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July 2018 Investment Commentary
Choppy financial market conditions continued in the second quarter. Bonds and stocks both encountered headwinds as investors gauged the sustainability of GDP growth. The U.S. economic recovery turned nine years old on July 1st, just a year shy of matching the 1990s run, the longest in our history. Positive investor thoughts over current mid-teens (or better) earnings growth, and second quarter GDP expansion possibly more than doubling the first quarter’s 2.0% rate, have been checked by escalating trade war fears, and concerns that the immediate tax cut boost will be short-lived, with higher deficits looming.
|Second Quarter||Year to Date||Five Years (ann.)|
|Developed International Stocks||-1.2||-2.8||6.4|
|Global Hedge Funds||0.2||-0.9||1.3|
While affected by these challenges, client portfolios benefitted from advantageous positioning in both the bond and stock allocations, while also seeing recovery in the energy and commodity areas. Hedged managers were mixed, the mutual funds detrimental, but larger fund of funds largely helpful. The earlier year move partly out of emerging markets (off 6.9% year to date as shown above) and into U.S. small capitalization stocks (up 7.7%) was effective. The move had been driven by an expectation that President Donald Trump would act on his protectionist campaign rhetoric, having held off throughout 2017, and this became true in short order. Bond indices were pressured by foreign currency weakness and upward rate pressure, particularly at the short end of the curve, but most managers were able to avoid or at least downplay their effects.
With nine years on the books, the economic recovery, from a deep 18-month recession running through the first half of 2009 and in which more than 4% of output was lost (twice the average of the prior four recessions), has been consistently substandard. While post-World War II expansions have produced annual growth rates above 4% on average, the current recovery has tracked at 2.1%, running right up to the 2% advance in 2018’s first quarter. The second quarter looks decidedly better, however, with some estimates above 5%, which would be the first near that level since the third quarter of 2014. The acceleration comes from a confluence of strong consumer spending supported by job and wage growth, healthy corporate spending aided by tax cuts, and a kick-up in net exports.
President Trump’s trade stance, beginning with tariffs on Chinese solar panels and washing machines in January, has darkened the market tone in general. At the same time, U.S. stocks have regained the upper hand over non-U.S. stocks. The chart below shows a massive U.S. advantage over the four years of President Barack Obama’s second term, and a modest reversal favoring non-U.S. stocks during President Trump’s first year. During this period President Trump held off on trade battles, and also quickly pulled out of agreements such as the Trans Pacific Partnership. China and other nations were perceived winners, stepping into the leadership vacuum and forming ex-U.S. trade alliances. But since the president’s protectionist campaign began to take shape early this year, targets spreading from Asia to Europe and North America, investors penalized all stocks, non-U.S. ones especially (including a 20% take-down in China’s Shanghai-listed shares):
|1/21/13 to 1/20/17||1/23/17 to 1/19/18||1/22/18 to 6/29/18|
(indices: S&P 500; All Country World ex-US)
The above chart does run the risk of over-simplifying the situation, however. The trade theatre has offered many twists and turns, and it’s early. So far, the U.S. has instituted a 25% tariff on steel imports and 10% on aluminum, including from Canada and the European Union. (President Trump has been able to skirt World Trade Organization bands by invoking national security grounds.) In early July a new round of tariffs on $34 billion worth of technology-related imports from China kicked in, with larger chunks of our $550 billion annual imports from China threatened. For context, the larger number represents around 19% of our total imports and 3% of our GDP. China has retaliated by teeing up tariffs on a matching $34 billion of U.S.-to-China exports, including soybeans, other farm goods, and sport utility vehicles. Likewise, both the EU and Canada have announced retaliatory tariffs on imports from the U.S.
