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emerging markets

Record Highs. But elections coming

The Days Ahead: Fed meets and will raise rates.  

One-Minute Summary: Stocks reached another record high. We're now up 10.1% for the year and up 15% since the mini correction in February. Small caps have done even better at 16.1% and 19%.

We've seen stocks rotate. That's when stocks that were previously unloved come back in favor. We looked at sectors like Consumer Staples, one of the worst performing sectors, which was down 5% to the end of August but rallied 2.3% so far in September. Tech, the clear winner for most of this year, is down for September.

It’s happening at the stock level, of course. Exxon, the sixth largest company in the S&P 500, was down 4% from January to August. It’s up 6% so far in September. It’s the same story with companies like Caterpillar, Altria, Cigna and some major insurance companies. What this tells us is that prior favorites like Tech and Small Cap are taking a breather or open to profit-taking and lagging companies are having their day. It doesn't change our Small Cap outlook…Tech is different, it’s under some regulatory pressure and much more expensive. Small Caps have a relatively high exposure to REITs, Financials and Specialty Retail…all of which have come under recent, temporary pressure.

The dollar looks like it peaked a month ago. It was up 9% from February but has since weakened against some key currencies…down 4% against the Swiss Franc, 3.5% against the Euro, 2% against the Yen and 3% against sterling. Yes, the dollar has the rate advantage but exchange rates are also driven by confidence, diversification and capital flows. The U.S.’s twin deficits (current account and budget deficit) are heading the wrong way and eventually they’ll show up in the exchange rate.

We don’t think anyone’s winning the trade war. Despite the big numbers from the Administration, the tariffs amount at worst, to $60bn, which is less than 0.3% of U.S. GDP and a drop in the bucket compared to the $220bn of tax cuts coming into the U.S. economy. Because so much of the imports from China are intermediate goods (here’s the list, it’s 195 pages), the costs may show up in higher prices or squeezed margins some months from now. But it won't be big and it won't solve the broader “Made in China 2025” problems.

Also big news: the sector definitions for the S&P 500 will change on September 24. We’ll no longer have a tech sector at 28% of the index. Instead we’ll drop Telecom and have a new Communication Services group. It will bring in some companies which are now Consumer Discretionary, like Comcast and Netflix, and some which are now in Tech, like Google and Facebook and will be around 11% of the S&P 500. Expect some rebalancing trading on Monday.

 1.     “Tax Cuts will lead to pay increases”. Said some and indeed there was a 2.9% increase in hourly earnings (AHE) in the August payroll numbers. Hooray said some. Not so fast, said others.

There are a few ways to get a pay increase:

 1.     You're paid more

2.     You're paid the same but work less

But we’re not interested in nominal increases. We want to see increases in real purchasing power and wages, otherwise you're just pushing money around the economy, not really increasing broad wealth. And there are a few way you get a real pay increase:

3.     You're paid more than the increase in inflation

4.     You're paid the same but inflation falls

5.     You're paid the same but work less or get more benefits

It’s only #3 that matters and the results are mixed. The tax cut was meant to lead to higher investment, productivity and wages. It was one of those “it pays for itself” programs. As we pointed out at the time, that was a big ask because the tax cuts caused the deficit to increase by 1% of GDP immediately and by another 1% over 10 years.

We've seen companies increase share buy-backs. We've seen some increases in bonuses and time off. But wage increases have been very slow, even as the Fed frets about a sub 4% unemployment rate. Here’s the wage picture in one chart:

The blue bars are what’s reported in the payroll numbers with average hourly earnings up 2.9%. But if we deflate that by the CPI so get a picture of real purchasing power, we see a less impressive 0.23% (black line). And if we separate out the very large cohort of Non-Supervisory Employees from the All Employees category, we see the real hourly wage at $9.24, lower than a year ago.

Now, we bring this up again because of headlines like “U.S. wages grow at fastest pace in nine years” (Financial Times) and “Bumper Wage Growth”. Hey, we’d like nothing more. The U.S. consumer drives 70% of GDP, perhaps more than any other economy in the world. But it’s not showing up in things like retail sales or housing and it’s very likely personal consumption will grow a lot less than the 3.8% it showed in Q2.

2.     So, 3% on the 10-Year Treasury. Now what? Probably not much. There are some seasonal aspects to the Treasury market. They have to do with when new auctions come around, corporate cash needs, repatriation and even national holidays in China and Japan. This year, U.S. companies with pension deficits could deduct the cost of funding them using the old 2017 corporate tax rate up until September 15. That meant a CFO could save some 15% on buying Treasuries. We feel that kept the 10-Year Treasury under 3% for most of August. That buying has now stopped.

 We've discussed the inverted yield curve. After moving relentlessly from 60bps in January to a low of 19bps in late August, it has now reversed back up to 27bps. Here's the chart:

We're not sure if the move to inversion (i.e. the upper blue line falls to below zero) is a solid indicator of a recession. Sure, looking back over 30 years, there it is…the spread falls to below zero and a recession appears some 14 to 26 months later. So that’s three times in 30 years.

But here’s the thing: being early and right is the same as being wrong. There is no point heading to the long part of the curve in the expectation that all the price weakness will be at the short end.

 And as for coming out of equities, well, we’re not timers and markets can have strong and late rallies for quite some time. Here’s the curve shown in stark terms…compare the yellow line to the shape of the curve a month and year ago. It’s only the 2 to 10-Year Treasury spread which is flattening. We'd argue years of QE and low absolute and real rates mean that any inversion will have to look at 3-month bills and long-term bonds. And we’re not close there.

Meanwhile, here’s how we look at the Treasury market:

All we did here was look at several U.S. Treasury prices today and work out how much rates would have to rise in order to lose money on a Treasury trade over 2, 5, 10 and 30 years. The duration measures how much the price of the bond would fall if rates increase 1%.

The best risk/reward right now looks like the 2-Year Treasury (actually it’s about 19 months, maturing in April 2020). It yields 2.38% for a risk/reward of 0.56.

