Thoughts on the Current Outlook

January 18, 2017 Jon Zeschin

Three Key Thoughts:

Markets Herald The Trump Era
Trade and Tax Wildcards
Growing Inflation, Rising Rates

It has been two months since Donald J. Trump pulled off a surprise victory in the US Presidential election. With the Republicans also retaining strong control of the House of Representatives and weak control of the Senate, the GOP has effective control of the Washington agenda for at least the next two years.

Surprising many pundits, stock markets did not react negatively to this news. Indeed, we have seen a strong rally in certain parts of the market that are expected to fare well under a Trump presidency. His agenda is expected to focus on corporate and individual tax cuts, deregulation, infrastructure spending and health care changes. This pro-business agenda caused a spike in interest rates on US Treasury bonds and fueled a sharp dollar rally.

Predictably enough, the sectors that rallied were banks (beneficiaries of deregulation and higher interest rates), industrial companies (more infrastructure spending) and energy-related companies (less restrictions on development and transportation). The biggest beneficiaries were small capitalization companies in these areas which not only have proportionally more to gain but whose US-centric businesses will not be affected by a stronger dollar.

It is our job to look beyond the short term reactions to the longer term fundamentals that are likely to affect our capital markets for the next several years. First, we believe a reduced focus on new regulations (and even a rollback in some of the regulations that were put in place during the Obama era) will be a fundamentally positive development for the business environment. It is very difficult to put a value on this shift but if the initial improvement in business sentiment can be sustained, that will benefit the US economy.

Opening up the tax reform debate is a dual edged sword from our perspective. Certainly, our corporate tax structure is in dire need of change not only to rationalize it but to make the US more competitive in the world economy. Currently, enormous amounts of resources are expended to set up structures to allow corporations to take advantage of more favorable tax regimes elsewhere in the world. However, in any negotiation of this magnitude there are likely to be winners and losers. Our biggest concern is that tax policy could become a tool for trade policy and, on this latter point, we believe the Trump inclinations could be dangerous to the world economy. It is too soon to tell whether the tough talk on free trade is just that or will be followed up with counterproductive measures.

While we aren't necessarily fans of the current tax rate structure for individuals, the current system has one huge advantage over the scheme it replaced: permanence. Looking back over the first decade of this millennium, the phasing ins and phasing outs of various rates and tax provisions were head-spinning, creating needless uncertainty. We hope that some fiscal discipline is attached to the tax negotiations as well. The US fiscal deficit will begin growing in the next few years as entitlement obligations expand, particularly for retiring baby boomers. In our view, sharply higher deficit spending, either on tax cuts or infrastructure could lead inflation and interest rates much higher, choking off the growth they were intended to create.

Even though there are many reasons to be optimistic that growth may well accelerate in the coming years, there are some sobering realities that serve to limit that potential growth. First is the structural issue that an economy’s growth potential is the sum of the growth in the labor force and the productivity of that labor force. Labor force growth is pretty much baked in for the next 5-10 years at around 0.5%, which leaves productivity as the wild card. Save for the 1990s, recent productivity growth has averaged around 1%. Even if we doubled that, we still only get real growth of 2.5%.

We may feel a bit better about that 2.5% real growth though because inflation is likely to pick up, giving us higher nominal (total) growth. With the economy nearly at full employment, wages have begun to rise more quickly. Combine this with stable or rising oil prices (off a low base) and we should expect higher inflation reports ahead.

Speaking of inflation, we believe the other governor on growth may be interest rates. We have already seen a healthy rise in the ten year Treasury bond rate, which is most commonly used in setting mortgage rates. And the Fed is likely to hike short term rates further in 2017, especially if we see wage gains and inflation reports exceeding their targets. The economy is strong enough to withstand a gradual increase in rates and businesses (not to mention savers) will welcome a return to more “normal” interest rate levels. However, there is clearly a risk that rates could rise too quickly, damaging the financial and housing markets.

Our asset allocations views are shifting gradually. We have reduced and will likely continue reducing the allocations to hedged strategies. Returns in this area have largely been disappointing and we believe the period ahead is not likely to be any more kind. We continue underweight in fixed income, focusing on strategies that will do well in a rising rate world. Among stocks, we are adding cautiously to US equities, while maintaining exposure to growth opportunities elsewhere in the world.

Thoughts on the Current Outlook

October 7, 2016 Jon Zeschin

Three Key Thoughts:

Big rally in credit continues
Central banks stay at center stage
Slow growth begets low returns

The positive tone of the financial markets that kicked off in mid-February continued through the third quarter. US stocks ended the quarter near historical highs, helped by a mid-September decision by the Federal Reserve not to raise short term interest rates. With an accommodative Fed, decent economic growth and steady oil prices, prices on corporate bonds rallied strongly, while US Treasury yields stayed relatively stable.

International stocks rose more than their US counterparts in the third quarter as investors realized that Brexit implementation is going to take several years. In addition, scares about capital flight and slow economic growth in China subsided for now.

The Federal Reserve surprised almost no one by not raising rates in mid-September. Still, investors’ nerves were calmed, even though the Fed made it clear that it could raise rates at any upcoming meeting. December now seems like a likely choice but the markets remain somewhat skeptical. Just as the Fed has earned a reputation for being too positive about future economic growth, it is also earning a reputation for being easily derailed from hiking rates by events unrelated to the US labor market and inflation. Meanwhile, the US labor market continues to gain strength and inflation is beginning to appear. We think the Fed now risks getting behind the curve and having to hike more quickly than it would like next year.

The central banks of Europe and Japan are trying to strongly encourage growth and inflation, with relatively little success. In Europe, the central bank continued its asset purchase plan, similar to the quantitative easing we had here in the US, except that their plan includes a broader range of bond types. In recent days, concerns have arisen about Deutsche Bank’s capital adequacy, if it is required to pay large fines to settle with the US government over mortgage crisis transgressions. This will pose an interesting dilemma for the German government, as a 2008-like bailout is politically untenable.

