Quarterly Commentary

Q1 2018

Investors greeted the New Year with notable enthusiasm. Almost a decade removed from crisis, worries about the strength and stability of the economy and the financial system had faded. 2017 demonstrated that stocks could march higher in the face of heightened political uncertainty, and the new tax regime appeared to “guarantee” that a recession was not coming any time soon. Indeed, the newest fear seemed to be a fear of missing out on stock market gains to come.

Our contrarian side reminds us that excessive optimism generally leads to disappointment, just as the darkest outlook tends to precede a turn for the better. The first quarter did not end in the same fashion as it started. Inflationary forces - global economic growth and deficit spending in the US – are in conflict with the deflationary transition away from central bank asset purchases. The consequences of major policy changes (regulatory, trade, tax) won’t be apparent anytime soon, reinforcing our view that the future defies prediction – being just one of many possible outcomes. Our strategy is to remain alert and focus on what we can control – asset allocation and individual security selection.

Quarterly Review

Investors poured record sums into stock funds in January – in just a few weeks the S&P 500 raced to a 7% gain. But the buying quickly turned to selling on February 2nd, when a jobs report showed a jump in wage growth that was interpreted as an indication of an overheating economy. Concern was deepening that accelerating fiscal stimulus (otherwise known as deficit spending - tax cuts coinciding with increased federal outlays) at a time of near full employment might cause the Federal Reserve to raise short-term rates more aggressively than previously expected. Stocks suffer when interest rates rise too quickly because higher rates can slow the economy, and higher-yielding bonds can tempt investors to reallocate away from stocks.

By itself, the jobs number was not significant – the wage bump was reversed in the next report. It was the timing of the report that mattered – it was the spark that set off a 10% correction. This reaction is an example of the inherent unpredictability and complexity of markets. January’s buying energy had pushed prices for stocks and bonds to levels where they were vulnerable to even a hint of bad news.

Further evidence that 2018 would not follow the 2017 script was provided in March as regulatory and tariff concerns triggered selling in the tech sector, recently the bellwether for US stocks. It was also the first quarter in almost ten years that stocks and bonds both posted negative returns. Instead of rallying as stocks were falling, bonds merely managed to lose less than stocks.

Next Up

The economy remains healthy at home and abroad. Corporate earnings are growing, and valuations are reasonable. Yet the stock market is unsettled. We see this as a move toward normal – wish as we may, 2017 was an exception, particularly over the final four months when stocks rose without pause.

The threat of trade wars is making headlines as we start the new quarter. From an economic perspective, trade wars are neither good nor winnable. Tariffs tend to push up prices and reduce overall demand for both raw materials and finished goods.

Few expect that the current skirmishing will escalate into a “war.” (Perhaps even fewer expect a “win” in the form of improved trade terms for the US.) We hope for a quick resolution to the current tension – a prolonged period of trade anxiety might suppress the appetite to invest for long-term returns. To put it another way, assets with long payback periods, such as growth stocks, infrastructure operators, and long-term bonds receive most of the punishment when investors shorten their time horizon. However, few investments would be immune from the damage inflicted by a full-blown trade war.

Also in the headlines, yet not an attention-grabber, is the evolution of central bank policy. Remember that central banks (specifically the US Federal Reserve, the European Central Bank and the Bank of Japan) purchased assets valued at $14 trillion in response to the financial crisis. The Fed was first to begin its buying campaign, and first to dial it back. It began reducing its bond holdings in October 2017, at a pace that will accelerate over the next year and extend to 2021 or 2022. Now the ECB is starting to pull back. Overall purchases by the Fed, ECB and the BoJ will fall from $110 billion a month last fall to one-tenth that amount by this coming September.

The initial purpose of the purchases was to provide liquidity to financial markets in distress – buying huge quantities of bonds encourages the sellers to replace them with something else (riskier bonds, or high-yield stocks) – and the sellers in those transactions do the same – and so on. As this monetary stimulus (aka quantitative easing or QE) did its job, its role in support of economic activity expanded – the Fed launched new versions of QE over the ensuing five years whenever financial markets looked vulnerable. With the Fed and its peers providing this kind of support, investors learned that “buying the dips” would pay off.

Central bank policy is just one of many factors that influence economic progress and the path of asset prices. The tempo of the policy change from easing to tightening will be influenced by the economic outlook and by future market action. Weakness in either should cause the central banks to remain accommodative for longer, while a pick-up in growth or inflation might speed the transition to tightening. A new leader arrived at the Fed in February – his willingness to act in support of markets is an unknown.

We view the removal and expected reversal of monetary stimulus as a deflationary backdrop for asset prices. We assume the central banks will be willing to err on the side of keeping rates lower for longer, because they will not wish to be blamed for stifling either the markets or the economy. However, history is littered with mistakes made along the way.

Current Strategy

In the latter decades of the last century, both stocks and bonds generally recorded strong returns. But since the point some twenty years ago when investors ceased worrying about inflation, those returns have been negatively correlated, meaning that over periods of months or quarters when stocks fell, bonds rose in value, and vice versa. During this period of short-term negative correlation, diversified portfolios still generated robust returns overall – making a balance of stocks and bonds an easy choice. The sub-zero returns posted by both this past quarter serve to remind us that when inflation worries are rising, diversification via a stocks/bonds balance may not provide the protection investors have come to expect.

During such times cash may be used as a substitute for bonds in a diversified portfolio, augmenting its usual role as a ready source of funds for spending or investment. With returns on cash creeping up (many money-market funds are finally yielding more than 1%), the penalty for holding cash is less than it has been for many years.

The market swings since the February correction signal that market participants are in the process of lowering their expectations. While we are keen observers of the evolving “big picture,” we try to avoid overreacting to the concerns of the moment. Our actions are based on research and price changes. Within fixed income, we see more value and less risk in shorter-maturity, higher-quality bonds. Within stock portfolios, we are limiting exposure to cyclical stocks with a high percentage of foreign sales that would be most at risk to trade wars.

Our research process seeks to identify businesses that are run by people who are adapting to change and investing in new products and services that will contribute to profit growth over many years. These managers will adjust to difficult conditions as they inevitably come to pass.

With the increasing popularity of index funds and ETFs, we think that many are invested without much consideration of fundamental valuation. For us, it is not enough to assume that stocks will rise over time. Like the managers of the businesses you are invested in, we anticipate that many challenges lie ahead. With a disciplined approach that considers valuation over a range of scenarios, we expect to come out ahead in the long run.