to the mid-20s, some repatriation for foreign profits and substantial depreciation of capital spending, the effect could increase real GDP growth by 0.3-0.5% to about a 2.3-2.5% pace. Although a long way from the 3% or 3.5% that some in the Administration have suggested, it would still be a noticeable improvement while keeping the Fed from tightening too quickly.
We believe that the secular (multi-year) bull market in U. S. stocks highlighted in our October 2013 Market Commentary will continue. The key is the economic expansion, whose moderate pace is intact and absent of almost all of the excesses that normally accompany recessions and subsequent bear markets. Valuations are not cheap, but neither are they in bubble territory.
We also are constructive on global equities, both in developed and emerging markets. We remain cautious on fixed income with yields still at low levels.
“There are two times in a man’s life when he should not speculate: when he can’t afford it and when he can.” — Mark Twain
Second Quarter Highlights
During the spring, both the economy and the markets continued their slow grind upward, confounding investors flush with cash. Equities appreciated, even as the Trump agenda of lower taxes and infrastructure spending stalled in Congress. Earnings surprised with double digit gains, revenues rising for the first time in three years. Bonds rallied alongside stocks at first, but later decoupled, as central banks in the Eurozone, the UK and Canada signaled that either higher interest rates or less monetary stimulus were on the horizon. For the first time in several years, it appears that many central banks, especially those in developed nations, are trying to pursue similar policies.
Current global central bank policy reflects the first global synchronous upswing in economic growth since 2010, with China and the Eurozone recovering and emerging economies such as India contributing to global growth. Increasingly, it appears that the cause of the market rally since last fall’s election has been due to excessive pessimism in the face of gradually improving economic growth rather than the realization of the more salient points of the Trump agenda.
A Lot of Activity Beneath the Surface
There was a wide disparity in sector performance, with leadership changing late in the quarter. The Information Technology sector initially led the market, as investors sought companies possessing their growth characteristics. Later, other growth stocks such as Healthcare followed. In June, with rates rising and favorable results from the Federal Reserve’s “stress tests”, value stocks such as Financials rallied.
The rising tide did not pick up all boats, however. The Energy sector continued to fall, with OPEC’s production cuts failing to stem the oversupply of oil due to the ramping up of production among U. S. fracking companies. Many retailers and other Consumer Discretionary companies plummeted, feeling the effects of overexpansion along with the disruptive aspects of ecommerce companies such as Amazon.
Changes were happening in the geopolitical scene as well. The ascension of Saudi Crown Prince Mohammed bin Salman signaled a more aggressive foreign policy, especially with respect to archrival Iran and its allies, while moving closer to the US. On the economic front, MbS (as he is widely known) is seeking to diversify the kingdom away from petroleum and planning the partial sale of Aramco, the Saudi oil giant, as a first step in that direction. Social changes may also gradually occur, with the 31-year-old heir acknowledging the young population by suppressing the country’s religious police. Other reforms, including some concessions to women, may be introduced. This heralds an eventual change in the entire Middle East region.
In other parts of the world, North Korea’s recent test of an intercontinental ballistic missile will likely change the geopolitical paradigm in East Asia, with China and Japan as major participants.
The Fed is still indicating one more interest rate hike this year, possibly in September. Afterwards, it will probably pause and begin to shrink its massive balance sheet. It will be interesting to see if upcoming economic reports confirm the US central bank’s forecasts, and if enacted, what will happen to the shape of the yield curve when the balance sheet shrinking commences.
A noteworthy point is that most of financial deregulation does not require Congressional approval and the Administration is proceeding rapidly in that regard. Besides helping the banks, it may also increase lending and could finally cause an increase in “velocity” — an economic term referring to the rate money changes hands in the economy within a given period. The anemic pace of velocity for the past several years has been cited by many economists as a major reason for the slow recovery thus far.
Locally, Hawaii’s economy continues to be helped by tourism, which is showing its sixth consecutive year of growth both in arrivals and spending. Construction also remains strong, with both residential and commercial permits increasing nicely. The mid-Pacific hurricane season may be slightly more active than normal this year, though hopefully, the islands will be spared any direct hits.
We remain constructive on equities, although recognizing that a correction can occur at any time, especially after the rally in prices that has happened so far this year. Valuations are not cheap, but earnings and revenues are finally rising again and should continue for the next few quarters.
The economy is still growing at a moderate pace and does not show the excesses that normally appear prior to recessions. It will be aided by a Federal Reserve that will tighten monetary policy only gradually. We still believe that bond yields will rise in both the short and long term maturities, causing the yield curve to steepen. Global financial markets should mirror the US, with improving economies worldwide aiding stocks while causing low bond yields to rise.
“Successful investing is about having people agree with you…later.” — James Grant
First Quarter Highlights
Most financial markets rallied in the first three months of 2017. Equities continued their upward push following the Presidential election, with the U. S. and other developed markets as well as emerging stocks all delivering positive returns.
Sector performance showed some rotation from fall of last year. Information Technology, Health Care and Consumer Discretionary led the way, while Energy and Telecomm lagged. Meanwhile, prices of fixed income securities bottomed by early March before moving higher.
Other asset classes were mixed. Oil fell due to a ramp-up in American fracking production while copper, iron ore and precious metals such as gold, rose for the quarter. The U. S. dollar pulled back from its highs as China and emerging economies continued to improve.
The End of the Presidential Honeymoon and Its Aftermath
A good deal of investor activity revolved around changing opinions about the “Trump trade”. This included stocks that require a strengthening economy and those that benefit from an enactment of new policies such as tax reform lowering overall corporate rates and allowing tax breaks on the repatriation of profits of foreign subsidiaries), deregulation and increased infrastructure spending. The failure to pass a new healthcare bill, a contentious Supreme Court nomination and other distracting delays of the Administration’s agenda also had an impact on the investment market. As a result, buying has returned to growth equities, which do well even in a moderate growth economy, as opposed to value and cyclical stocks.