In Japan, negative rates are still in effect and attention has gradually been shifting toward more creative ways to generate growth and inflation. So far, nothing has broken the long-ingrained expectations of falling prices and a stagnant economy.

With stock prices going up while earnings are flat, investors are paying pretty high prices for future earnings, particularly here in the US. This may be okay so long as interest rates are stable and earnings begin to grow. But if longer term rates were to start rising with inflation expectations, the prices that investors are willing to pay for stocks may tumble. Particularly vulnerable, we believe, are high dividend, low growth stocks that have been bid up for their dividend yields. These normally defensive stocks could be much less stable during the next market decline.

As the market gains clarity about the US presidential election, it would be typical to see a rally in stocks between now and year end. However, the new president will face a long list of problems that have been left unattended because of the unwillingness to compromise from either side. We can only hope that the new president takes a constructive path forward, working with Congress to address some of the nations problems.

Our core views about the outlook for the financial markets remain unchanged.

Global growth will be slow. The EU was already in slow growth mode and Brexit confirms that there will be no breakout to the upside soon. China’s growth rate is coming down but the base is now large enough for it to still be a major contributor to global growth. We continue to believe that the US is stuck in a 1-2% real growth economy for some time to come. The first two quarters of 2016 have confirmed that trend.

Interest rates will stay lower for longer. Interest rates in the US may rise a bit as wage inflation makes an appearance but will be held down on the short end by a reluctant Federal Reserve and on the long end by lower yields available on sovereign debt in Europe and Japan.

Positive investment returns will be hard to find. We are neutral on US large cap stocks while staying negative on US small caps. Outside the US, we favor a mix of carefully selected active stock fund managers, including those with dedicated emerging market and Asia exposures. The hedged strategy portion of most portfolios is relatively large as we maintain our underweights to bonds and US small cap. In most portfolios, we initiated a small position in a diversified commodity basket as an inflation hedge. Despite these shadings in our investment allocations, we still aren’t excited about any asset class right now.

We will summarize by reiterating that we see lots of potential sources of volatility and not many sources of great prospective returns. This combination of low expected future returns and high risk is not a hospitable environment for investors. We are emphasizing a broad diversity of strategies in client portfolios and expect to use volatility to clients’ advantage when we believe it is appropriate.

Thoughts on the Current Outlook

July 8, 2016 Jon Zeschin

Three Key Thoughts:

• Populism strikes markets

• Volatility almost everywhere

• Attractive returns hard to find

We have long been advocates of leaving politics aside when it comes to planning investments as changes tend to be evolutionary, not revolutionary, given the checks and balances built into the US system of government. However, in this uniquely wild presidential election year, there is a distinctive edge to the fervor on both sides and growing sentiment for “none of the above” as a write-in candidate. Beneath the surface of this fervor are some underlying trends which bear watching as they hold the potential for significant impact on the world economy and financial markets.

The (apparently) successful candidacy of Donald Trump, the huge support given to Bernie Sanders, and the surprising vote by the United Kingdom to exit the European Union all indicate that a large segment of citizens is not satisfied with a current system which they believe has treated them unfairly. Note I said system, not just policies. In each case, the proponents want to throw out the current system (immigration, banking and free trade, to name a few -- feel free to mix and match as you like) but don’t seem to have a compelling alternative to offer. Indeed, in the UK, it has been interesting to see the politicians who led the LEAVE movement stand aside saying their work is finished. Unfortunately, the real work has not even begun, leaving political and economic uncertainty for some time to come.

It doesn’t take a vivid imagination to see how these “throw out the system” sentiments could lead to harmful changes to the world economy, global financial markets and geopolitical relationships. That said, each of these movements is based on real concerns that have not been effectively addressed by current governments and their policies.

All of this background supports our investment view that heightened volatility in the financial markets is likely to continue and may well get worse before it gets better. For example, we saw a strong selloff after the Brexit surprise and then an equally strong rally back in short order. We don’t believe we are out of the woods by any means as the actual effects are only beginning to be identified, much less actually felt.

For now, politics seems to have shoved aside the more substantive economic issues we should still be quite concerned about: where are oil prices headed…will China be able to transition to a services economy without a crash landing…will the US dollar stay strong…and, of course, when will the Federal Reserve finally embark on a sustained increase in interest rates. An even more pressing and puzzling question is what will be the ultimate impact of negative interest rates on a large share of global sovereign debt?

While we don’t believe we know the answers to any of these questions in advance, there are a few clear implications in the questions themselves.

First, global growth will continue to be quite slow. The EU was already in slow growth mode and Brexit confirms that there will be no breakout to the upside anytime soon. China’s growth rate is coming down, probably faster than they care to admit, but the base is now large enough for it to still be a major contributor to global growth. We continue to believe that the US is stuck in a 1-2% real growth economy for some time to come. The first quarter’s number just confirmed that trend.

Second, interest rates will stay lower for longer. At this writing, US Treasury yields are at historic lows as investors seek safety over return. While this flight to safety may fade over the coming months, US rates are being pulled down by much lower interest rates on government debt across the globe.

Third, sources of positive investment returns will continue to be hard to find. We continue to be neutral on US large cap stocks while staying negative on US small caps. Outside the US, we favor a mix of carefully selected active stock fund managers, including those with dedicated emerging market and Asia exposures. The hedged strategy portion of most portfolios continues to grow as we maintain our underweights to bonds and US small cap. Despite these shadings in our investment allocations, we have a hard time getting excited about any asset class right now.

