2017 SECOND QUARTER COMMENTARY

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“It ain’t what you don’t know that gets you into trouble. It’s what you know for sure that just ain’t so.” – Mark Twain

ECONOMY – US

Ten years after the beginning of the financial crisis, the US economy appears to have passed an inflection point and the economic recovery is continuing without further monetary stimulation from the Fed.  Indeed, economic growth continues (albeit at 2 – 2.5%) after two ¼% rate increases by the central bank and two more that are planned in 2017.  In today’s fiat money system, central banks have no constraints on the amount of money “printed” (i.e. injected into the financial system) and with liquidity restored, fears of deflation have abated. Deflation fears have transitioned into reflation confidence as evidenced by the Conference Board’s Consumer Confidence Index standing at the highest level since 2000 (128.6).

With history as a guide, stock prices appear to be moving into phase three of this Long-Term Secular Bull Market. We believe equity markets will be supported by positive trends in US and global expansion, rising household wealth, recovery in corporate earnings growth and a pro-business financial environment. Several positive factors are listed below:

  • Leading economic Indicators (See Chart A) have been rising for several months.

  • Gross Domestic Product (GDP) is growing at a 2 – 2.5% without any contribution from the new administration’s programs for fiscal spending or tax reduction, which are still anticipated.
  • Several executive orders from the new administration designed to reduce government regulations on business have contributed to rising optimism in the private sector.
  • Inflation remains subdued with a “rise to 2% over the medium-term” projected by the Fed.
  • As stated above, the Fed has increased short-term interest rates twice and has indicated two more this year, without disrupting markets.
  • Corporate profits are estimated to rise more than 10% in 2017 and about the same in 2018, without factoring in the effect of possible tax reductions or fiscal spending on infrastructure. (Each dollar of tax reductions is estimated to produce an increase of more than a dollar in earnings of the S&P 500 companies)

Chart BECONOMY – INTERNATIONAL

Major international economies are beginning to move in sync with the US recovery. Synchronized global growth should end the divergent interest rate policies which have been a headwind limiting the US recovery.  Chart B shows the synchronized rise of manufacturing in major industrial economies.  (Purchasing Managers Index – PMI)

BOND MARKET

The 60 year interest rate cycle has registered a double bottom (around 1.3% on the 10-year Treasury) and can be expect to rise gradually from the current 2.35% range as the economy continues to recover. However, the increase of ½ of 1% in the Fed Funds rate so far this year has not pushed free market rates up, indicating expectations of continuing slow economic growth with no signs of significant near-term inflation.  In addition to sluggish economic growth that has been limiting loan demand and putting downward pressure on interest rates, major central banks’ “easy money” policies have left the world awash in liquidity seeking a return.  US rates may be constrained from rising for some time considering that the German 10-year bund rate remains well below ½ of 1%.

STOCK MARKET

Although major stock indices are at or near all-time highs, fear and doubt remain and large pools of investable funds still sit on the sidelines waiting for a price decline.  So far, each price dip has been quickly reversed by those funds seeking a return.  The fact is that in a free market system, capital flows to where it will be best treated in the future.  With investor sentiment high and the economic recovery on a sound footing, common stocks are seen by investors as a preferable choice compared to other investment alternatives.  A deeper sell-off could occur at any time, but long-term investors are advised to stay with high quality companies and add to equity investments during periodic price declines that occur in rising markets.

There has been a definite change in sentiment on the stock market as well as on the pace of economic recovery.  There is widespread optimism among businesses, large and small, and a pro-business administration has helped move markets in anticipation of better times ahead.  Whether we call it “animal spirits” or “irrational exuberance”, as some have, the post-election sentiment change is an example of Adam Smith’s* “invisible hand” that motivates millions of people, acting in their own self-interests, to create positive economic activity and move markets.  (*Author of the 1776 magnum opus – “WEALTH OF NATIONS”)

TREND TOWARD GLOBALIZATION IS SLOWING

Since 2001 when China entered the World Trade Organization (WTO), low priced imports from China and rising US deficit masked the displacement of US labor and lost income, while new technologies led to automation further displacing American workers; but not before a populist political turning point in 2016.  Commerce Department Secretary Wilbur Ross told CNBC:  “We have been in a trade war for decades. The only difference is that our troops are finally coming to the rampart,” as he warned about the consequences of doing nothing.  He added: “Our trade deficit overall is about $500 billion a year … that equals the net trade surplus of the rest of the world.”  The President set the tone for the April 7th meeting with Chinese President, Xi Jinping, by tweeting that the US could no longer tolerate massive trade deficits and job losses.  CHART C shows the decline in employee compensation since 2000 vs. the rise in corporate profits, a trend which is now beginning to reverse.

SUMMARY

 The capitalist economic model is too dynamic and adaptable to be accurately predicted, but we believe the 10 year period of deleveraging by households and businesses is ending.  The path of least resistance is a continuation of the economic recovery and the accompanying Long-Term Secular Bull Market. Historically, bull markets have ended when the Fed moves interest rates up to a level that stalls the economic expansion and removes liquidity from the financial system. Financial indicators that would cause the Fed to raise rates too fast or too high are not evident or likely in the near-term because such action would negatively impact the Fed’s objectives of fostering growth and supporting financial markets.  Therefore, our investment policy remains positive, though cautious, and asset allocations are weighted in favor of high quality, large cap, dividend paying stocks with earnings and dividend growth potential and ETFs with similar characteristics.

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