Three Key Thoughts:

Better Growth Expectations Fading?
Fed Staying Ahead
Non US Markets Picking Up

The resurgent growth narrative (lower taxes + less regulation = improved growth) continued through much of the second quarter. For the first two months of the quarter, a small group of very large cap technology stocks dominated the returns of the market indices, causing some investors to see visions of 1999. As these technology stocks sold off in June, health care, industrial and financial stocks took over the market leadership, leaving market levels at or near all time highs at quarter end.

In many ways, the bond market’s second quarter looked much like the first. Treasury yields declined, spreads in credit sensitive sectors tightened further and non-dollar debt generally appreciated as the dollar weakened. The bond market also absorbed another one-quarter percent hike in the Federal Funds rate without much reaction.

Because short term rates were raised while long term rates were declining, the spread between short and long term rates narrowed further. This spread is something we will keep a careful eye on because further narrowing could be an indicator of economic weakness to come. The other indicator we are watching is the spread between high yield corporate bonds and comparable maturity Treasury bond rates. If this spread begins a sustained rise, this may also portend weakness in the equity markets and a potential recession on the horizon. Given that we are about eight years into this economic expansion, we need to be vigilant in looking for signs of future weakness.

Some of the stock market’s current buoyancy is based on expected fiscal stimulus from lower tax rates. With Obamacare repeal and replace on life support, keeping tax reform “revenue neutral” will be a much more difficult task. As a result, a meaningful reduction in tax rates is unlikely. On the plus side, reducing (or just not introducing new) regulation is something the administration has in its sights and could well make progress on.

Another restraint on growth will be tighter monetary policy. As we look at the Federal Reserve’s objectives, we see the table set for continued “normalization” of interest rates and reduction of the Fed’s balance sheet. The US economy is growing at or near its potential, inflation is just shy of the Fed’s 2% target and the employment picture is solid with unemployment well under 5% and monthly job additions pretty strong. As long as all three of these boxes (economy, inflation, jobs) stay checked, we believe the Fed will continue to raise rates gradually and will begin to reduce the size of its balance sheet according to the plan they laid out recently.

Speaking of the Fed, we have heard more chatter from Fed members recently with concerns about stock market valuations. While there are certainly pockets of excess valuation, we don’t believe the 1999 analogy is apt at this point for a couple of reasons. First, concentrations of value are not out of line with historical averages. Second, many of these highly valued companies are growing real earnings at high rates, justifying higher price to earnings ratios. However, we are far more concerned about excessive valuations of stocks in many large, slow growing companies. Many of these stocks have P/E ratios that are 4 or 5 times their growth rates – a very unattractive valuation – yet investors appear complacent. We think the Fed chatter is more likely to indicate that they are putting normalization of rates ahead of supporting markets.

Outside the US, North Korea is right where it wants to be – in the center of controversy over its nuclear capabilities. So far, there has been little but tough talk from both sides. China is the key to solving this problem - it will be quite interesting to see if President Trump and his team can work out a diplomatic deal that China will fully support.

Meanwhile, President Trump’s first meeting with Vladimir Putin seems to have mollified critics for now. That said, the surrounding G20 meeting provided much less enthusiasm for Mr. Trump’s America First agenda. Interestingly, this confab took place in the context of a growing view that many non US economies are improving quite nicely. And if you believe that policy is translated quickly into currency movements, then the still weakening dollar says a lot.

Stronger economies and currencies propelled non US stock markets to a very strong first half. We believe this may be the beginning of a longer term trend but only time will tell. Many of these markets have everything going for them (supportive central banks, increasing growth and reasonable valuations) except sentiment. And sentiment can change quickly with positive returns and supportive cash flows.

We have kept asset allocations relatively stable in client portfolios. While being cautious about deploying new cash, we have not reduced US equity exposures meaningfully despite a good first half of the year. We continue to believe that non US stocks provide a more compelling value proposition than US stocks and hold a substantial weighting. Finally, we continue to evaluate fixed income and alternative investment opportunities as returns from these areas have been disappointing. As a result, client portfolios contain somewhat more cash than usual.