Fourth, in the short term, currency re-alignments may have an outsized impact on returns. Predictably, the British pound suffered a big decline after the surprise Brexit result. However, the Euro stayed relatively stable and the Japanese yen rallied strongly. The yen rally this year has been particularly surprising as Japanese economic results have been somewhat disappointing and the central bank shows no signs of slowing its easing program. Meanwhile, stability in oil prices around $50 per barrel has allowed some strength to return to the currencies of big oil producing countries. Finally, political change in Brazil gave rise to some optimism about Brazil’s future, affording a rally in its currency.

We will summarize by reiterating that we see lots of potential sources of volatility and not many sources of great prospective returns. This combination of low expected future returns and high risk is not a hospitable environment for investors. We continue to emphasize a broad diversity of strategies in client portfolios and expect to use volatility to clients’ advantage when we believe it is appropriate.

Thoughts on the Current Outlook

April 7, 2016 Jon Zeschin

Three Key Thoughts:

Recession? What recession…
Dollar bulls run out of steam
Europe: Opportunity in chaos?

On February 9th, we published a piece in this space entitled “Markets on Recession Watch.” In it, we noted that the US financial markets were strongly reacting to the possibility of an impending recession, induced by a credit crisis in the energy sector. Yet, as we noted, several key ingredients for a recession were missing: an inverted yield curve, a consumer pullback and high energy prices.

Three days after publication, on the back of stabilizing energy prices, stocks and credit spreads began a big reversal. By quarter end, stocks had more than made up the 10+% loss posted in the first several weeks of the year, finishing in positive territory for the quarter. Similarly, high yield bonds turned in a solidly positive quarter after an abysmal start.

As if on cue, subsequent economic reports showed solid consumer income and spending, supported by a strong employment outlook. However, oil prices have not been able to hold their strong rally. It is too soon to tell if this is just a “too far too fast” pause or a resumption of the oil bear market. Regardless, the negative impact of low energy prices on the credit markets will continue for some time, with the ever present possibility of spillover effects.

On the positive side, the employment picture continues to improve on several fronts. After falling consistently since 2009, the labor force participation rate has ticked up for the last few months, as a large number of previously sidelined potential workers rejoined the labor force. In addition, we are finally seeing some wage growth. This well could be the beginning of a stronger move up in employment costs, something the Federal Reserve has been predicting (too early) for some time.

Meanwhile, aggregate GDP growth for the first quarter will look somewhat weak but it will be positive and not materially out of the 1.5% vicinity that we believe is now normal. With growth this low, there is always a heightened risk that unexpected events could throw us into recession. We need to get accustomed to living with this risk.

Long time readers will recall our continued preference for non-US stock markets, primarily for valuation reasons. With few exceptions, this preference has brought much disappointment as international stocks have dramatically underperformed their US counterparts over the last several years.

The first quarter continued this trend, with the surprising exception of emerging markets. Higher oil prices, dollar weakness and potential political change in Brazil all provided sparks to both the currencies and the stocks. Further easing announcements by the European Central Bank and the Bank of Japan brought strength, not weakness, to the Euro and the Yen. Unfortunately, this reaction says more about the perceived impotence of central bankers than it does about the success of their policies.

China’s capital flight “crisis,” which naysayers were using to predict a major devaluation of the Yuan, has seemingly vanished as recent reports show a rebuilding of currency reserves. Add all of these developments up and the US dollar took a beating in the first quarter. We believe this was overdue, after a very long winning streak for the greenback. That said, we don’t think the dollar is in for prolonged weakness either, just some stabilization.

We have previously noted our concern about the long term effects of the Syrian refugee crisis on Europe and the resulting implications for managing the Eurozone economies. The recent, tragic terror attacks in Paris and Brussels have highlighted weaknesses in the open border system and the still strongly nationalistic views about how to respond. Unfortunately, also highlighted is the inability of the bloc to respond to the crisis in any unified way.

The Eurozone economy remains on fragile ground, still in the early stages of recovery from a series of small recessions after the Great Recession of 2007-2009. An upcoming referendum by Great Britain on its membership in the European Union adds to an already uncertain environment. For the last several years, reports of the imminent demise of common currency were overblown (often authored by those outside the currency regime cheering for its failure). We have believed that the central players (Germany and France, most importantly) would figure out a way to make the experiment work given their overarching objective of internal peace. However, the schisms laid bare by the refugee crisis and exacerbated by terrorism shake our optimism. We hope these challenges become a unifying, not dividing, force.

Last quarter, we summarized our outlook by saying that this “leaves us with lots of potential sources of volatility and not many sources of great prospective returns.” Little did we know how prophetic this would be of the first quarter of 2016! The combination of low expected future returns and high risk is not a hospitable environment for investors. Among individual stocks, we are focused on companies that can grow revenue and profits at healthy rates even in a slow growth environment. Finally, we are adding to investments in hedged strategies that control risk, as we expect the markets to continue to be volatile.

Markets on Recession Watch

February 9, 2016 Jon Zeschin

Just five weeks into the new year, stocks have taken a beating across the globe. Continuing a trend we saw beginning in early 2015, stocks of a small number of very large US companies have been the best place to be. Almost everything else -- US small caps, other developed market stocks and emerging market stocks -- has done poorly, with many segments already in bear market territory.

And, after initially reflecting concerns about the impact of the enormous decline in oil prices, spreads on high yield bonds have continued to widen across industries, reaching normal recession levels. Even spreads on high quality US corporate bonds have now reached a level typically associated with recessions. Conversely, investors have flocked to the perceived safety of US Treasury Bonds, driving yields down and prices up very significantly.

All of these market reactions are classic signs of an impending recession. However, we are missing some typical ingredients. First is that the yield curve usually inverts (short term rates higher than long term rates) ahead of recessions. This will be hard to achieve with short term interest rates so low and, with the markets having tightened financial conditions, it seems very unlikely that the Federal Reserve will raise rates further this year.

Second, the US consumer needs to stumble. So far, consumer spending has been very consistent if not spectacular. Consumer leverage is low and the employment market still seems to be on solid ground. Indeed, the most recent reports on jobs show good wage growth, longer work weeks and strong openings. Only initial jobless claims are a bit weaker than expected -- something we need to keep an eye on.