Another way to look at that is that rates would have to rise 1.7% immediately for that investment not to have a positive return. For a 30-Year Treasury, rates would only have to rise 0.16%. To be clear, we’re not ringing any alarm bells here. We're just taking advantage of the recent rise in yields, which makes a short-term Treasury investment look quite attractive and, for the first time in a while, a valid asset class.

3.     Any relief on Emerging Markets yet? Some. Performance in 2017, when Emerging Markets were up 45%, seems distant. So far in 2018, we’re down 8% but up 4% from the bottoms just two weeks ago. We've discussed before what’s happened (basically a dollar, interest rate and trade problem) but the question now, of course, is what next? Here are some quick thoughts.

  1. Buying into Emerging Markets is not an exchange rate or trade story. It’s about growth, demography and expanding economies.

  2. Turkey and Argentina are basket cases. They're not in the Emerging Markets asset class to any meaningful weight but their stories grab headlines. We don't believe the financial contagion story for a moment but agree there’s a sentiment problem.

  3. Drawdowns in Emerging Markets are common.

  4. 50% of global growth comes from Emerging Markets.

  5. The new NAFTA with Mexico is good for Mexico.

  6. The 22% annual increase in oil prices has hurt Emerging Markets but the supply issues (Iran and Venezuela) are no longer driving up prices.

  7. Seasonal patterns happen in Emerging Markets especially after a bumper year like 2017.

  8. China stocks had their best day in two years on Friday…these things move fast.

So while the short-term can stretch patience, the longer-term strategic case remains.

Bottom Line: Fed meeting. Much will depend on whether the Fed removes the “accommodative” wording. They’ll also review the long-term projections for the Fed Funds rate. It’s currently at 2.3% to 3.5%. If that heads up by 0.5% we may see some pressure on bonds.

 Please check out our 119 Years of the Dow chart  

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Instagram can kill you

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

 

Karl Hyde - 8 Ball 

While Away...

The Days Ahead: Trade and more trade. Unemployment numbers.  

One-Minute Summary: We're away but not absent. Off on a short recharge break. Back in two weeks.  While we’re gone, this is what we’ll be paying attention to:

1.     Trade Talks. China, Canada and Europe. We'd look for a de-escalation with China and some progress with the EU. There’s a sort of “good cop (Treasury), bad cop (Commerce)” play going on and Treasury is up first. We'd also look for Canada to be included in the “just don't call it NAFTA” discussions. There seems to be some urgency going into the midterms to get something done.

2.     Growth. We talked about some so-so housing numbers last week but Industrial Production keeps chugging along. The Q2 GDP revised numbers came out. They went up a bit from 4.1% to 4.2%. You can see from the graph what a rapid departure Q2 was from prior quarters (blue bars):

The big question is, how much is growth borrowed from the future? We'd say at least 0.5% but admit this is a very rough estimate and we’re not economists. Take a look at the second line. That’s GDI (Gross Domestic Income) and is an alternative way to measure GDP. They should be the same but there is a very big discrepancy right now. In the second quarter, investments in “Intellectual Property” were revised up by a whopping 2.8%. That’s basically software. But personal consumption and imports were revised down.

The theory behind the tax cut is that companies’ lower tax bills lead to increased profits, which mean more investment, which grow employment and wages. The first one is happening. Pre-tax corporate profits were up 7% YOY and post-tax up 17% (these are national numbers…. S&P 500 companies are way ahead). Investment growth slowed and the personal side is back to where it was a year ago.

So far the consensus is for another 3.5% GDP growth Q3 but the latest trade numbers were not great and are set to be a net drag in Q3.

3.     Employment and the Fed: First Friday in the month so jobs numbers next week. We would expect around 180,000 but given the margin of error on this number, +/- 40,000 would not make much difference to the market. Hourly earnings will also be mostly unchanged at 2.5% but down and close to zero in real terms. The Fed doesn't meet until September 26, at which time they’ll almost certainly raise the Fed Funds rate by 25bp to 2.25%.

Meanwhile, we’d expect 10-Year Treasuries to trade around 2.8% to 3.0%.

4.     Stock market breadth: We've seen some improvement in the advance/decline ratio. What we look for is wide participation in the market. A “bad” participation day would be if a few stocks are enough to push the index up but the majority of stocks fall. Recently it’s been about half the stocks up and half down on an upday, which is good.

5.     Emerging Markets. Markets bounced 4% this week, based on the Mexico trade deal and a weaker dollar. The big three influences are at work: trade, rates and the dollar. None of those will disappear overnight. But we’d look for some relief on the currency side. And on Emerging Markets….

6.     We had an interesting question come up in our Emerging Markets call-in (it’s here)

Is the term “Emerging" accurate? Or are the so-called "emerging markets" comparable to the time-honored description of Argentina, i.e., "has a great future and always will have?"

The Argentina reference comes from the fact that at the turn of the 20th century, Argentina was the world’s 10th largest economy. Now it's not even in the top 20.

We don't think the term “Emerging” is terribly helpful. It was 40 years ago but when you have the second largest economy (China) and South Korea or Taiwan all called “Emerging” there is a definitional problem. Just to confuse things further, Argentina is Emerging with some index providers and “Frontier” for others. Same goes for South Korea. Some say “Developed,” others “Emerging” and the differences are down to the Chaebols, not to South Korea’s heft in the world economy.

The “Emerging” definition these days is as much about governance as economic size. So countries with restrictions on foreign ownership, non-GAAP reporting standards, cross-holdings or voting shares are all in the Emerging bucket. When they start to address those they're promoted into Developed.

There are some real powerhouses in emerging markets: China, South Korea, Taiwan and India. They're 65% of the index. And even eastern European countries (12%) are pretty advanced these days.

We don't think there are many that are perennial hopefuls (i.e. probably not going to do much in coming years) and not one of those countries is more than 2% of the index. Here’s what it looks like:

So, yes, while “Emerging” has a nice ring to it, “Less developed” is probably more accurate. 

