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October 2018 Investment Commentary
Trade jockeying drove markets in the third quarter. And the country calling the shots, the United States, enjoyed the best returns. China and the United Kingdom, among others, posted losses. President Donald Trump’s strategy has shown success as he has been able to push other countries off-balance before coming back to the table. In the quarter’s final hour, literally, Canada’s accession to join U.S.-Mexico talks led to a new version of NAFTA. This followed an earlier bilateral trade agreement with South Korea.
|Third Quarter||Year to Date||Five Years (ann.)|
|Developed International Stocks||1.4||-1.4||4.2|
|Global Hedge Funds||-0.4||-1.2||1.0|
Typical client portfolios gained in the quarter. A year-beginning tactical move from emerging market equity (a second emerging market cut since early 2017) to small capitalization U.S. equity, ahead of trade wars, was helpful. At around 2.5%, direct portfolio exposure to China has indeed been fairly modest this year. But a bigger move would have been better. Portfolio equities rose about in line with average mutual fund returns, but were behind benchmarks, following a strong 18-month run. Bond allocations performed well in a difficult environment, weathering a significant rise in interest rates, the 10-year Treasury moving up from 2.86% to 3.06% over the quarter (continuing to 3.23% as this is written), versus 2.41% at the start of the year. The commodity sleeve also was additive, helped by strong oil prices and a continuing rebound in the oil and gas pipeline master limited partnership (MLP) space. Hedged investments moderately added value.
Following a unified upswing in 2017, world economies now are indicating more mixed performance, with trade conflicts beginning to impact behavior. London-based Fitch Ratings cut its forecast for 2019 global growth from 3.2% to 3.1%, and China from 6.3% to 6.1%, on the trade restriction ramp-up. Meanwhile, conditions appear to remain solid in the U.S., its GDP growth a robust 4.2% in the second quarter, up from 2.0% three months earlier. Strength appears to have continued through the summer, and a 3% calendar year is within reach, having not been achieved since 2005. This has been powered by consumer spending and very robust employment. The September report included a 96th straight month of job gains and a 3.7% unemployment rate, the lowest since 1969. There are now almost one million more job openings – 6.94 million – than people officially looking for work --- 5.96 million, that positive increment having first been achieved in March.
The European Union, also dealing with U.S. tariffs, has seen last year’s 2.5% growth taper to less than 2% this year. Further, a recent budget dispute with Italy has dredged up unpleasant memories of the 2012 Greek debt crisis. We’ve again seen populist leadership resistant to E.U. austerity, and a smoldering exit threat, but the latter still seems remote. The U.K. also is facing increased uncertainty, thanks to Brexit, with the firm March 29, 2019 deadline for the break fast approaching. Prime Minster Theresa May has had difficulty negotiating exit terms with the E.U. while at the same time fending off dissent at home. Her leanings toward a soft break, in order to preserve trade, as well as an open border with Ireland, have been challenged by hard liners such as popular rival Boris Johnson, and the E.U. has also held firm, well aware that other member countries are watching. A summit is set for October 17th.
China has seen a cooling of public works investment, and export industries have shelved capital spending plans as the tariff response is sorted out. Manufacturers of cars and machinery have retrenched, their export orders dropping. On top of an earlier $50 billion, President Trump in September effected tariffs on an additional $200 billion of Chinese goods, backed by a plan to raise the tariff from 10% to 25% early next year. He also threatened to hit the remaining $267 billion in China’s exports to the U.S. China countered with new tariffs on $60 billion of US exports (on top of an earlier $16 billion), about half of what we sell to them. While China’s economy is mainly driven by increases in consumer spending underpinned by a rapidly expanding middle class, exports still are critically important, accounting for 19% of GDP in 2017, roughly a sixth of that sold to the U.S.
The new NAFTA agreement – called the United States-Mexico-Canada Agreement (USMCA) – would bring 1) enhanced U.S. access to the Canadian dairy market, in exchange for more imports of Canadian sugar and peanut products, and 2) a requirement that at least 75% of parts for cars made in the three countries are sourced from the three, up from 62.5%. USMCA also updates the 24-year-old agreement to include internet commerce and social media. Critics say that the changes are minor, risk new bureaucratic red tape, and that Canada’s concessions were essentially already included in the Trans Pacific Partnership, which the White House dropped out of in early 2017. Absent the national security grounds that allow tariffs against other countries to come from only the president, USMCA will need Congressional approval, which would likely follow the mid-terms and seating of the new Congress in January.
