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April 2018 Investment Commentary
Following a tranquil and buoyant 2017, the new year brought in a new environment for financial assets. Bonds and stocks alike encountered laws of valuation gravity, and volatility returned. Investors were re-acquainted with multi-percentage point daily moves, the S&P 500 index experiencing six days above 2% after seeing none for all of 2017.
After big intra-quarter losses, most indices rallied to close the period modestly lower. The 10-year Treasury bond lost more than 4% in value through February 21st -- its rate spiking from 2.41% to 2.95% -- before trimming the loss to 2.4% by quarter-end -- the rate easing back to 2.74%. Stocks started the year with an extension of 2017’s rally, the S&P gaining 7.6% through January 26th, and then suffered a 10.1% loss over the next nine trading days, creating a 3.3% year-to-date loss. Stocks fought back a bit over the rest of the quarter, leaving the S&P 0.8% lower. Overseas markets also encountered rougher sledding, but dollar-based investors were helped by strength in foreign currencies against the dollar, as has generally been the case since early 2017.
|First Quarter||Last 12 Months||Five Years (ann.)|
|Developed International Stocks||-1.5||14.8||6.5|
|Global Hedge Funds||-1.0||3.2||1.3|
Along with an ongoing need to trim lofty valuations, pressure on stocks, bonds, and the dollar came from a number of incipient sources during the quarter. The intense tandem selling of stocks and Treasuries in early February actually was triggered by a strong data point -- a surprisingly robust 2.9% 12-month wage gain within the January job report. This was good news for workers, whose wage gains had been mired closer to 2% over several years, but the report spooked investors, rekindling worries about labor-push inflation and a hawkish turn in Federal Reserve rate policy. Uncertainty and edginess were heightened by the handover of chair reins from Janet Yellen to Jerome Powell on February 5th. Headwinds later in the quarter came from the White House’s first major protectionist moves, and Facebook’s data breach, affecting some 87 million users, which cast shadows on the company and technology sector as a whole.
The trade skirmishes have not been well received either by investors or most economists. It was a pleasant surprise that Donald Trump’s protectionist campaign rhetoric was not acted on in 2017, but enactment at some point remained a risk (as we put forward in the last letter). After an initial announcement of pan-global tariffs on steel and aluminum, and subsequent backtracking with country exemptions and other side deals, a more focused confrontation with China took shape. The two countries devised 25% tariffs on roughly $50 billion worth of a wide range of goods, and Trump then threatened an additional targeted $100 billion. For context, we imported $506 billion of goods from China last year, while China imported $130 billion from us, creating a $376 billion trade deficit. Also, China has long required U.S. companies to form joint ventures with local companies in order to avoid tariffs, which has created an outflow of intellectual property -- theft, in the view of some -- worth additional hundreds of billions.
Trade wars generally are considered destructive and therefore unwinnable. The actions rarely pass the cost/benefit test. If effective, aluminum and steel tariffs would help sectors employing about 150,000 workers, a mere tenth of one percent of our workforce. Meanwhile, U.S. aerospace, construction, and automotive manufacturing, major buyers of imported aluminum and steel, employ more than 6 million people, or 4% of our workforce. Car buyers and consumers in general would be hit with higher prices. And potential retaliation by China against U.S. soybean imports, our largest export to them, is putting our farmers at risk. The good news is that trade officials from both countries have shown an understanding of these issues, with China and the U.S. starting cursory discussions in late March. More recently, Xi Jinping has offered renewed assurances that the joint venture requirement may be relaxed for certain industries.
Markets also are dealing with the armor-piercing of Facebook, one of the several-year rally’s golden knights. The Cambridge Analytica data breach has revived concerns about privacy and a need for regulation. But it is only the latest issue that puts a harsh glare on the original laws passed during the internet’s infancy. The Communications Decency Act of 1996 (CDA) has protected platforms such as Facebook and Google from liability for content and usage of their sites, in the same way that a library would not be responsible for what is written in its books. In the intervening years, spanning countless technology lifetimes, this line of the federal code, a free speech tenet, arguably has created more economic value than any other. But it has also brought social detraction, such as the proliferation of human trafficking aided by third party websites. Legal challenges and Congressional action are ongoing, and Facebook’s recent travails may tip the scales toward new rules of the road. Senate testimony by CEO Mark Zuckerberg took a conciliatory tone with offers to work with Congress to that end.
