July 12, 2017
It’s a pleasure to send your second quarter 2017 performance report and statement of management fees. A synchronized global recovery with many record highs, along with record-low volatility, led to widespread strength in equity markets. Thus, we maintained our market positions.
Q2 capped off the best first-half performance global markets since 2009. NASDAQ hit record highs, while the Dow and S&P 500 closed near highs. International markets outperformed the US and emerging markets rallied despite weaker commodity markets. Fixed income faded into quarter-end to post minor gains. Natural gas and crude prices fell into bear-market territory, as gold edged lower while copper was up for the quarter.
What happened? Strong economic fundamentals drove the markets despite a messy political backdrop. Corporate earnings were the strongest in six years as 82% of companies beat or met expectations. Consumer confidence closed at multi-year highs as unemployment fell to the lowest levels since 2001. More people re-entered the work force as part-time jobs declined. Incomes were up modestly and consumer spending increased at a sustainable pace. Workers seemed focused on the future, pushing the savings rate above 5%. Corporations are driving economic growth as industrial production grew at its fastest pace in three years. Capital expenditures, ex-energy, have grown eight years in a row. Despite falling energy prices, producers doubled oil rigs in production. Now the US is a large oil exporter and closer to energy independence. Overall, US exports are up and imports are down. Finally, all Tier 1 banks passed the Fed’s stress test for the first time, allowing more freedom to increase dividends, buybacks and lending. This looks a lot like Goldilocks.
Washington politics disappointed. Rhetoric against Trump’s agenda said healthcare proposals cut Medicaid, when the plans only cut spending growth. Executive orders reduced regulations, accelerated business investment and saved corporations close to $1 trillion. President Trump exited the Paris Accord, similar to President Bush abandoning the Kyoto Protocol. Today, the US is still the only country to meet the protocol’s goals… At the Fed’s June 14th meeting they increased interest rates 25 basis points. More importantly, they announced a plan to reduce securities on their balance sheet. This caused the yield curve to steepen.
Global growth spread across countries and sectors, while the French and Dutch elections eased political tension. Eurozone economies had their best growth since the recession, which helped businesses chalk up their highest profits in over six years. Mario Draghi stated there is no longer urgency to take further actions. Emerging markets are also experiencing stable growth. Manufacturing and capital expenditures supported the emerging market recovery despite weak commodity prices. The Chinese economy, despite banking issues, grew at 6%+/-. This was below expectations but still a very positive performance.
Going forward – We expect profits to continue growing as business spending on plant and equipment drives the economy forward. The Fed is normalizing rates from excessively low levels, so this should not impede growth. Corporations should move up investments to take advantage of current low rates. Massive technological disruptions are opening growth opportunities while reducing inflation. Energy is a clear example. Technologies are reducing costs and increasing supply, leading to more high-paying jobs, increased exports and lower prices. Expect the same for the wireless industry as fierce competition led to unlimited data and calling plans and a 13% annual decline in prices. This is opening new industries for streaming media, online transactions, video conferencing from anywhere… More jobs! Changing demographics should also be a plus for growth. Boomers are working longer, saving more, helping the construction industry via downsizing. They are also consuming more from the med-tech industry. Overall, we see a virtuous cycle of increased productivity offsetting wage pressures, while the economy grows.
We feel political rhetoric from both sides will dial down as Washington deals with real issues. Medicaid is growing at 7-10% per year, 3x the economy’s growth rate and not sustainable. Both sides agree we need tax reform and we expect something by the end of the year. Talking infrastructure, it is the 200th anniversary of the Erie Canal. It was funded by private money and muni bonds (no federal funds), completed ahead of schedule and paid for itself in less than ten years. It was a huge growth driver accelerating the expansion of the west as it transported people, goods and ideas. The Trump plan is to create a similar private-public infrastructure partnership. We expect the Fed to move deliberately to shrink its balance sheet and normalize interest rates. Expect rate increases later this year into early 2018. We see progress, but messy progress.
Most global economies are earlier in the business cycle than the US. Therefore, they have fewer headwinds like tight labor markets, rising inflation and rising interest rates. The eurozone’s manufacturing and service indicators have been strong, consumer confidence is rising and the French election has been viewed very favorably. This is very positive. The emerging markets have been helped by the developed markets’ growth providing demand for their manufacturing sector. Also, the 2016 fears about commodity prices have given way to guarded optimism as prices seemed to have bottomed. Their domestic markets are growing, creating 3 billion new consumers. China, the largest emerging market, is a prototype for this evolution. They still utilize infrastructure and exports for growth but are evolving toward a consumption-based model. Today its citizens enjoy going to KFC restaurants, ordering take-out and eating more beef. They will be an exporter and an importer and a force for global growth.
Our Bottom Line – Risk assets look fully priced but the economic backdrop is still favorable. Fully-valued markets can stay that way and we believe it is too early to get defensive. In fact, excessive P/E ratios have more often been resolved by higher earnings, so we continue to emphasize equities. After a two-year rally, the US dollar peaked on January 3rd and has pulled back 5%. We see this favoring US equities which are helped by international trade. We feel Europe is a compelling value and emerging markets a good risk/return. The Fed’s move toward normalization should translate to a steeper yield curve, so we continue to favor short-duration securities. To increase income, we would favor less quality over longer maturities.
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.
George Bernard, President Doug Woods, Director of Research
 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.
 Dow Jones Industrial Average is an unmanaged index of the common stock prices of 30 widely held stocks, not including reinvestment of dividends
 S&P 500 is an unmanaged index of the common stock prices of 500 widely held stocks and does not include reinvestment of dividends.