7.     And finally: In a month when we hit several all-time highs, we’d remind ourselves of the long term. Here’s the Dow Jones stock index back to 1900 (the S&P 500 is a better index but only goes back to the 1950s). Through some bad times, the market has powered ahead. On the 10th anniversary of the Lehman crash, it’s worth looking at how well the market has done over time.

As always, if something comes up please feel free to call Rita on 415 435 8330.

 Bottom Line: Stocks are trending up but with no big stories or conviction but on macro and political headlines.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

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Five lessons from the ultimate innovators

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

Summer Sun (Plein Soleil)

Whiff of Contagion

The Days Ahead: Jackson Hole Symposium, which is often a good source of Central Bank think. Very thin economic reports and corporate earnings season is all but done.

One-Minute Summary: Consumer confidence fell. That surprised some but we think it’s not tied to claims and employment, which are running well. But to wages. I know we bang on about this a lot and there are plenty of others following the same story. Here are the latest wage increases:

Wage increases are barely positive and we believe even those numbers are inflated by supervisory pay. In other words, non-supervisory employees are seeing negative growth in real wages. There are many more workers than bosses so we think the average number is misleading. And it’s been happening all year. There are plenty of plausible and conflicting reasons why this is happening but none are important to markets right here right now. We'll just leave it that consumer spending cannot sustain a 4% growth rate. Wages aren't strong enough.

Gold was down (it usually drops if the dollar strengthens). The S&P 500 finished mostly higher with defensive sectors (telecomm and staples) ahead. The 10-Year Treasury was up. Economic news was mixed. Slow housing starts. Strong retail sales. Productivity growth stayed around its recent, not-so-great trend. Tesla dropped and Elon Musk apologised.

1.     How’s Turkey doing? Not well. If you're an Emerging Market with an inflation and budget deficit problem, you're meant to:

  1. Increase your domestic interest rates…it helps to defend the currency
  2. Tighten fiscal and credit markets…anything, like raise the pension age, curb bank borrowing, but, you know, something
  3. Get some external funding, which usually means calling the IMF

It’s a pretty well-trodden road and see, passim, Argentina, Thailand, Mexico and even Turkey in 2002. What you're not meant to do is:

  1. Pick a fight with your allies
  2. Openly seek assistance from countries with sanctions against them
  3. Not increase bank rates and keep your son-in-law as head of Finance.

So Emerging Market bears continued to sell Turkish stocks, bonds and currency. The bonds alone widened out by 200bps in the last few weeks, which means they had a capital loss of around 22%. Here’s the chart:

One might reasonably ask why Turkey, with its 1% weighting in the Emerging Markets stock index brings everything else down? It’s mostly because of contagion fear.

First there are European banks with outstanding loans to Turkey. Those loans will be impaired. Banco Bilbao, in Spain, is down 13% in the last few weeks and down 25% over the year.

Second, investors start to look at countries that share the same problems as Turkey, and number one on that list is South Africa.

Third, there’s a problem with covariance in Emerging Markets. If a developed market runs into a recession, stocks fall and interest rates fall. So, there is some portfolio diversification benefit. But in Emerging Markets, currencies need protection so interest rates rise and stocks fall. There is no diversification benefit.

Emerging Markets are also caught up in the Sino-U.S. trade war. News of renewed trade talks later in August helped markets recover on Friday but China is still slowing…the trade talks may help but signs in the currency (it’s down) and commodities (way down) suggest the Asian correction isn't over. Again, we’re using protection for what might be a troubled few months.

2.     Fidelity launched a 0% ETF. Isn't that great? Perhaps. So, yes, Fidelity launched a zero cost ETF and even stuck “zero” in the name, so they would be taken seriously.  What could possibly go wrong? Well, not much, perhaps, but there are other things to think about when we get to near zero fees. For every $10,000 you have in the Fidelity account, you would pay $4 in a similar Vanguard fund and $3 in a Blackrock iShares fund. Fidelity is a fine company. But we’d also look at:

1.     Securities Lending: Many ETFs lend out their securities to custodian banks. We could not find how much of the securities lending proceeds Fidelity will credit to the fund and how much to the investment company. The split should be around 80/20. Our guess is that the investment company will take a larger share.

2.     Index: Fidelity came up with its own index to track the U.S. market. Again, nothing wrong with that but others like Blackrock, Schwab and Vanguard use external, independent indices. Which, we sort of prefer.

3.     Returns: not all indexes are created equal. We've written about the performance of the small cap S&P 600 (up 213% in 10 years) over the better-known Russell 2000 index (up 162%). While not quite as big a difference, here are the 10-year returns of five big, U.S. multi-cap stock funds and ETFs:

They’re all bunched together but squint at the end lines and the extra returns for a $100,000 portfolio over 10 years for an investment in the top and bottom funds turn out to be $17,530. The best fund was not the cheapest. Nor was the worst (we’re talking relative here) the most expensive. It all came down to which index the fund tracked. Some indexes are better than others.

So, pick your index, then the cost. Cheapest does not mean the best (h/t Dan Wiener).

 Bottom Line: Treasuries will remain bid, mainly because of the expensing of pension contributions we discussed last week. We'll be testing Emerging Markets contagion again.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Pastafarianism is not a thing

--Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

Closing note: Aretha and Chains

Tesla, Turkey, Treasuries.

The Days Ahead: Earnings mostly over. Productivity report

Listen to the Podcast: Apple Podcasts • Soundcloud • Google Play

One-Minute Summary: Strong week for equities with not much to change the tone of good results, modest inflation and economic numbers and a truce of sorts on the trade side.

Tesla said, “enough of this reporting nonsense, we’ll go private”. Then thought about it. Then couldn’t decide. Normally, we’d ignore stocks like these but the company has a record short position and there’s a lot of money at stake proving or disproving the Tesla dream. We raise it because, well, it’s just not good when i) CEOs announce market sensitive news by Tweet ii) there are convertible and iii) regular bond holders to consider and iv) there’s a very convoluted process for buying out shareholders that may just leave them shareholders, if they want. It’s just, you know, not good governance. And they're not the only ones. Call us old fashioned. Here and here have the best take on it and the SEC is on the case.

