Economic and Stock Market Update (2nd Quarter 2018)
By Bret Hartman, IAR
We value communication with our clients regarding their accounts and the atmosphere surrounding the markets in general. Each client receives a personalize letter, every quarter, updating them on the performance of their individual portfolios, the assets that they hold and where we think that the market is going.
This is a letter that we send to our clients every quarter. It will be individualized with their personal account performance.
Economic and Stock Market Update
U.S. GDP grew at 2.0% in quarter one of 2018. GDP is expected to surpass this clip for the remaining quarters of 2018 and get close to averaging 3% GDP growth. The U.S. economy’s short-term outlook remains strong, with low unemployment, wage increases and strong corporate earnings + buybacks. Consumers balance sheets remain relatively healthy and will continue to add to growth. Short-term rates are scheduled to rise, and we are expecting a flat yield curve to persist as the bond market is not forecasting an increase in long term growth rates. A common trend remains in markets – down days are triggered by Trade War rhetoric. This remains a looming threat. Another major concern is that the Fed will raise rates too quickly, pushing the economy closer to a recession.
Trade war rhetoric continues and, so far, the bark is worse than the bite. However, the administration has stuck to several of their campaign promises and we cannot brush this under the rug. From an investing standpoint, the negatives of a trade war outweigh any positives and we expect markets to decline if meaningful proposals go into effect. We need to account for this risk, which we have done from a macro level in overweighting fixed income vs. equities for those clients who need the downside protection. Much of our previous commentary still remains in effect–
“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.”
As we threaten to levy tariffs and other restrictions, we should expect an equal response from the corresponding party. If threats turn to actions, growth will slow in the U.S. and could have a much bigger impact globally with emerging markets feeling the burden. With all of this being said, a recession is more likely to occur due to where we are in the economic cycle (late stage expansion) vs. the trade war possibility.
Equity Portfolio Update
Forward valuations have not changed much since our last letter.
|Forward PE (Last QTR)||Forward PE|
U.S. corporate earnings are strong and share buybacks have hit the largest in history, more than doubling from last year. This can be attributed to the corporate tax reform. We are late in the economic cycle and risks do exist. Many corporations are signaling that buying back stock is more attractive than investing in new projects to fuel future growth. This is a short-term positive for stock prices but is an indicator that companies are remaining less optimistic. Unless we are talking about the Technology sector. Research and development expenditures and CAPEX remain strong within tech, which is a strong sign for future productivity gains. Technology can continue to take broad market indexes higher, but we must be wary of their extended valuations.
We are equal weight to the technology sector and have been overweight to energy/MLPs for quite some time. With tax reform passed, many public companies structured as Limited Partnerships are considering converting to C-Corps due to lower tax rates. KKR, which is one of our stock holdings, has made this conversion. The market cheered this as the move is beneficial to the company and also adds a new layer of investors who would be willing to invest. This conversion is also taking place in the MLP space and has occurred inside our mutual funds such as Salient MLP & Tortoise MLP.
International and emerging market regions of the world are allocated roughly 20-30% of the equity portfolio per client. In a recession, the U.S. portfolio is highly correlated with our international and EM managers, but as of now our EM and international positions provide diversification and potential return enhancement over time. Compared to U.S., markets in these regions look much more attractive from a valuation perspective. However, larger risks are held in EM and international companies, which we are becoming more cautious of as trade war talks escalate.
Bond Market Forecast and Update
Rates rose early in the quarter and have since fallen from their highs. But yields remain attractive across the yield curve. We have been aggressive buyers in the three to eight-year range, and we have locked in the higher yields with some longer purchases for clients that can handle the additional risk. 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.
There is a lot of news concerning the flattening yield curve (the difference between 2yr and 10yr treasury yields) and the fact that an inverted yield curve is a good indicator of a coming recession. We believe this is overblown at the moment; but keep an eye on the relation of interest rates along the maturity spectrum. If rates are higher on the short end than they are on the long end, trouble is ahead. Currently the two-year treasury is 2.55%, the ten year is 2.85% and the 30 year is 2.98%.
Money market fund yields have increased to a point where it is worthwhile to consider them as a savings tool. Current yields on Vanguard Federal MMF are 1.82%, Vanguard Prime is 2.02% and Vanguard Tax Free is 1.36%. Depending on your tax bracket, one of these funds should be an excellent vehicle to hold your short-term cash.
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.
This section is for the account performance for each client’s individual investments.
This section is for informing our clients of all the transactions that took place in their portfolios throughout the quarter. We regularly meet with our clients to stay current with their income, tax and financial situations.
Donald R. Gross, Jr., CFA & Bret Hartman, IAR