Finally, we are missing high oil prices, another common ingredient in the recession recipe. Near term prospects for price increases seem pretty dim as inventories are very high, weather is mild, demand is growing modestly and supply continues at a high level. Of course, cutbacks in capital investments and employment in the energy sector will continue to be a drag on growth here in the US.

All of this said, we believe the risk of recession continues to rise. Economic growth in the US is weak by historical standards (although our belief is that 1.5 - 2.0% growth is the rate we should expect based on workforce growth and productivity trends), leaving us little cushion to absorb shocks.

Persistently low oil prices raise the risk of shock from several sources: geopolitical conflicts, bank credit problems and adverse credit market events. And we have to add into the mix the impact of a slowing China, particularly on capital flows and currencies throughout that part of the world.

Bottom line, the markets have real reason to worry so we are remaining somewhat cautious in our investment stance for client portfolios. We continue to add to hedged strategies in pursuit of reasonable returns at moderate risk.

Thoughts on the Current Outlook

January 13, 2016 Jon Zeschin

Three Key Thoughts:

A bear hug for oil
Collision of the economic and political in China
Higher risk, lower return prospects call for caution

Energy prices remain firmly in the grip of a major bear market. In the near term, production is expected to stay elevated with OPEC not budging and Iran output expected to add to the glut. Meanwhile, demand is relatively stable as the world remains in slow growth mode. If US production begins to fall off in 2016, forced by the financial realities of low oil prices, then we could see some stabilization in the supply/demand imbalance.

Expectations of defaults on energy-related high yield bonds caused ripples across the entire high yield bond market late in 2015. This is certainly a warning sign that actual energy defaults could create problems across the credit markets.

Two other energy related matters are surprising. First, we have not seen much of an energy savings “dividend” in consumer spending. This usually takes some time to play out but we would have thought we would be seeing more of it by now. Second, rising tensions in the Middle East (Russia joining the Syrian fighting, open feuding between Iran and Saudi Arabia) should lead to stable or higher oil prices. That has simply not been the case as investors believe the supply/demand imbalance will continue despite these developments. Apparently, it will take an event that actually changes the supply situation to jolt the markets.

In China, the year started with a big drop in the A share market as concerns about currency devaluation and expirations of selling bans came front and center. Imposition of a poorly designed circuit breaker deepened the uncertainties and contributed to selling pressures in stocks around the globe. It’s important to remember that the A share market is primarily for locals and does not represent a major portion of Chinese wealth.

The Chinese authorities are trying very hard to balance four things: (1) a long term transition to a service oriented economy which means substantially lower, but more sustainable, growth; (2) a gradual transition to a freely floating currency, when the market is expecting a dramatic devaluation; (3) developing open stock and bond markets that can support a market based economy; and (4) cracking down on dissension and perceived corruption on the part of those who don't fully support the government’s policies.

Any one of these initiatives would be incredibly difficult in an economy the size of China’s. But trying to do all four invites policy mistakes. We have seen several missteps already and will likely see more. Our greatest concerns are at the point of intersections of the initiatives, particularly when “corruption” could be defined to include market-based selling of stocks, bonds or currencies at a time when the government wants them bought. This is a sure way to delay the development of the markets. We should expect continued bouts of volatility as authorities work through this learning process.

Halfway across the globe, we continue to be concerned about the impact of the refugee crisis on Europe. These concerns are heightened now that weakness in the immigration system has been linked with terrorism. All this adds to uncertainty against a weak economic backdrop. The European central bank is trying hard to stimulate growth and inflation but so far they have met with limited success.

Finally, here at home, our economy continues to muddle along at an expectedly slow rate. The employment picture remains pretty strong and so far inflation has been quite limited. At some point, we may see a pickup in wage inflation as employers are forced to pay more to hire a dwindling supply of available workers. That assumes the economy doesn’t stall before then.

The Fed is certainly counting on this return of inflation as it plans further rate hikes over the course of this year. But the Fed’s track record is mostly on the “too optimistic” side of things. Recognizing this, the markets don't believe the Fed will raise rates sharply, as short term rates have moved up modestly and long term rates have stayed stable after the Fed’s first hike.

Slow growth and low inflation leave us with low nominal growth, which means low growth in earnings for companies. And if inflation picks up because of wage pressures, that could hurt corporate profitability further. Bottom line, we expect corporate profits to be weak generally, particularly absent a bounce in oil. One possible bright spot could be a stable dollar, which would eliminate the large drag on revenues and profits that last year’s strong dollar had.

So where does all of this leave us? Quite honestly, it leaves us with lots of potential sources of volatility and not many sources of great prospective returns. The combination of low returns and high risk is not a hospitable environment for investors. Among individual stocks, we are focused on companies that can continue to grow revenue and profits at healthy rates even in a relatively weak environment. We continue to add to investments in the “alternative strategy” space, mostly in long short equity or debt strategies, seeking moderate returns with moderate risk. Finally, we are far underweight US small cap stocks as we view that category as high risk with quite uncertain rewards in the period ahead.

Thoughts on the Current Outlook

October 9, 2015 Jon Zeschin

Three Key Thoughts:

• Fed in a quandary with conditions tighter before rate hike

• Risk of recession rises as weaker growth leaves less cushion

• Middle East uncertainty grows

In 2014, the US Federal Reserve wound down its “quantitative easing” program (buying of US Treasury and agency mortgage bonds) with little apparent impact on economic growth, bond rates or stock prices. Some of the volatility we experienced this year is likely a lagged effect from the termination of that program. More important, we believe, is that investors have been obsessed with the first prospective Fed rate hikes since 2007.