Berkshire Hathaway (BRK.B) had a good week. It reports on a Saturday to keep the news cycle at bay. One big change was that unrealized gains on the stock portfolio now report through the Income Account. This is a weird rule. Berkshire holds $50bn of Apple stock, which is around 10% of Berkshire’s market capitalization. If Apple goes up, Berkshire now has to recognize that through the income statement. So, in Q1 investments showed a loss of $7.8bn and in Q2, a profit of $5.9bn. You get volatility in return for transparency, I suppose. Some might like that. The core operating business did well and that was mostly what drove the stock up 5% for the week.

The 10-Year Treasury auction went well. As we wrote last week, this was a record amount of $26bn and we were concerned dealers would have trouble placing it all. But no, it was well bid.  But it adds to our concern that the yield curve will invert. Meanwhile, the TIPS curve inverted last week for the first time in 10 years. We should note that the yield curve inversion is not a sure recession indicator (see here) but more of a concern that growth will slow. Which we already know from other data.

1.     Is inflation out of control? No. But you may think so from some Friday headlines. The headline inflation hit 2.9% and the core inflation hit 2.4%. Here’s the chart with the blue bars getting all the headlines.

We expected these numbers mainly because there was a big base effect from 2017.

First, remember the cell phone expenses? They were falling at an annual rate of 20% a year ago. Well those deals are over.

Second, gas prices were flat a year ago but are now up 25%.

And third, used car prices are running high, probably as a legacy from the hurricanes when people needed to replace lost vehicles quickly.

These account for around 12% of the CPI. Take them out and we’re left with an inflation rate of around 1.5%.

Treasuries rallied by about 1%, so markets do not think any of this will change Fed policy. We'd agree. Meanwhile, real hourly earnings didn't change and average hours worked dropped. So, the outlook for personal consumption (the bit that's 70% of GDP), which was half the headline GDP rate of 4% in Q2, looks not so hot.

2.     How’s Turkey doing? Not well. Without diving into the dodgy politics and economics of Turkey…oh all right, Erdogan’s son-in-law runs the Ministry of Finance (here but they took down his bio) and promises to do something about the financial mess.  But it all came to a head on Friday as the Turkish lira dived. Here it is:

It's not often you see a 25% fall in a week for a sort-of major currency. The problems are fairly commonplace:

  1. over leveraged banks with
  2. mismatched FX
  3. 10% inflation and
  4. high government debt.

These are not good headlines but Turkey’s role in the world and Emerging Markets is small. Its economy is around $850bn and its stock market, down 50% this year, is around 1% of the Emerging Markets index. But even at that level, investors tend to hit the sell button on whenever there is a story like this. It's not enough to change our long-term thinking but adds to our short-term caution.

3.     Stocks at record high. Time to sell?  No. The S&P 500 is slightly below its all time high from January 26, 2018. But the better index is the S&P 500 Total Return. This one takes the 2% dividends from the S&P 500 and reinvests every quarter.

 And wow, what a difference that makes.

 Here's the chart with the S&P 500 on the bottom line and the total return on the top. One hundred dollars invested in the S&P 500 in 1989 is worth $1,070 today. With dividends reinvested, it's $2,066.

The total return index has had four all-time highs this year. The regular S&P 500 only one. That’s pretty normal and the only reason it’s not more widely reported is because, well, it’s kind of boring. “Remember to reinvest those dividends” doesn’t quite have the ring of “Why stocks will crash next week.”

So, dividends matter.

 Bottom Line: Earnings drove stocks to an all-time high. There’s little corporate news in the calendar so expect macro/tweets/trade to drive returns short term. Treasuries to remain strong because companies can expense pension contributions at the old higher corporate tax rate for another month.

Please check out our 119 Years of the Dow chart  

Subscribe here for our investment updates

Other:

Best not to provoke bison

 --Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

Friday Music - Nils Lofgren

Hog Wash

The Days Ahead: Employment report and probably some trade talk. Shorter week.

One-Minute Summary: Markets lost their patience with the trade issues. Ye gods, on Friday the rumor was that the U.S. will withdraw from the WTO. That actually require an act of Congress so no immediate threat. The market recovered from its lows but there was a general risk-off theme.

The 30-Year Treasury had a good week, with yields falling from 3.08% to 2.96%. Why? Well, we’re in the middle of a great quarter for growth. We know this because 1) first quarter GDP was revised down to 2% 2) since the crisis, there are some very weird seasonals not captured in Q1 that flow through to Q2 and 3) with things like a lower trade deficit, the GDP now model is flashing around 4% growth.  There have been some quarters of 4% growth since 2009 but they have very quickly rolled over to the lower average growth of 2.0% to 2.5%. We think that’s going to happen again. The decline in the 30-Year Treasury yield tells us the market is not convinced growth will last.

A rough week for Emerging Markets, which are dominated by the dollar, interest rate and trade issues. We're watching to see how China reacts. They may impose more tariffs. But they could just 1) weaken the Renminbi 2) sell U.S. Treasuries or 3) go after U.S. companies doing business in China from China. Apple has 18% of its sale in China and another 18% in Asia Pacific. Any iPhones sold there are made there. If China was to start making life difficult for firms selling in China, then goodbye Queensberry and hello cage fighting.   

1.     Markets are jumpy – maybe because there are fewer defensive stocks around. Stocks feel like they're volatile but the standard deviation and VIX numbers are pretty much in line with levels from two years ago. It’s only against the unusually low 2017 levels that it feels more risky.

 But in some ways the market as a whole is a more risky animal than in past years.

 We looked at the classic defensive sectors of the S&P 500. So, that’s utilities (e.g. DUK, SO) telecommunications (T, VZ) and consumer staples (PG, WMT, KO, MO). We took their combined market capitalization as a percent of the S&P 500 market capitalization. Here it is:

Defensive stocks have indeed fallen to a near all-time low of 12% of the market from 21% in the pre-crisis era. Some of that is because these companies face more competition and they’re just not great businesses. But some is because big companies keep getting bigger because, well, they are good businesses and there has been little to no anti-trust enforcement.