And, to be sure, there have been, and will continue to be, casualties on the American side. Harley Davidson, facing 25% higher steel input costs as well as 25% tariffs tacked onto motorcycles sold in Europe, has indicated plans to move some production overseas. In a column in The Wall Street Journal, Karl Rove notes that higher costs passed on to consumers potentially as high as $145 billion a year could erase the benefits of the tax cut. Potential job losses could exceed 600,000 over one to three years, according to the Peterson Institute, and several hundred thousand U.S. soybean farmers already have seen effects from lower prices – off 18% during the second quarter. And ex-U.S. alliances continue to form, recently including Japan-EU, Japan-China, and China-Mexico.
Following the seemingly strong second quarter, the economic expansion’s sustainability thus could be challenged by trade war escalation. Other potentially building headwinds derive from difficulties in balancing economic policymaking this late in a cycle. The Federal Reserve Bank in June effected its seventh quarter point federal funds rate increase since December 2015, to 1.75-2.00%, and indicates plans for two more this year and three in 2019. At quarter point intervals, this adds up to a no-longer-easy 3.00-3.25%. Along with a historically low unemployment rate of 4.0%, the Fed has seen inflation attain, in fact slightly exceed, its 2.0% target. This would mean both elements of the bank’s dual mandate --- effectively full employment around 4% and prices stable around 2% -- have been met. Rate increases going forward would be geared to keeping prices in check.
Moving into the second half of 2018, investors and Fed-watchers will have to gauge the extent to which Chair Jerome Powell might see increased recession risk and alter course, tapping the brakes on rate hikes. One issue is a projected surge in the federal budget deficit in the wake of aggressive tax cuts put in place at the start of this year. With a return of 2009-era trillion-dollar deficits on the back of already record debt levels, and rates rising, the government’s fiscal war chest would be largely stripped, owing to a burgeoning debt service burden. Bond markets over recent months have seen a flattening yield curve, with longer rates coming off recent highs while the Fed pushes up short rates --- the spread between the 10-year and 2-year Treasuries has declined to .33% as of June 30th, down from .50% three and six months earlier, and from 1.23% 18 months earlier. With squeezed interest margins disincentivizing banks from lending, flattening or inverted yield curves are normally predictive of economic slow-down or recession, a phenomenon about which Powell is fully aware.
Meanwhile, geopolitics are sure to play into the investor attitudes about risk-taking. The trade friction, increased nationalism and breaks with standard alliance management have raised levels of uncertainty. Implementation of migration policies has tested leaders in the U.S. along with other countries, including Germany. The early June G7 meeting laid bare a disconnect between the U.S. and the other six, which could undermine our ability to garner their support for efforts including new measures against Iran, following our pull-out of the nuclear accord. The real test of the efficacy of the June summit with North Korea is yet to come, the early evidence suggesting the country’s nuclearization continues. And on July 18th in Helsinki, the high stakes continue with a U.S.-Russia summit. All of this will lead into the U.S. mid-terms, which carry policy-making implications for the next two years.
On this shifty landscape, we feel portfolios are well positioned to exploit attractive, continuing growth themes while building in some protection. We are making adjustments in the hedged and fixed income allocations, seeking to enhance the return profile and exploit pockets of bond weakness. This entails selling an absolute return manager and applying proceeds to flexible-mandate bond managers along with a more credit-oriented absolute return manager. Equity allocations are held in place following the U.S. add early this year. Developments on the trade front of course will bear watching. We remain underweight in Hong Kong, for example, following two recent emerging market cuts, and this has been helpful recently, but we may revisit on further weakness.
We are no doubt in the late innings of the economic cycle. But without major excesses, thanks to the dull annual growth rates that have persisted throughout the nine-year recovery, the slope of any slow-down could be gentler. We take note that debt levels are lofty not only in the U.S. government but also overseas, often above 2007 amounts. On the other hand, banks are in a much stronger position than ten years ago and leverage in real estate and other investments is decidedly more sober: one of our managers noted that 2007’s 5% down payments are unheard of today, with almost all deals at 35% or higher. And for the moment, corporate performance and health in general appears very solid.
We hope this letter finds all of you well and enjoying the summer. Please let any of us on the team know if you have questions on the foregoing or if we can help in another way.
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.