As 2018 winds down, investors will be grappling with, among other things, cyclic tea leaves. If the economy is now in full bloom, are we at a point where the wave will soon crest? With low unemployment and plentiful job openings, the University of Michigan consumer sentiment report hit historic highs in March, but has not reclaimed that level in the months since. This may reflect an increase in consumer prices over the last year, to the 2.5-3.0% range. As reported by the Bureau of Labor Statistics, median real earnings, which factor in inflation, actually have not been robust: from January 2017 through June 2018 they declined 1.9%, thanks to higher inflation. This compares to 4.5% real median earnings growth over the prior 18 months (July 2015 through December 2016), helped by significantly lower inflation. Job growth has supported consumer spirits and spending up to now, but a pocketbook reality check may be due.
As household budgets of average Americans possibly face new challenges, the same may be in store at the federal level. Over the first eleven months of fiscal 2018 (latter ending 9.30.18) the U.S. budget gap swelled to $898 billion, 33% larger than the same point a year ago. This reflects the combination of a $1.3 trillion two-year spending plan put in place earlier this year as well as eight months of corporate tax cuts, part of the $1.5 trillion tax relief bill effective January 1st. Trillion-dollar, rising deficits, representing more than 5% of GDP, are thus likely in the years ahead. Further, this coincides with continuing annual roll-off of Federal Reserve bond holdings of around $200 billion, cresting at $253 billion next year, as part of its quantitative tightening agenda. Pressure on our Treasury market seems likely to continue, pushing interest rates still higher, exacerbating the deficit while also rippling through the economy.
The cresting wave image might also apply to corporate earnings. Building momentum over the last two years, earnings growth reached a heady 24.9% year to year rate in the second quarter (according to Thomson Reuters). The impressive comparisons reflect both healthy upper single digit revenue growth and high margins, aided by the recent corporate tax cuts. Third quarter estimates have edged down a bit, to 21.6% from 23.4% three months ago, and next year’s expected rate is closer to 10%. The recent big earnings gains, having steadily risen from zero over the past thirty months, have supported stock prices and kept valuations reasonable. At about 17 times forward earnings, the S&P 500’s multiple only slightly exceeds its 25-year average and is roughly 35% lower than 1999’s frothy level. Still, current valuation levels could come under greater threat should earnings deceleration lead to investor disappointment.
To be sure, it is a bit early to declare the U.S. the trade war winner. China will not be passive, and it has tools other than reactive tariffs. As our rising deficits and Fed selling pressure our Treasury market, China’s leverage as a $1.2 trillion holder of this debt increases, with some evidence of stepped up selling already apparent in recent months. Further, U.S. tariffs are reinforcing a Chinese incentive to move up-market, shifting low-skill manufacturing out of the country to trim costs and pricing, and upgrading factories to make high-tech, higher-value goods. This aligns with Xi Jinping’s already established “Made in China 2025” program, its sights set on global leadership in high-end manufacturing. According to industry analyst Mary Meeker, China already has nine of the world’s top 20 publicly traded technology companies, and an internet economy more highly valued than that in the U.S. These dynamics naturally bring China into the mainstream investable universe, not just for managers specializing in emerging markets.
We maintain healthy U.S. exposure in portfolios, running through all asset classes. We are also maintaining exposure to non-U.S. equity markets, which arguably offer better value. (Bank of America Merrill Lynch recently asserted that the U.S. stock market now sells at fully twice the valuation of the rest of the world on a price to net worth basis -- very uncharted territory.) Several changes within asset groups are recommended. We are removing sector-specific commitments to both real estate investment trusts (REITs) and energy-focused master limited partnerships (MLPs). Both are vulnerable to higher interest rates as well as to late GDP cycle dynamics. We’d prefer to put proceeds into either passive or active U.S. equity with greater sector diversification and flexibility as we navigate this arguably mature, “cresting” stage of the economic recovery. Other changes move dollars from lagging international managers to better performers along with lower cost passive exposure. Overall, both manager count and portfolio costs are reduced.
We send our very best to you and as always invite you to contact anyone on our team with questions.
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.