So, Amazon is 25% of the Consumer Discretionary sector and accounts for 35% of the gain in the S&P 500 this year. The top 10 growth companies account for 100% of the gain. And the top four tech companies (AAPL, GOOG, FB, MSFT) are 42% of the tech sector.

It’s going to get worse too. In the fall, S&P will create a new sector called “Communication Services” by taking some stocks away from tech and consumer sectors. When that's done, the top five stocks of each of those three sectors will account for 50% to 70% of those sectors.

So, yes, the market has become less defensive which means the market is more vulnerable to any correction in non-dividend paying, momentum stocks (h/t David Ader).

2.     Bought a washing machine lately?  So how much will the tariffs cost us in the end? We're more concerned about the on/off mixed messages of the tariffs. If we take a more or less worst case scenario and all imports from China are taxed at 25%, we would see a about a $125bn cost to the U.S. economy. Sometime in the second quarter of this year, the U.S. economy passed $20 trillion. So that’s a 0.6% hit to GDP. The economy will grow around 3% this year. A drop from 3% to 2.4% does not remotely qualify as a recession. Of course, we can play with even bigger numbers. How about 25% on all auto imports? That’s 0.2% of GDP. Or the EU throws a 20% tariff on all U.S. exports? That’s 0.3%.

But of course, it’s much more than keeping score on who can raise the most or who blinks. The real problem is in the complex global supply chains of modern companies and flow of intellectual property. So, if Harley Davidson, which was in Twitter’s sights last week, faces a 20% increase in its prices in the EU and higher steel prices in the U.S., it must divert production to its existing overseas plants. To do otherwise would surely be a breach of its responsibilities. The stock (HOG) is down 25%.

We don't really know yet what the impact of the trade disputes will be. We do know that tariffs are a tax. Someone has to pay the tax. If companies pay the tax, margins are squeezed. If consumers pay the tax, prices go up. Back in January, the administration imposed a 50% tariff on washing machines and 25% on solar panels. Consumers ended up paying for this one. This is how washing machine prices have changed:

That top green line shows prices accelerating by 83% in the last few months. That's after many years of price declines. This tariff was targeted at LG Electronics and Samsung. Both companies’ share prices fell 13% to 25% this year and showed up in South Korea’s exports to the U.S. (in the blue bars).  

So, all together, tariffs hurt consumers. The question now is how will consumers, businesses and politicians respond to the trade talks? If there’s enough of a blow-back, we might get less bluster and more thought. But it will take at least six months to show up in the data. (h/t Ian Shepherdson at Pantheon Economics)

Bottom Line: Large cap will probably remain in a trading range. The S&P 500 should remain above its 2700 support level but expect some rapid moves.  Emerging Markets remain the weak point.

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NIMBYism San Francisco style

Rodents in ATM

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice. We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security. The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended. Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data. Past performance is no indication of future results.

All charts from Factset unless otherwise noted.

Dreams

Summer trading starts in fits

The Days Ahead: Some durable goods orders. But trade will dominate as a problem.

One-Minute Summary.  We were unchanged on the week but had some odd days when the market fell at the open but closed higher. That seems to be a lot of quants at work (h/t Cameron Crise), which is leading to higher volatility.

Markets are trying to make sense of the increased taxes coming their way. They're in the guise of tariffs, of course, but they have exactly the same effect as a tax. Take steel. It’s up 53% from a year ago and 25% since March (the date the first tariffs came out). Someone has to pay the tariff. It will either come in higher prices to importers, which are then passed on, or in margin compression. Or both. The market doesn't know how all this will work out yet but last week’s Philadelphia Fed survey suggests there are price pressures around the corner. 

Meanwhile the U.S. will have another strong quarter ending in a week’s time. Most earnings estimates are for a near 20% annual gain. At least half of that is down to the lower corporation tax but a 3.5% GDP rate is certainly helping. Small caps and the NASDAQ index (confusingly it’s not the NASDAQ exchange but a warehouse for tech stocks) reached record highs. Europe is struggling with politics in Germany and, of course, trade concerns. The 10-Year Treasury marked time at the 2.85% to 2.95% range. Every time it tries to break through 3%, it rallies.

1.     Markets are jumpy – Emerging Markets edition: Not a great week for Emerging Markets. It’s nearly all tied to trade and the escalating tariffs. First, it was the U.S. imposing 25% tariffs on $50bn of Chinese imports (here’s the full list). Second, China came back with an unspecified tariff on $50bn of U.S. imports. They’ll probably target agriculture and autos. Third, the U.S. thought carefully and said they would charge a 10% tariff on another $200bn of goods. Fourth, the U.S. (well the White House) said, fine, we’ll charge the EU 20% on tariffs on all cars coming into the U.S. It’s true the U.S. can hurt China more than the other way round, for now, simply because imports from China are four times greater than exports to China.

Chinese large cap stocks fell around 11% (in thin markets, there was a national holiday). But Chinese small cap stocks “only” fell 7%. It’s the same story in much of the developed and emerging markets: small cap, domestically focused and non-financial companies have done much better than the large export, headline companies. This makes sense. They're more insulated from the trade problems and benefitting from domestic growth.

A good example of the complexity of the situation is Daimler Benz, Germany’s fifth largest company. It gave a profit warning not because of the U.S. threat of tariffs on cars from Europe, but China’s tariffs on imported cars from the U.S. because…Daimler makes a lot of cars and trucks in the U.S. for the Chinese market. So, it’s a roundabout Emerging Market story. And it's a good example of trying to target one trade sector and not knowing the complex global supply chain of a major U.S. employer.

There’s some short-term uncertainty in Emerging Markets right now. Not just trade. There’s an election in Mexico that will bring in a reformist administration that may not be good for business. The U.S. dollar is still strong and oil still high. Both will hold Emerging Markets back. Again, small caps are doing well, which is why we like the exposure. But we’re investing in protection for our large cap exposure.