At the same time, emphasis on fiscal policy gave the Federal Reserve the opportunity to raise the Federal Funds rate in March and maintain a course to raise rates two more times this year. The Fed is also considering shrinking its huge $4.5 trillion balance sheet over time, beginning as early as late this year. This approach, recently suggested by New York Fed President William Dudley, would take the place of additional rate hikes, as it is another form of “tightening.”
Curiously, the economy has so far displayed the same pattern of growth that has characterized most of its expansion.
- The first quarter looks to be anemic, due once again to weather factors and late timing of tax refunds.
- The rest of this year will likely feature a snapback, leaving 2017 real GDP increasing at the same 2.0-2.2% pace as previous years.
- Any bump in growth attributed to expansionary fiscal policy will most likely be felt either in the autumn or in 2018.
The forecast for corporate profits however, is a bit more sanguine.
- S&P 500 earnings are slated to increase 10-11% from either the top-down (macroeconomic view) or the bottom-up (analyst) consensus.
- Revenue growth is also expected to return after almost a two-year hiatus. Two major reasons for the increase are: 1) an improvement in energy company results due to a bottoming in oil prices early in 2016; 2) a better global economy.
Locally, Hawaii’s economy is being helped by a record 2016 increase in tourist arrivals. However, housing affordability and widespread traffic problems continue to plague the state, and may temper near term economic growth.
We maintain the view that the U. S. economy is in the mid-stages of an expansion. Though chronologically it is eight years old, the expansion has grown more slowly than previous growth cycles. The excesses that manifest themselves just prior to a recession are still not there. Likewise, signs of excess in the equity market are largely absent.
We continue to tilt portfolios toward equities over fixed income, especially with the Fed still in the early stages of raising rates. Though there may be a pullback in stocks from their recent gains, it should be thought of as a buying opportunity rather than the beginning of a bear market.
Tax reform will probably be realized, although in a more diluted form. Less regulation should be easier to accomplish, since it does not require Congressional legislation. Ten-year yields should eventually resume their climb towards 3.00%, and global markets overall should continue to move higher for at least the intermediate term.
“The World Turned Upside Down” – Tune played by the British army band at the Yorktown surrender ending the Revolutionary War, 1781
Fourth Quarter Highlights
2016 ended as it had started – totally confounding many investors, economists and especially pollsters. The surprising victory of Donald Trump in the Presidential election caused a huge rotation from bonds into stocks, contrary to what had been predicted and showing some similarities to the Brexit reaction this past summer.
From Election Day until the end of the year, the S&P rose almost 5% while the Russell 2000 surged almost 14%. Meanwhile, yields on Treasuries rose sharply, with 10-year yields going from 1.85% to 2.44%. The divergence continued among other asset classes, with most commodities such as copper and steel going up and precious metals such as gold, falling.
The U. S. dollar rallied, causing a selloff in most emerging markets, especially those with significant dollar-denominated debt. China, however, continued to improve, as developed markets such as Japan and the Eurozone surged on the prospect of increased exports. Finally, oil prices rose after a better-than-feared OPEC production cut agreement, an action soon followed by major non-OPEC producers as well. Of course, the success of any agreement depends on a minimum of cheating and this won’t be known for a few more months.
Early Implications of the Election
Reasons for the sudden divergence in performance between the asset classes have varied. With a unified government for the first time in several years, most market observers believe pro-growth policies such as corporate tax reform, foreign profit repatriation and new infrastructure spending will spur economic growth, while helping to raise bond yields from historically low levels. This analysis assumes the “good Trump” policies will prevail, as opposed to the “bad Trump” policies of trade protectionism and severely curtailed immigration. Although initial signs are encouraging, the economic impact of legislation from Congress will probably not be known until later this year.
In the meantime, investors will have to rely on the present trend of economic growth, which is lingering between 2.0-2.2% on a real GDP basis. Consumers are still spending, though more online now and less at brick and mortar stores. Manufacturing, however, remains anemic. Overall corporate earnings have finally bottomed and are forecasted to grow about 12% this year, led by Financials and Energy. Bank earnings are being helped by a steepening yield curve, which boosts net interest income. Energy companies will get a lift from earlier cost-cutting and easy year-over-year comparisons.
With the focus on new fiscal policy, the role of monetary policy has somewhat diminished. Currently, the Fed is contemplating a rise in rates two or three times this year, depending on the economic data, as well as the extent to which fiscal stimulus initiatives are implemented. Keep in mind that the Fed originally intended to increase rates four times in 2016 but ended up doing so only once.
Early indications is that the economy in Hawaii may slow a bit into 2017, as estimates for tax revenue growth for the state have been cut from 5.5% to 3%. Although tourist arrivals remain good, per capita spending hasn’t kept pace, and construction spending may slow as well. Of course, the year has just begun and economic indicators may pick up as we go forward.
We continue to favor equities over fixed income, as the new Administration plans expansive fiscal policy. The stock market has come a long way since Election Day, in part from 2016’s returns being pulled forward by eager investors. Additionally, the market anticipates a great deal being enacted early in the year – probably, a stretch at this point.
As a result, we could see equity returns in the high single digits, with volatility still a factor from past years. Our upgrade on the SMID (small to mid-cap) stocks was early, but is now performing very well. Bonds will continue on the defensive, although longer rates have already moved up higher and resistance to the 10-year Treasury seems significant at the 3.00% area. Internationally, we still like developed markets, though selected emerging countries may also participate in the rally.