Along with snapping out of any daydreams about the technology sector’s invincibility, investors, for the first time in almost a decade, are beginning to contend with the varying impacts of more normal, thus higher, interest rates. In the near term this is a good sign, indicating continued economic momentum into 2018. In his first Fed meeting and press conference in March, Powell backed a .25% funds rate hike (to 1.50-1.75%) with upped forecasts for U.S. GDP growth from 2.5% and 2.1% this year and next to 2.7% and 2.4%, respectively. This reflects a strong run in job gains (though cooled in March) as well as an added fiscal boost. The latter includes the $1.5 trillion tax cut bill passed late in 2017 as well as a supplemental spending bill of $300 billion tacked on in February to keep the government open for the next two years. The hefty amount, a tell-tale of Congressional irresolution as both parties were granted their wishes, could add .5% to GDP growth rates this year and next.
Interest rate fears have risen amid concerns, a bit further down the road, that Powell and his Fed will overshoot monetary tightening, a possible mistiming as economic and employment growth run their course. We have, after all, taken a full six points off an unemployment rate that stood at 10.1% eight years ago, and today’s 4.1% is close to all-time lows. Also, a new drag could result from a fiscal hangover, as the near-term tax cut/spending increase sugar high gives way to much higher annual deficits and national debt. Factoring this in along with higher rates, Moody’s has estimated that an allocation of 8% of federal revenues to interest payments in 2017 will rise to 21% in 2027. This gargantuan shift would crowd out resources for everything else, including stimulus in the event of a severe downturn.
Recent market pain has a few silver linings, and factor into our thinking as we move deeper into 2018. While stock prices have backed off, corporate fundamentals have held up well. Solid 2017 S&P 500 earnings gains are forecast to carry over into 2018, maintaining a mid-teens pace. This combination has brought the S&P’s forward price/earnings ratio down to just over 16 times, about in line with its 25-year average. Similarly, thanks to the 10-year Treasury’s sell-off, its 2.74% quarter-end yield exceeded its ten-year average (2.54%), a first since the financial crisis. Further, bearish trading in the quarter pushed up several bond sectors’ yield spreads over Treasuries, amplifying their overall rise. Quarter-end investment grade corporate bonds, for example, yielded 1.09% over the Treasury’s 2.74%, or 3.83%, versus .93% over 2.41% (3.34%) three months earlier, according to Bloomberg.
Notable price pain, and arguably significant value creation, have occurred in the U.S oil and gas transmission and storage sector, within which many companies are structured as master limited partnerships (MLPs). New tax laws affecting a handful of MLPs and a few company-specific concerns around distribution levels have undermined trading across the sector. MLP yields thus average around 9% today, well above a roughly 7% 10-year average. And on virtually any measure of price, such as enterprise value to operating earnings, the sector trades at discounts at the high end of historical ranges. At the same time, fundamentals on the ground appear robust, with energy production volumes near highs, and U.S. energy independence an ongoing American success story.
On this overall backdrop, we are suggesting a few adjustments in portfolio positioning. These include a small add to U.S. stocks in our most equity-driven strategy. Also, we are adding to bond exposure on the higher rates, including a manager who can buy Treasuries and corporates. Within MLPs, we are trimming slightly due to the sector’s volatile trading and inherent risk but maintain meaningful exposure on the sound outlook. (Moreover, energy independence arguably takes on even greater value under President Trump’s more nationalist cabinet, and as new tensions in diplomacy with Russia emerge.) Finally, we are counseling a few changes within the hedged group, in most portfolios reducing the manager count and bolstering higher conviction holdings.
Thank you as always for your support. We hope you enjoy the imminent spring. Please reach out at any time with questions for Jason, Mike, or me.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.