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Economic and Stock Market Update (1st Quarter 2018)

This is a sample of the letter that I send to all of my management clients on a quarterly basis.

Economic and Stock Market Update

U.S. GDP grew at 2.9% in the previous quarter and forward-looking estimates show U.S. GDP growth in the 2.5-3% range for 2018.  Current valuations are rich but the following data points support this: “Full employment”, wage growth, tax reform, strong corporate earnings + buybacks and low interest rates (although rising).  However, as we have said in previous letters there are large risks that were not priced into the market.  Most notably a potential trade war.  The market has begun to discount this risk. Other risks that could push the U.S. economy closer to a recession include:  The Fed hiking too quickly, accelerating consumer debt levels, growing deficits and other geo political risks.  We expect GDP growth to come in at the low end of consensus estimates.

An important note from our previous letter stated:

“Economies just don’t slide into a recession, they need to be pushed.  So as long as we do not have a shock that pushes the U.S. over the edge, the economy will continue to grow.  But risks are on the horizon (and the stock market is not discounting these risks).”

As time has passed, the threat of a potential trade war has gone from an extreme tail risk event to an event that has gained probability. Although a full-blown trade war is unlikely, markets should discount this risk. Our underweight to equities will continue until these risks diminish. The current administration has threatened multiple countries with tariffs.  This includes tariffs on aluminum, steel and intellectual property.  China is a main target of these tariffs.  After announcements of these tariffs, the affected countries have all responded with retaliatory measures on paper.  China responded with tariffs on U.S. aerospace products, technology products, soybeans, imported pork, fruit and other nuts.  The European Union threatened U.S. exported bourbon, Harley Davidson vehicles, blue jeans and more. Although the initial tariffs will not move the needle, we are concerned that a much larger percentage of exports and imports COULD get caught in a trade war.  A Bloomberg study estimated that a modest 10% tariff followed by retaliation could cost close to $500 billion globally by 2020.  This would dent global GDP by 0.5% and send markets lower. Again, probabilities are low for a trade war but the risk needs to be addressed.

Asset Allocation

We use this section to review the client’s target asset allocation and compare the actual allocation to the target.

We are overweighting to high quality bonds and under allocating to equity markets.  We have been taking advantage of the increase in interest rates and have laddered bond portfolios to put us in a position of strength if equity markets sell-off.

Stock Portfolio Update

Since our last letter equity markets have seen a volatility spike.  From an absolute perspective this has made valuations look more attractive.  U.S. equities saw the largest change in re-pricing (PE ratios):

Forward PE (Last QTR) Forward PE
S&P 500 19X 17X
International 15X 14X
Emerging Markets 13X 12X

U.S. corporate earnings are projected to improve in 2018 due to many factors, including tax-reform, buybacks and a relatively strong consumer.  However, we must note that we are late in the economic cycle and risks do exist.  A main risk is lack of productivity growth and capital expenditures (CAPEX).  While corporations will receive large amounts of excess cash from tax reform and repatriation, it is likely most of those funds will flow to shareholders.  This is good for stocks, right? In the short-term it can be good for stocks as companies buy back more shares and increase dividends.  But over the long-run we need companies to implement capital expenditures (machinery/equipment, new projects, increased hiring) to continue to grow the economy.  Research and development is crucial to add labor productivity as well.  Permanent wage increases can be seen as a crucial ingredient for long-term growth.

We believe the market has priced in increased growth in the upcoming years, while long-term growth remains flat.

Our value bias is in effect now more than ever, as we believe the higher-flying stocks and asset classes have larger downside risk if we were to experience another correction.  Our MLP overweight has been a detractor within the equity portfolio.  We still believe in the investment and will continue to hold.  An equal weight to technology remains a common theme in our portfolios, with our mutual fund manager and tech stocks continuing to outperform non-tech sectors.

International and emerging market regions of the world are allocated roughly 20-30% of the equity portfolio per client.  Compared to U.S. markets these regions look much more attractive from a valuation perspective.  We also see many regions of the world growing GDP faster than the U.S.  We continue to diversify in these regions with our mutual fund managers.

Bond Market Forecast and Update

Rates continue to rise, and we are buying attractive bonds across the yield curve.  The Fed recently increased rates by 0.25% and is said to be on track for at least two more rate hikes in 2018.  Due to the Fed’s influence, interest rates rose more on the short end (under 10 years) and have been steady on the 30-year bond.  This seems to indicate that the markets do not anticipate a permanent rise in inflation.

The relationship between tax frees and taxables is bouncing all over.  At the time of this writing, a tax-free money fund is beneficial to all but the lowest tax brackets.  But moving out a few years then favors the taxable bonds.  The long end of the yield curve continues to favor tax-free munis.  We monitor this situation for every bond purchase in a taxable account and will buy the type of bond favorable to that investor.

We continue to purchase high quality bonds, including tax free municipals, taxable municipals, CD’s and Federal Agencies.  Where appropriate, we have extended our ladder out to 6 and 7-year paper.  We find the 3% YTM on taxable bonds in the maturity range particularly attractive.  In some accounts, we will extend to the 15 and 20-year range to lock in the attractive yields on the long end.

Performance

This section is used to provide the client with account specific returns.

Transactions for the Quarter

Each client would have their transactions detailed in this section.

Please call me if you have any questions on this letter.

Sincerely,

Donald R. Gross, Jr., CFA