Three Key Thoughts:

Fed dials back its optimism about US economy; 2+% is the new norm
China's stock market volatility complicates market reformers' job
Greece is the word

Last quarter, we talked about our expectation that the US economy would grow in the 2-2.5% range for 2015, a result very similar to the previous three years. Now that we have seen much more data on the first quarter and some preliminary figures for the second quarter, the Federal Reserve has dialed its consensus forecasts down into this range as well. And the discussions about interest rate hikes are more about the Fed wanting to get off of zero so that it has room to maneuver if the economy weakens. This is a very different viewpoint than one which had been concerned about strong growth and inflation.

You might wonder why we spend any time thinking about the aggregate growth of the US economy. After all, gyrations in that growth rate show very little correlation to stock market returns. We care because stock prices are tied quite closely to corporate earnings and aggregate corporate earnings growth is tied to the nominal growth (not adjusted for inflation) in the economy. Stock prices can rise for either of two reasons: (1) growth in corporate earnings; or (2) an expansion in the multiple (the price/earnings ratio) that investors are willing to pay for future earnings. At this point in the market cycle, those multiples have already expanded significantly so further gains are very dependent on earnings growth.

There are other underlying reasons why we expect the economy to grow slowly over the next several years. In aggregate, the economy can only produce more by a combination of increases in the labor force and increases in productivity. The Bureau of Labor Statistics projects that the US labor force will grow by about 0.5% over the next 7 years. With the exception of a short period in the early 2000s, productivity has increased about 1.5% annually over the long term. Adding these together, we get about 2% real (after inflation) growth as the new benchmark. If we add 2% inflation, then we can expect about 4% in corporate profit growth, certainly not a very exciting number.

With the US stock market trading at a price/earnings ratio of about 17, investors are paying a relatively high price for pretty slow growth. So what is a good corporate executive to do? Predictably, corporations have been raising dividends and buying back stock. While stock buybacks boost reported earnings per share (because the share count is lower), they do nothing to grow the underlying business. Bottom line: we expect modest returns on US stocks.

Outside the US, we are more optimistic about stocks as earnings growth is picking up in many places and prices are much more reasonable. However, the major non US economies all have their issues.

In China, financial regulators are getting a lesson in what can go wrong when markets are opened up without all of the proper regulatory controls in place. The China A share market soared for more than a year and now is suffering a severe correction. Day to day volatility is through the roof and regulators are scrambling to put in place proper margin account controls and other initiatives to stabilize the markets. Ironically, this stock market volatility was caused by the rush of domestic investors speculating on A shares, betting that prices would go higher once non US investors are fully allowed in. This game was bound to end poorly and it is a distraction from the government’s long term efforts to open China’s capital markets to the outside world. We view these developments as growing pains and, as in the past, China will learn, adapt and move forward.

Japan continues to make progress, albeit slowly, in creating sustainable economic growth and a moderate level of inflation. If we look at Japan with the same lens we examined US growth potential above, it is easy to see how difficult their challenge is. Japan’s demographics are poor (rapidly aging and low birth rate) and they do not encourage immigration so their labor force is not growing. Addressing these issues is one part of Prime Minister Abe’s “third arrow” of comprehensive labor and corporate governance reforms.

In Europe, Greece is the word, for now anyway. Having stolen the limelight from the rest of Europe (which seemed on the road to a respectable recovery), Greece now seems to be playing the part of your erratic drunk uncle at the family party. His behavior gets increasingly bizarre up to the point at which he is ushered out the door by the largest family members. It seems to us that the only reasons the Europeans continue to negotiate are: (1) to prevent other weak members (Portugal, Spain, Italy and France) from trying to renegotiate their own debts; and (2) to prevent Greece from leaving the Eurozone and providing an opening for a competing rescue with geopolitical implications (think Russia). If the Europeans could dispatch Greece in isolation, they would have long since done so. It is just not that simple and the entire episode raises questions about the wisdom of the currency union for weaker members. So we must be mindful of the broader risks and how they are managed.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international stock markets where growth is emerging. In addition, we are under-weighted in fixed income as yields generally are not attractive except in closed end funds where discounts to net asset value have widened to very attractive levels. We continue to add to carefully selected hedged strategies as a way of controlling portfolio risk.

Three Key Thoughts:

Fed dials back its optimism about US economy; 2+% is the new norm

China's stock market volatility complicates market reformers' job

Greece is the word