In being so obsessed, the markets have largely discounted in the effects of one or even two rate increases. The value of the dollar is much higher against virtually all other currencies, credit spreads have widened to levels not seen since 2008, stocks have wobbled, volatility has increased and the narrative is now about whether the global economy is too weak.

Having achieved these tighter financial conditions with the mere threat of an initial rate rise, we suspect the Fed now finds itself in a quandary: should they get it over with (how much worse could it be…) or do they risk making conditions even tighter, maybe causing a pullback in a weak growth environment. We have long believed that the Fed will keep rates lower for longer than most investors (and the Fed itself) expects. That said, markets would have been well-served by the Fed getting an initial hike out of the way, rather than leaving the prospect out there for investors to worry about.

Bottom line, however, we view this debate as a near term financial market obsession rather than something likely to have a major impact on the growth rate of the US economy. As we have said repeatedly, we expect the US economy to grow at around a 2% rate for the next several years. At that slow rate, a recession is always a risk because of the small margin available to absorb any shocks. Conversely, we think an overheating economy with rapidly rising inflation is a highly unlikely scenario.

This rising risk of recession is reflected in the growing spreads on investment grade and high yield debt. Earlier this year, spreads on debt of energy issuers blew out to very wide levels, as investors expect a wave of defaults in that space beginning in the next several months. However, that uncertainty has spread more broadly to corporate issuers who have used low rates to increase the leverage on their balance sheets at low cost.

The geopolitics of oil is certainly complicating the picture as well. On a pure supply and demand basis, we are oversupplied in the short term, which will keep prices subdued. And, with the Iran nuclear deal moving forward, the supply picture will likely get worse before demand begins to catch up. On the flip side, unrest is bubbling up throughout the Middle East once again and no one can predict how the conflicts might progress.

With Russia having entered the Syrian civil war more forcefully, the risk of wider conflict in the region is much higher. We aren't surprised by their moves as they were widely telegraphed by President Putin. However, Russia is the one country with the power, economic incentive and guts to raise the price of oil by creating unrest. Under the current administrations, the US and its allies have prioritized diplomacy over military action but it is unclear to us if this reduces risks or creates a vacuum into which bad actors like ISIS can grow their power.

Regardless, we view the uncertainty in that part of the world as a rising risk to the global economy, more so than other popular concerns like the slowdown in China. While we are talking about risks, there are two in Europe that deserve mention. First is the growing tide of refugees streaming into southern and central Europe. We expect that this will continue to grow for some time, taxing both the resources and political agenda of an already weak Eurozone. Second, and perhaps more troubling, is the Volkswagen emissions fiasco. This situation has the makings of Europe’s Enron/Worldcom moment and we could see it harming Germany’s export- driven economy and spawning a new wave of regulation.

China continues along on its bumpy descent toward a more sustainable growth rate, driven by a service-oriented economy. The authorities badly handled the A share market run up (cheering too loudly) and subsequent crash (several ham-handed interventions intended to stop the selling), destroying some of their reformist credibility. They are learning as they go, however, and market reforms in the currency, bond and equity markets will continue at a slower pace.

Prime Minister Abe of Japan announced Abenomics 2.0 to little fanfare, as his new “arrows” added little of substance to the original three arrows. Much reform has been accomplished in the corporate sector and a greater emphasis on reforming work rules and growing the work force will continue to help the Japanese economy increase its potential growth rate. The recently agreed Trans-Pacific Partnership should also help boost Japan’s export sector. However, big challenges remain, including the inability to grow the work force over the long term without immigration, and recent data show mixed results for Abe’s aggressive agenda.

With risks rising outside the US, we cut back our international stock exposure somewhat in favor of an increase in hedge fund strategies. So we are now overweight in a broad group of hedged strategies, underweight in US small cap and underweight in fixed income. We have maintained a neutral approach on US large cap as we believe this area of the market will continue to serve as a safe haven for equity investors.

Thoughts on the Closed End Fund Market

July 30, 2015 Jon Zeschin

We have been investing in closed end funds for our clients for more than a decade. Over that time, we have developed an extensive knowledge of the unique nature of that market and the intricacies of how closed end funds operate for investors. Since March of 2009, we have applied this knowledge in managing the Essential Absolute Return strategy with excellent results until the last twelve months.

In the early days of this strategy, we invested primarily in corporate action situations that were low risk and which provided relatively steady and predictable returns. Many of those corporate actions were a direct fallout of the 2008 financial crisis. As the effects of that crisis faded, so did the number of opportunities of this type.

More recently, we have focused on convergence trading. We believe the closed end fund market is structurally inefficient which gives rise to temporary mis-pricing of assets, relative to their “normal” value. We try to buy mis-priced funds, and then wait for the pricing to return to average or normal levels. These types of opportunities tend to give rise to more volatile return streams (both positive and negative) and, because we never know when markets will return to normal pricing, the timing of such returns is uncertain. However, because of the leverage inherent in most fixed income-oriented closed end funds, our clients earn a high current income stream which serves to mitigate somewhat the risk of price declines.

Over the past twelve months, closed end fund discounts have widened to levels not seen since the financial crisis of 2008. Yet, there has been no crisis, no significant widening of spreads (except in a few emerging markets where we have limited exposure), and no dramatic changes in the levels of short or long term interest rates. There have, however, been periods of market uncertainty caused by concerns about the US Federal Reserve raising interest rates, a potential Greek default or exit from the Eurozone and China’s boom and bust A share market. These events had relatively little impact on our holdings’ underlying net asset values. Yet discounts continue to widen.

This time period has left us wondering if something has fundamentally changed in the closed end fund market. There have been a few developments: (1) the market for new closed end funds is quite muted and new funds that are being brought to market have more innovative structures designed to limit discounts; (2) the number of institutional investors has grown to the point where pure corporate action arbitrage opportunities are now rare; (3) fixed income exchange traded funds continue to gain popularity, potentially distracting investor interest away from closed end funds; and (4) investors have been hearing for years that the end of bond bull market is upon us and they need to prepare for rapidly rising rates.