2.     Why is everyone talking about the yield curve?  When you buy a bond, you're a lender. You want your money back. Lending overnight should be cheap and safe. Lending for 30 years should be more expensive and riskier. There’s a lot of discussion about what this “term premium” should be. For a five year bond, should it be an extrapolation of the 2-Year note? Or with some adjustment for inflation? Or other macro risk? If so, how much? The number has declined in recent years. We think it’s because investors don't require a lot of premium to lend long because they feel rates will ultimately settle at lower levels. And that the economy won't grow at the rate it used to. Think of it as a sentiment indicator.

A hard indicator, however, is the yield spread between two bond maturities. The most commonly used is the 2-Year Treasury and 10-Year Treasury. Here it is:

That spread is down to 36bps from 130bps at the beginning of 2017 and 71bps in early 2018. That means an investor only paid an additional 0.3% for lending money for five times as long. Why? Well, here’s a quick summary:

  1. The Fed is raising rates at the front end. It’s the only rate they control. The market sets all others.
  2. The market thinks that short-term rates will go up but either that or other things (think trade) will slow the economy, so…
  3. The Fed will start lowering rates long before that 10-Year Treasury matures, so…
  4. The spread or premium will be back to where it should be because short-term rates will fall, while the 10-Year Treasury will not change.
  5. In 2018, we think it means i) yes, the economy is growing gangbusters now, but ii) the Fed is worried about tight labor market so iii) will continue to hike but iv) trade/budget deficits/length of cycle/debt will slow the economy and v) we’ll be back to a Fed cut cycle.

In the past, when short-term rates rise above long-term rates, a recession is just around the corner (the shaded parts in graph). But here’s the thing: you can have a low or inverted curve for a couple of years before the recession hits. It’s all up to the Fed. If they wait too long to cut when the spread inverts, the worse the recession.

We think the rate hike cycle may stop in 2019 and it’s one reason why we’re cutting exposure to corporate credit, and using a short bar bell strategy of 2- Year and 10-Year Treasuries. Or simply, we're unconvinced this late cycle boomlet is going to run for long.

So, here’s a reminder:

h/t Macro Market

Bottom Line: U.S. large cap stocks will struggle to break out of a trading range. European stocks should recover from some of the trade shocks this week.

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GE out of the Dow

Senegal’s triple fist bump

 --Christian Thwaites, Brouwer & Janachowski, LLC

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.
Football's (ok soccer's) best actor awards

Hike but no spike

The Days Ahead: Fed meets Wednesday. Yes, they will raise rates. Bonds won't move much. New dot plots will be important

One-Minute Summary.  After flirting with crossing below its 50 and 200-day moving average (better known by its Wagnerian title, The Death Cross), the S&P 500 had a solid week and is up 4% for the year. The Small Cap world of the S&P 600 and Russell 2000 reached all-time highs and are up around 10% this year. Bonds hung in the 2.90% to 2.95% range. Pretty much unchanged for the last month.

Europe is still worried about the Italian politics, debt and bond world. Italian banks were down over 6% and even the news of a merger of Unicredit with SocGen was not enough to stop a 2.5% drop in the share price. The trade news was not good. One would expect the markets to freak out at the retaliations, a very grumpy G-7 meeting and rate pressure. But the trade war has not changed the generally good narrative. Why? Well 1) the devil is in the details on trade and until we know what they are, it’s tough to put a number on growth and 2) perhaps markets are in the “take it serously, but not literally” world.

Something very definite came in last week from Commerce Department on Chinese steel flanges. You know, the things that look like this. If it goes ahead, U.S. customs will charge importers around $50m. But imports would quickly take up the slack so the final cost to consumers will be negligible in a $20 trillion economy.

Meanwhile, the U.S. ISM numbers were good. Job openings were up. The trade deficit narrowed. The FANG basket of tech stocks has outperformed the S&P 500 every month this year except April and have done it again in June. This won't continue but there’s a trend in place.

1.     Markets are jumpy (Part 3): This week was the turn of the Brazilian stock market.

The basic story was that the government imposed fuel price controls following the trucking strike, which has been going on for weeks. The central bank stepped in with some aggressive currency swaps to try to prop up the Real. But inflation is on the rise (hence the price controls) and there’s an election in October. Throw in trade problems, the Emerging Markets (EM) debt problems, and one wonders why it took so long for the market to wake up.

We think the EM story is solid but the recent weakness is because:

  1. Core yields have risen in developed markets and EM’s track the increases. We think these will moderate.
  2. The dollar has strengthened which hurts EM’s debt management. We expect the US dollar to soften over time.
  3. Crude has been on the rise which hurts more EM economies than it helps. We think that’s about to end.
  4. Trade tensions are high. They will remain so but we don't expect them to affect intra-EM and EU trade.

So, it’s been a test of resilience for sure but Emerging Markets remain an excellent asset class for solid growth.

2.     There’s an awful lot of debt. Yes, but not in the usual places. If we’re looking for the next bear market, one place you can pretty well know is that’s it’s not going to be in the same place as the last time. So, as we said last week, don't go looking at the MBS world. In fact, don't even go looking at consumers. The new snappily-titled Z.1 report came out this week. It was called the Flow of Funds report, which describes exactly what it is. But, hey, I’m not a branding expert and someone came up with Z.1. And who can blame them? It’s a ton of information that gives us plenty of blog subjects if the markets aren't really doing anything or we need a break from tweets and headlines like this.

Here’s what caught our eye:

The blue line is household debt. That’s all the mortgages, credit card, auto loans, and home equity lines thrown in together. You can see the peak of 120% of GDP a few years ago. Since then, households have taken the message of running down debt very much to heart. It even fell more last quarter. So it seems consumers are a) not following through on the confidence they say they have and b) not using the tax cuts to borrow more.

The other line is non-financial corporate debt (we need to exclude banks who need debt for capital and loan growth). It’s at an all-time high. Now we know one of the themes of the last few years was for companies to borrow at low rates to offset cash held offshore and pay for share buy-backs. And we know that we should probably adjust the number for cash and cash equivalents held by companies (remember Apple’s $100bn cash pile).

