October 15, 2015

Dear Client:

We raised cash expecting volatility to increase due to falling commodity prices, economic weakness in China and seasonal weakness.  We feel this helped our portfolios weather a very difficult quarter.

Developed country markets had a ten percent correction for the first time in four years. It’s normally an annual occurrence.  In the quarter the S&P 500[1] was down 10.7%, the Dow[2] -11.2% and EAFE[3] -15.0%.  Emerging markets[4] were an even more volatile -20.6%.  Investment-grade corporate and government bonds were positive, while sharp losses occurred in high yield and emerging market debt.  Commodity losses were led by crude down 26% from its June high.  Natural gas, copper and gold closed well off their peaks.

What happened?  The data was mixed but positive for the economy.  Q2 GDP growth was revised from the initial +2.3% reading to a final +3.9%.  S&P earnings disappointed at 1.4%, but exclude energy and they were up 9%.  Consumer confidence was lower than the previous quarter, but had some of the highest readings since 2004.  Consumer spending was up due to the low 5.1% unemployment and low inflation.  Two key economic drivers were strong.  September auto sales hit an annual rate of 18.2 million, highest in a decade.  New housing starts surged above one million units and existing home sales are experiencing a sharp upturn.  On the negative side, US manufacturers have taken a double-barrel hit of slowing China growth and a strong dollar.  Fortunately, they are only 12% of the economy while the strong service sector represent 88% and present a positive picture.  We see the private sector as a positive with growth continuing at 2.5-3%.

Efforts in our nation’s capital can be described in two words – dysfunctional and disappointing.  The long-awaited September Fed meeting came and went, and rates were unchanged.  Markets were not enthusiastic.  Their desire to move slowly created uncertainty and raised concerns for global growth.  Congress returned from summer break only to miss lowered expectations.  GOP bickering raised the possibility of another government shutdown.  John Boehner resigned as Speaker of the House and reached across the aisle to keep the government running through mid-December.  Little will get accomplished, a negative for the economy.

The Greek drama is behind us for now.  Europe rumbled to life with a rebound in retail sales and purchasing manager sentiment.  Optimistic businesses and consumers alike helped drive a Eurozone growth of 1.5%.  Is it too soon to declare victory?  China’s currency devaluation changed the world.  China represents a third of global growth so investors feared its miracle growth was coming to an end.  This impacted countries with a commodity focus.  Canada reported they entered into recession, joining Brazil and Russia.  Australia may be next after avoiding recession for 25 years.  Also impacted are OPEC nations, raising political strain in the Middle East and Africa.  Clearly, commodity producers and vendors around the world have been impacted, but service-based economies are growing and we see the international situation as neutral to slightly positive.

Going forward – We feel the US fundamental outlook is improving.  Companies are unable to find workers for open positions, a positive leading indicator.  Unemployment is down to 5.1% and initial claims data indicate the rate will move even lower.  Further, we are finally seeing signs of upward pressure on wages.  Also key, employment has been stronger for 25-49 year olds, a primary period for family formations.  This supports the housing industry underscored by building permits rising 3.5% in August.  The year-over-year drop in gasoline prices should bolster the consumer.  It usually takes a year for a gasoline price drop to impact their spending, we should see that impact in the fourth quarter.  Perhaps as auto purchases, since the average age of a car is still over eleven years.  We do see growth issues.  Uncertainty around rate hikes, a stronger dollar and plunging commodity prices.  Even so, we think 2.5-3% growth is in the cards.

Unfortunately government is a growth impediment.  The battle lines are drawn and struggles to concur on modest proposals suggest signature issues will not be addressed.  There seems to be bipartisan support for increased military and infrastructure spending, but there has been no efforts toward the elephant in the room, long-term entitlement reform.  The Fed also seems stuck in neutral.  We all expect higher interest rates but do not know when.  We think delay creates uncertainty, and business hates uncertainty.

As for the rest of the world, Europe seems to have positive momentum.  The drop in oil prices, low interest rates and a cheap Euro will have a positive impact on the Eurozone economy.  European banks are in much better shape.  They’re better regulated and stronger financially, and the credit channels are open for both consumers and business.  China will still experience pain as they transition to a consumer-driven economy.  We believe their current issues are more financial than economic, so don’t expect a hard landing.  If the situation gets worse, policy makers have tools to deal with the problem — $3 trillion in foreign reserves and the willingness to use them.  As we have said in the past, we expect sub-5% China growth, but it is still growth.  We see the impact of commodities moderating, a help for producing countries.  The oil surplus should continue to hold energy process down and we would hope move Middle East opponents toward politics versus force.  We see the international picture improving and a positive for global growth.

Our Bottom Line – We are aware of the numerous long-term problems facing the world:  sovereign debt, decaying infrastructure, rising social welfare costs, Middle East uncertainty and dysfunctional government.  Because of this, we feel the best period for investing in equities may be behind us, but still think solid risk-adjusted returns are possible.  Our preferences are the US, Europe and looking for opportunities in emerging markets.  Treasuries and high-quality bonds are less attractive, so our emphasis continues to be short and intermediate maturities.  We have no interest in high yield and international debt at this time.

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] The MSCI EAFE Index is comprised of 21 MSCI country indexes, representing the developed markets outside of North America: Europe, Australasia and the Far East and does not include the reinvestment of dividends. 

[4] The MSCI Emerging Markets index is designed to measure equity market performance in 25 global emerging market countries and does not reflect reinvestment of dividends.