The first two factors should actually bring more rational pricing to the closed end fund market, not less. The last two factors may actually be depressing the demand for closed end funds among retail investors, making a return to rational pricing more difficult. We believe the fourth factor — fear about the impact of rising rates — is likely the biggest contributor. For many reasons, we believe this fear is overblown.

Over the course of the past year, we have continued to selectively add to positions in closed end funds that meet our investment criteria, only to see discounts on these funds widen further. And we have allocated additional client (and personal) assets to this strategy, believing that the opportunities now present are extraordinary. We hear the same story from our fellow institutional investors in closed end funds. Here is a chart recently published by RiverNorth, a well-known manager in the closed end fund space.

Taxable Bond Funds: 30-day Moving Average Discount June.1997-June.2015

As you can see, discounts have only been at this level immediately prior to the last two recessions. In 2000, discounts quickly recovered, even before the recession fully kicked in. In 2008, the financial crisis wreaked temporary havoc with all financial assets before a strong recovery kicked in. We believe this time period is more likely to be like the early 2000s but there is of course no assurance that it will turn out that way.

We are exercising patience in waiting for prices to return to more normal levels with the comfort of knowing that we are able to buy the assets of closed end funds at 10-15% discounts off the prices available directly or through open end mutual funds or exchange traded funds.

July 30, 2015 Essential Investment Partners, LLC

Thoughts on the Current Outlook -- July, 2015

July 8, 2015 Jon Zeschin

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.

Social Security -- The Perplexing Retirement Asset

May 22, 2015 Jon Zeschin

With thousands of baby boomers reaching retirement age each day, tens of millions of people will be signing up to receive their Social Security benefits over the coming few years. Until President Reagan worked out a deal with Congress to raise the retirement age gradually, many of us expected that Social Security would be bankrupt long before we reached retirement age. The good news is that the system is solvent for at least another decade but it will need another, perhaps similar, fix to keep full benefits going through retirement for boomers and gen Xers.

What many don't know, however, is that maximizing your Social Security benefits takes some planning. Most know that delaying benefits until age 66 (so called Full Retirement Age for most boomers) is good and delaying until age 70 is even better. While that is generally true, the situation can get quite complex and confusing for two earner couples, divorced individuals, couples with substantial age differences and even those couples who have uneven employment records.

As more of our clients are approaching their full retirement age, we decided to dig deeper into this subject and, quite honestly, we were surprised by what we found. While the simple rules of thumb do apply, they may not maximize benefits, depending on the specific situation. And, not surprisingly, the helpful folks at the Social Security Administration may not be able to provide you the best answers. Perhaps more importantly, they likely won't know if you are asking the wrong questions for your situation.

In addition to lots of reading on this topic, we have purchased software that allows us to help clients determine the optimal claiming strategy for their specific situations. You might think: how much difference can this make? The answer is: quite a lot. For example, one change to the simple "defer until 70" strategy for a two career couple could net them an incremental $50k in benefits!

This is the type of service we provide to our wealth management clients as part of helping them live the best life possible with the resources they have available.

A few thoughts about mutual fund share classes

May 21, 2015 Jon Zeschin

The US Supreme Court weighed in Monday of this week on an arcane area of the mutual fund world: whether 401(k) plan sponsors have a continuing obligation to search for the lowest cost share class options for their participants. Leaving aside the details of that case, investors might be wondering whether similar logic might be applied to mutual funds selected by their investment advisers.

Here at Essential Investment Partners, we are fiduciaries for our clients so we are required to put their best interests first, always. In the context of selecting share classes, that means we pick the share class we believe makes the most economic sense for our clients.

The math involved is usually pretty straightforward. Typically (though not always), the difference in the annual cost of a fund's "investor" class and its "institutional" share class is 0.25%. On the flip side, our clients typically pay a $25 fee to buy an institutional share class and there is no upfront fee to buy the investor class. So the question is: what is the breakeven point? If we assume a one year holding period, the answer is $10,000 (10,000 X 0.25% = $25).

This is the rule of thumb we use in selecting share classes for client portfolios. If the purchase is for more than $10,000 and we expect to hold the fund for at least a year, then we buy the institutional share class, if it is available. (Not all fund companies offer institutional share classes and some that do have very high minimums that our clients might not be able to meet.)

This is just one of the elements we consider when making investment decisions for our clients. And, there may well be circumstances when an approach other than our rule of thumb for share class choice is appropriate.

Back to the US Supreme Court case for a moment. This is likely to turn into an "inside baseball" case before it is done because of the complexity of how fees are shared in 401(k) plans. That is a subject for another day. However, we are happy that the Court took up a case that is likely to shed light on the importance of the costs of retirement investing. And, most importantly, how we should be putting plan participants' long term interests first.

Thoughts on the Current Outlook -- April, 2015

April 15, 2015 Jon Zeschin

The US economy grew by 2.3% in 2012, 2.2% in 2013 and 2.4% in 2014, despite a number of volatile quarterly reports. We expect a similar result in 2015. In fact, 2015 is shaping up in some ways very much like 2014: an unexpectedly poor first quarter, resulting from temporary factors, followed by a bounce back to somewhat stronger growth. The net result is slow but surprisingly consistent growth.

This time, the special factors have been the east coast weather (again!), the west coast port labor dispute and a sharp reduction in energy projects. In the last few weeks, we have seen expectations for first quarter growth get marked down quickly. Optimism for a second half rebound remains high, however.

The Federal Reserve seems to have become cheerleader-in-chief for the economy. Perhaps it isn’t too surprising that they would “talk their book,” hoping their optimism becomes contagious, allowing a move off of zero interest rates. Unfortunately, their track record in the last several years is consistent: too much optimism, which must be tempered significantly as reality sets in. Bond investors now believe the Fed will be slower to raise rates than the Fed members themselves believe. We agree.

