July 15, 2015

Dear Client:

Debt woes in Greece and Chinese market volatility led us to emphasize US-based, high-quality equities in our portfolios to ride out the storm.

Q2 was full of highs and lows. The major US equity indexes all hit record highs in May but ended the quarter mixed. The S&P 500[1] and the Dow[2] ended slightly down for Q2, while the tech-heavy NASDAQ[3] surpassed a 15-year record high and ended +1.8%. International equities and fixed income posted losses. Commodities were mixed with crude up 25% (but down 44% from its one-year high) and natural gas followed a similar pattern. Copper lost 4.4% while gold was again basically flat.

What happened? The news was a mix of good and bad as the economy shook off the frozen first quarter. Earnings surprised in the face of falling oil prices and a rapidly rising dollar. Q1 earnings were up slightly, but excluding energy they increased more than 11% year-over-year. Consumer spending, normally 70% of GDP, was key. Consumers had been guarded due to the subpar recovery and meager wage gains. But rising home and stock prices increased household wealth to a record $85 trillion, which helped real consumer spending jump to a 3.2% annualized pace (most in nearly six years). These spending spirits were supported by both rising employment and salaries. This occurred despite businesses answering the old question of build, buy or lease with record merger and acquisitions. These efforts to control costs through consolidation were only a minor headwind against a tide of rising housing, household formation, and consumer confidence.

Washington disappointed on the domestic side with no progress on entitlement reforms nor immigration. A positive, gridlock froze spending leading to the second lowest annual deficit since 2008. Congress approved Fast-Tract negotiating authority on the Trans-Pacific trade agreement, and in a bipartisan moment agreed any Iran nuclear agreement had to be approved within 60 days. Fortunately, or unfortunately depending on your point of view, the Supreme Court filled the void by supporting the Affordable Care Act while nixing the EPA’s efforts to create climate change rules without a full cost study. Finally, everyone waited for a Fed moment, yet there was no interest rate movement. Overall, government was neutral.

The international picture had both negatives and positives. Europeans seem tired of the Greek kabuki. We feel Greece has defaulted, is bankrupt and is too small ($249 billion GDP) to damage the Union or the Euro. Pressure’s building for an exit or agreement, stay tuned for the last act. The rest of Europe started their quantitative easing, had the best growth in years and appears on solid footing. China posed a bigger problem. Government policies targeted growth while trying to manage the transition to a consumer-driven economy. The unintended consequences have been malinvestment leading to an infrastructure bubble to a housing bubble to a stock bubble. The last bubble has cost over $3 trillion in market losses. Chinese leaders view this tumult as a threat to the state, which explains the barrage of measures unleashed to counter the downturn. The Middle East conflagration continues with ISIL, Iran and now Saudi Arabia fighting for supremacy.

Going forward – We believe reports on the economy’s demise are greatly exaggerated. Pundits have focused on this recovery’s weakness and have not given sufficient respect to its prolonged length. We think the recovery will last quite a bit longer due to low inflation and interest rates. Our advice: look at the megatrends. Due to the fiscal crisis and slow recovery, a record 50.2% of Americans over 16 are single. This is changing as a stronger job market and rising incomes will accelerate household formations, and this should reinforce surging home sales. We expect strong retail sales to increase and broaden as more-confident consumers satisfy pent-up demand for big-ticket durable goods, vacations, clothing… Aging boomers and the rise of the millennials will drive healthcare, demand for connected cars, portables and wearables. This should lead corporations to increase capital expenditures and exploit technology. They’ll utilize cloud computing, where today’s improved software allows 20,000 servers to communicate within seconds. Companies will cut costs and employment to drive efficiency in the old economy while investing and paying up for talent which will help them succeed in the new economy. Competition will lower costs and make this technology affordable and effective for small businesses. This may not be Goldilocks, but it is positive for growth and profits.

In Washington, efforts toward an Iran nuclear deal will continue. If successful, they would realign existing relationships in the Middle East and possibly promote more stability. On the domestic side, gridlock on spending plus economic growth should mean even better news on the deficit. We’d like to see entitlement and immigration reform but are not hopeful. The Fed should increase rates by year end.

The EU kicked the Greek can into Q3. Do not expect a more generous European deal due to fears of electing more anti-austerity governments in Spain and Portugal. Whether agreement or exit, there will be no “Lehman moment.” If an agreement is reached there will probably be a laser focus on tax collections (Greece only collected 10% of taxes in 2010). We do not think China’s market volatility has come to an end. Investors got ahead of the fundamentals and the markets will have to rationalize valuations. Only 6% of the population is involved with the market so the impact should be minor. Still, confidence has been shaken and consumers should retrench. We expect China’s growth to slow. A final point, we expect a US-Iran agreement. We see Iran’s hardliners bumping up against an emerging force: Iran’s youth. More than half of their 75 million people are under 35 and didn’t know the Shah. They are weary of over-weening religious edicts, economic mismanagement and isolation. To quote one of our clients, “Iran has more to fear from Facebook than nuclear weapons.” Again, we expect an agreement and it should be positive for the Middle East.

Our Bottom Line – Historically, it’s not the first rate hikes that kill a bull, so we expect this cycle to continue. Also, profits are not falling. The decline is isolated in the energy and material sectors. We believe stock picking is key and continue to favor well-capitalized, profitable companies. We favor Europe over the other international markets. We continue to limit our fixed income exposure to special situations and short-duration investment-grade notes.

As always, we appreciate your trust. This letter provides our outlook of the most probable events, but at best is a summary. If you have any questions, please call us. Better yet, we would enjoy meeting with you to discuss our outlook and your current situation.

Yours Truly,

George Bernard                                                                      Doug Woods

President                                                                                 Director of Research

[1] S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.

[2] Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends.

[3] NASDAQ is a market-cap weighted index of more than 3,000 companies listed on the NASDAQ Stock Market and does not reflect reinvestment of dividends.