But still, that’s a fair amount of borrowing and we think it’s one of the main reasons why stocks have been tepid in recent weeks. Yes, the tax cuts have helped a lot. Estimates for S&P 500 earnings in 2018 made in early December were $146, up 11%. By January, they were $158, up 19%. The difference was entirely due to the lower tax rate. So in a high-leveraged world, companies with lots of pricing power (think software, personal products, pharma) do well. Companies with less pricing power and leverage (think energy, transportation, autos) will not. And there are a lot more companies in that second group than the first.

So what? We're keeping a close watch on the leveraged companies. We’re out of some of them (like REITs) and expect more sideways market action until the story is clearer.

Bottom Line: Yield curve is flattening again. This time in the 5s and 30s. Europe will struggle with the trade news. Volatile but sideways stocks.  

Light blogging only next week. Heavy travel. Back in two.

Call 415 435-8330 or email at cthwaites@bandjadvisors.com if you need anything. 

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Why farm-raised salmon are deaf

G6 plus one, more than G7

--Christian Thwaites, Brouwer & Janachowski, LLC

 Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

Weekend Music: Band Apart

A small dose of nerves

The Days Ahead: Jobs number on Friday. Short trading week.

One-Minute Summary.  Bonds were up, large and small cap stocks up a small amount and international stocks off around 1.5%...much of that was because of autos (see below), which are around 20% of the German and Japanese stock markets. Emerging Markets had a troubled week mainly because of the bad news coming out of Argentina and Turkey (we talk about it in our podcast here).

There are really two tracks going on in Emerging Markets. One, those countries with high U.S. dollar borrowing, budget deficits and importing oil. Two, those that don't. In the first category are Turkey, Argentina and the Philippines and in the second, China, Taiwan and South Korea. We're oversimplifying, we know.

Right now, there’s a great deal of concern about the former and they're overshadowing the better story from the others. It’s also a problem that a lot of Emerging Market investing is done en bloc, meaning investors buy a single ticker and they're either all in or all out. We think some of this will settle down but in the meantime are looking to protect our Emerging Markets exposure.

1.     Markets are jumpy. Combine coming up to a long weekend, month-end positioning, little company news and some unpredictable headlines, and markets can move very quickly. Here are two examples from last week. First, the 2-Year Treasury when the Fed minutes were released at 2.00pm on Wednesday:

It’s highly unusual for the 2-Year Treasury note to move that much. The reason was that the Fed said:

 “It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective. “

Which is Fed-speak for inflation may run a little hot for a while rather than hiking rates as soon as we see a CPI print of over 2%. So it was “dovish” and the 10-Year Treasury promptly dived back under the 3% level, which people got so worked up about a few weeks ago.

The second was this:

The catalyst was the Commerce Department announcing an investigation into automobile imports under the same Section 232 of the Trade Expansion Act of 1962 used in the case of steel a few months ago. Immediately, foreign car manufacturers fell and wiped off around $20bn in market cap from the five companies shown.

Now, the world auto market is a little tricky to get your arms around. Global production is around 97m units a year. But companies have multi-country supply chains. Germany, for example, exported around 450,000 cars into the U.S. but made 804,000 in the US, some for the U.S. market and some for export. European tariffs on U.S. autos and U.S. tariffs on European autos are about the same if you adjust for America’s high tariff on trucks (SUVs are “trucks” in the U.S. and cars everywhere else).

Similarly, Ford makes a lot of cars in Mexico and Canada and imports them to the U.S. In fact, the only car producer that makes 100% of its cars in the U.S. is Tesla and they account for 1.2% of U.S. total production.

It will be fiendishly difficult to target companies and levy the right amount of tariffs. Expect a lot of carve-outs or indeed nothing at all. This all may blow over. Meanwhile, it shows us the hyper-reactive phase the market’s going through.

2.     Volume Smile. We're big fans of ETFs. Sure, there are some dopey ones  and the clue is normally in the ticker. But they're generally great vehicles and do their job efficiently.

We talk a lot around here about whether they distort markets. I mean, look, they’re multi-billion dollar behemoths and to some extent transform liquidity, which means making something inherently illiquid, liquid. Here’s a good write-up of how the folk at Blackrock manage  their $55bn Aggregate Bond Fund (AGG), which tracks 10,000 bonds but “only” buys 7,000 of them.

What we look for is, a) are they distorting markets in b) a way that can harm investors? The answer to a) is emphatically “Yes.”  So, far the answer to b) “Not sure, don't think so.” In recent years we’ve seen the emergence of the “trading smile.” Here it is:

This shows the volume for SPY, which is the mother of all ETFs and tracks the S&P 500. It's $264bn, has 2,000% turnover and accounts for around 6% of NYSE volume (even more on a dollar basis). It's a good proxy for the market. The chart shows the volume for Thursday of last week and, there it is: a large volume at the beginning (9:30am but shown here 6:30am PST) and end of the day (4:00pm or 1:00pm PST)) and a very large drop off from around 7.00 am to 12.30am. And that’s a badly drawn smile on top (hey, no one hired us for Microsoft Paint skills).

What’s going on? Well, you would expect a drop-off around lunch but this looks like traders do their thing in the opening and closing half hour of the trading day. The answer is that passive products and complex algorithmic investors realign their portfolio at these times so active managers stay away from the market. Bob Mincus of Fidelity (here but behind FT pay wall and also here) sees an opportunity here and he should know, he manages billions in equities:

“We view the close as an opportunity. As more volumes migrate towards the close, we will follow it.”

This clearly creates some problems because a big buyer coming in mid-day will almost inevitably run into a liquidity shortage, which means more volatility. So, we have a weird situation where an efficient market vehicle (an ETF) creates an inefficient market. Some people are calling for a shorter trading day. In Japan, the stock market opens from 9:30 to 3:00 and closes for an hour at lunch. All very civilized. Their market is a lot less volatile.

Anyway, we don't much like this trade funneling and try to stay away from ETFs that we think might not do well under “smile” conditions (and SPY is one of them).