While the economy will likely do better later this year, three factors will likely keep inflation low and growth slow: (1) the large decline in oil prices will keep headline inflation low and producer prices stable, offsetting modest wage pressures; (2) gains in the value of the dollar relative to almost all other major currencies make imports cheaper and exports more expensive, leading to lower domestic growth; (3) reduced capital expenditures and losses in high paying employment in the energy sector will be reflected in economic reports over the balance of 2015. Over the longer term, we believe that very slow growth in the labor force, combined with small productivity gains, will constrain our growth to less than 3%.

Over the next few weeks, we will get another read on the magnitude of the impact of the stronger dollar and lower oil prices on corporate earnings. In aggregate, earnings are likely to decline modestly. For now, investors are giving companies a pass on the earnings hit from the stronger dollar and are expecting that oil prices will gradually recover. And so far, consumers haven’t been spending their oil bonuses – they have been saving them instead. Put all these factors together and US stock valuations remain disturbingly high, relative to earnings.

Despite all of this talk about slow US growth, we are still doing much better than Europe and Japan. Looking back, the dollar strength compared to the Euro and the Yen makes perfect sense. Higher rates, stronger growth, low inflation: what’s not to like? The question is: where do we head from here? We believe that as the European and Japanese economies recover, the gap between the respective growth rates will decline and the currencies will be more stable. However, fixed income investors will continue to be drawn to US bonds as our rates are still more attractive than those available in Europe and Japan. We expect this will keep a lid on US longer term rates and the dollar in a positive trend.

Europe finally seems to be turning a corner, even while dealing with the Greek challenge and uncertainty in Ukraine. With the European Central Bank’s quantitative easing program well underway, we expect interest rates there to stay low until the major economies show sustained growth and some inflation is evident. These green shoots have been welcomed by the equity markets, which have rallied sharply. Unfortunately for US dollar investors, a portion of those gains have been erased by currency losses.

In Japan, the third arrow of Abenomics – important economic and labor reforms – are beginning to take hold. Corporate governance reform, increased equity investments by pension plans, greater employer/employee flexibility and growing wages are a few of the more visible signs that genuine change is afoot. Serious problems remain, however, including a very rapidly aging workforce, an aversion to immigration and low productivity growth, all of which work to limit the potential growth of the Japanese economy.

Finally, China continues on its unique path toward greater free market reform, broader social safety nets and crackdowns on political dissent and “corruption.” In the west, we have a hard time understanding how capitalism can flourish in the absence of political and personal freedom. Meanwhile, given the miraculous growth of the Chinese economy over the last 30 years, the Chinese wonder why we don’t think their model is better than ours!

We expect China to continue its move toward a sustainable 4-5% growth rate, suitable for a mature but healthy economy. And they have accelerated the pace of capital market reforms, including a more freely traded currency, more flexible exchange rate and relaxed constraints on trading in the domestic equity (A share) and Hong Kong equity markets. Longer term, this greater economic openness is quite positive for the entire region.

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. We continue to add to carefully selected hedged strategies as we believe valuations of US stocks and bonds are high.

April 15, 2015

2015 Investment Outlook

January 15, 2015 Jon Zeschin

And everyone thought the Fed would be the main story in 2014…

In mid-2013, the Federal Reserve sent ripples across world financial markets when it hinted that it would begin “tapering” its bond purchase program soon. As it turns out, the Fed did wind down its bond buying program over the course of 2014 with virtually no apparent impact on the markets. Why no impact? The Fed’s buying was readily replaced by other investors, looking to put money to work in a strong currency at higher yields than most other high quality sovereign debt. In fact, despite the Fed’s withdrawal from the bond market, yields on long term US government debt marched steadily lower over the course of 2014.

This leads to two related questions: why is the dollar so strong and why are competing yields so low? The US economy is now the leading growth engine among developed economies. With growth at roughly 3% annually, the US economy is running circles around Japan and Europe, both of which face serious economic issues. So, against these two other major currencies, the dollar should be strong.

Japan is trying to boost itself out of a two decade malaise with its Abenomics agenda. However, a sales tax hike, enacted effective April 1 of last year to try to keep the program on a balanced fiscal footing, slowed the economy much more than anticipated. Prime Minister Abe decided to call elections in order to reaffirm support for his three arrow program. As we have said previously, the third arrow – genuine reform in labor markets and related policies – will be exceptionally difficult to execute but they are critical to the success of the program.

Europe, meanwhile, seems destined to take up the mantle of the world’s chief bureaucrat – all talk and no action. Nearly two years after ECB chief Mario Draghi promised “whatever it takes” to stimulate the economy, they are still in the same spot: no growth, no inflation and no stimulus. The question now is which route do they take next: backsliding into recession, renewed break up talk as peripheral countries tire of austerity or actual monetary stimulus designed to reignite growth. The only progress Draghi has made so far is weakening the Euro, which will help Germany, Europe’s biggest exporter.

…but oil pushes itself onto the main stage…

Behind all of the cheering about America nearing energy self-sufficiency, there was a subplot building that few foresaw in its scale: the impending collision of expanding supply and flat demand. While not wildly out of whack, excess global supply was enough to bring about a sudden and rapid decline in crude prices. Then, in late November, OPEC added more downward pressure by deciding to maintain production at its current level. There is much speculation about their motivation – to maintain market share, to wipe out recent higher cost-based producers, to keep income up for their weaker countries are among the possibilities – but whatever the correct answer is, the world now has excess oil. And the price has been in free fall.

First order winners and losers in this period of much lower oil prices are easy to spot. Consumers in oil-importing countries (US, China, Japan and Europe principally) now have more income at their disposal than previously. Meanwhile, the big oil exporting countries (OPEC, Russia, Norway, Canada) will see significant declines in oil revenue as fixed price contracts mature and spot prices take over.