Bottom Line: The market lacks a theme. Emerging Markets will move on any bad news even though the likes of Turkey and Argentina are hardly mainstream investment destinations. But otherwise, we think markets will drift for a while. They may also become inured to some of the sillier headlines and tweets. 

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Shrieking lynx

Ship caught in trade talks  does two gigantic U-turns

No, Uber is hopelessly unprofitable

 --Christian Thwaites, Brouwer & Janachowski, LLC

 

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.
All charts from Factset unless otherwise noted.

2018 Outlook.

A year to remember.

We sent this to clients recently, so if you're a client, you can skip this. 

It was a most extraordinary year. It started fearful and ended exhausted but exuberant. In January, stocks were in a “show me” mode. The brief post-election rally fizzled, bonds tracked sideways and only the dollar was showing any sign of weakness. But markets then took a calmer look. The givens were that the Fed was going to move slowly and announce clearly. No surprises and no drama. It was the opposite in Washington but markets seemed to distinguish bluster from threat. And anyway, one consistent motif was that government was going to go light on business regulation, cut taxes and spend on infrastructure. In the end they delivered on two out of three, although we’d be the first to agree, it was a messy process.

Overall, we’d point to three main themes:

1.     Supportive Monetary Policy: From March on, we had only minimal and short-lived corrections. For the year, the S&P 500 was up 22%, international markets +25%, long and short-term Treasuries +7% and 1% respectively and Emerging Markets +38%. From mid-year on markets never looked back. It was also a year when there was a noted absence of volatility. We were not surprised. Volatility in the past was often the result of the Fed playing its cards close and keeping markets in suspense. This time, the major central banks led by the Fed but closely followed by the European Central Bank and Bank of Japan, flagged their intentions loud and clear. Meanwhile, we saw steady and synchronized growth across the world.

2.     Corporate Profits recovery: But perhaps the most important feature of 2017 was that companies delivered on growth. For some years, we’ve seen U.S. companies produce decent earnings growth through a combination of share buy backs and financial and tax management. This was fine as far as it went but the fashion for big buy backs was on the wane going into 2017. Investors wanted real growth and they got it in 2017. We saw corporate earnings for the S&P 500 grow around 10%. All sectors participated including energy and commodity stocks, both of which had a tough couple of years. Only one industry sector had a negative return: telecomm, which found itself in the middle of a price war.

3.     Global Growth: Europe finally started to perform as the monetary easing fed through to the real economy. Two major elections in Germany and France returned centrist, pro-growth governments. Japanese stocks had a very strong year, up 19% (but up 23% to a U.S. investor). Why? A successful reelection by a popular Prime Minister, pro-inflation policies and a pick up in world trade.

So what’s ahead for 2018? As we write this in the first week of trading in the New Year, we’ve seen all major markets run ahead. Some of that is a reaction to the tax changes rushed through in the last days of 2017. Although the plan runs to 400 pages, its central tenet is lower corporate taxes. For many companies, especially if they are more domestic than multinational, the 15% tax decrease falls straight to the bottom line. Companies will start to talk more about the effects of a lower tax in the upcoming earnings season. But for most, there will be very little downside to the changes.

Elsewhere, this is what we see running in 2018.

1.     World Economy upswing. Global growth is moving along at 4% or so, up from 3.5% in 2017. The sheer size of the U.S. economy, some 25% of the world economy, looks like it will break through the 2% growth pattern we've seen for years and could grow at 2.5%. In the last three quarters of 2017, growth exceeded 3% but that may be unsustainable given recent trade numbers.

Emerging Market economies should have a strong year. China will grow at around 6% but more important, Russia and Brazil will recover from years of low energy prices and consumption. Japan will remain a huge beneficiary of global growth and we expect higher inflation and wage growth to support the domestic side of the economy. The EU is still early in its growth cycle. Many European multi-nationals will benefit from U.S. tax reform and corporate margins and profitability remain well below their 2007 peak. Plenty of room for upside.

2.     Interest Rates. The Fed will raise rates. The unemployment rate will remain around 4% and most of the Fed believes that a tight labor market means higher wages and prices. Of course, neither of the last two has happened and we don't expect them to. But the FOMC is more hawkish in 2018 than 2017 and several seats remain unfilled. So expect two to three rate increases this year. But, two important points:

1.     When interest rates rise, equity declines are rare. In other words, higher rates mean a better economy, which is good for stocks.

2.     If rates increase gradually, which is what we think will happen, bond markets and prices adjust. And total returns will remain positive.

We also believe rates will remain low globally. Other major central banks are three years behind the Fed in tightening. We expect German and Japanese long bonds to remain well under 1%.

3.     Equities will outperform bonds.  This may not sound like a high hurdle but equities here and overseas remain attractive compared to bonds. International markets are cheaper than the U.S. (even after adjusting for different industry weightings) and companies are still generating strong cash flow and paying and increasing dividends. We would look for an 8% improvement in U.S. stocks and stronger numbers overseas.

Some portfolio changes. We reduced our allocation to Treasury Inflation Protected Securities or TIPS and reinvested into longer-term U.S. Treasuries. We also will continue to take some profits on U.S. REITs, and allocate money to Asia-Pacific markets and international small cap.

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119 Terrible Years of the Dow

Please note that this discussion of our investments and investment strategy (including our research and investment process) represents our investments and investment strategy at the date of this commentary, and is subject to change without notice.  We cannot assure that the type of investments discussed in this commentary will outperform any other investment strategy in the future, nor can we guarantee that such investments will present the best or an attractive risk-adjusted investment in the future. This is for general informational purposes only; references to an individual security should not be construed as a recommendation to buy or sell that security.  The securities mentioned in this commentary are only several of the successful as well as unsuccessful investments by us, and do not represent all of the securities we have purchased, sold or recommended.  Although we deem reliable the sources of the statistical and other information referred to in this commentary, we cannot guarantee the accuracy or completeness of any statements or numerical data.  Past performance is no indication of future results.

All charts from Factset unless otherwise noted.