For world financial markets, the cross currents are many. An even stronger dollar reverberates through emerging market economies somewhat indiscriminately, knocking down debt and equity values. Inflation, already considered too low in many developed countries, will now be even lower. Capital spending plans for energy projects are put on hold, along with the employment growth that came with those projects. And high yield debt comes under fire because so much was issued to newer, less financially strong energy companies.

…and the ending to this story has yet to be written…

Where oil prices may go from here in the short term is anyone’s guess. Longer term, we expect the supply/demand imbalance to be resolved in favor of prices significantly higher than the current market (around $50/barrel at this writing). However, more important are the implications of low oil prices in the near term. We believe these are:

Higher financial market volatility as oil prices fluctuate and winners and losers are sorted out
A boost to consumers in oil importing countries in the form of direct cash benefits in those countries with significant automobile use and in the form of stable or lower prices for transported goods and services for those without as much automobile use
Short and medium term interest rates are likely to stay lower for longer than previously expected as reported inflation drops precipitously. For the US, we expect the Fed to stay on hold and stimulus programs in Japan to continue and to get started in earnest in Europe
More potential geopolitical instability as oil exporting countries assess the impact of lower oil prices on their domestic economies and decide whether and how to act in their own best interests. Russia seems like the biggest wild card, having recently shown little regard for others’ interests in Ukraine and routinely threatened supply disruptions for political gain
Second order effects such as high yield bond defaults, employment cutbacks in energy and retrenchment in capital spending plans will begin to take hold over the course of 2015 if prices stay at current levels

…but in the near term, we should use volatility to our advantage.

Here in the US, we believe the net short term effects will be positive as the benefit to consumers far outweighs the damage done to the energy sector of the economy. And, this stronger growth should come with little or no inflation. However, if oil prices stay low for long, we will begin to see the negative impacts on employment and capital spending. Outside the US, the effects will be highly variable, even among oil importing countries.

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are much more reasonable. Internationally, we believe active managers can use the recent volatility to their investors’ advantage. We continue to be underweight in fixed income as the yields available do not compensate investors adequately for the risks assumed.

January 14, 2015
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Thoughts on the Current Outlook -- October, 2014

October 13, 2014 Jon Zeschin

A few comments about risk…

At a point in time when many people think US stocks are very overvalued and even more believe that bond prices are in a bubble, we thought it made sense to talk a bit about risks we see. But first a little background. Howard Marks, Chairman of Oaktree, a highly-regarded investment firm, has written eloquently and extensively on the subject of risk. He sets the stage this way: “Here’s the essential conundrum: investing requires us to decide how to position a portfolio for future developments, but the future isn’t knowable.”

But even though we can’t know the future, we can still develop a plan to deal with possible outcomes in a logical way. Indeed, we, like most investors, view the investing world as a series of possible outcomes each with its own probability of occurring. Because each outcome only has a probability, we have no way of knowing in advance what will actually occur. Back to Mr. Marks: “Risk means more things can happen than will happen…Many things would have happened in each case in the past, and the fact that only one did understates the variability that existed…Even though many things can happen, only one will.”

Rather than trying to predict the exact course of events, it is our job to try to tip the scales in our favor, i.e., make informed judgments about investments that are likely to succeed based on the events we believe are most likely to occur. Of course, we will almost always be wrong about the specific events (unless we are just lucky) but if we correctly choose those investments with more upside than downside, we and our clients should fare well over time. Mr. Marks refers to this process as finding “asymmetries” – where the upside far exceeds the downside.

Are bonds now riskier than stocks?

Applying this thinking to the current environment, we can readily see good and bad asymmetries in the bond world. The very low yields on sovereign debt throughout the developed world can’t fall much further but those rates could certainly rise dramatically, if growth and inflation were to be ignited. This is particularly true in continental Europe and Japan where we believe the downside risk to bond prices is much greater than the upside – the bad kind of asymmetry.

Further amplifying this risk, the Japanese and European central banks are firmly in stimulus mode. Japan is much further along and the jury is still out on whether they will be able to jumpstart the economy. So far they have succeeded in weakening the yen dramatically and spurring sporadic growth. While a weaker yen might boost reported inflation, it could be counterproductive if rising import prices dampen economic growth. In Europe, the central bank is just beginning its quantitative easing program and the only result so far is a significant drop in the common currency. Due to limitations unique to the Eurozone situation, this program will have a tougher time succeeding. In addition, it has a big near term challenge in overcoming the negative effects of the sanctions against Russia on the Eurozone economy. Bottom line, both central banks are working hard to boost their economies and, if they are successful, rates will rise significantly. For these economies, we believe the answer is yes, bonds are much riskier than stocks.

Here in the US, the Federal Reserve is near the end of its bond purchase program and will likely begin raising short term rates sometime next year. Unless we get some spark of inflation, however, we expect those rate increases to be relatively modest. With energy prices recently declining and wage pressures non-existent, reported inflation is likely to be benign. So we think a large increase in US rates is unlikely but a modestly higher range of rates, particularly for short and medium term debt, seems like a quite reasonable outcome. However, we can buy fixed income closed end funds at very high discounts to net asset values (reflecting investors’ belief that a large increase in rates or spreads is around the corner) which we believe provides our clients a good asymmetry. In addition, high yield and floating rate loans provide good yields relative to inflation and higher quality bonds. For the US market, we don’t think carefully selected bond investments are riskier than stocks.

Stocks aren’t cheap either

Among US stocks, we have thought small caps were overvalued for a long time. We were wrong in 2013 but have been proven correct so far in 2014 as small caps have drastically underperformed large caps. However, even among large cap companies, we are finding it difficult to find high quality companies trading at reasonable values. One particular concern of ours is that many very good, but slow-growing, companies are trading at very high multiples on earnings. Typically, these stocks would be safe havens in difficult markets – that may not prove to be true if the market decides to mark these multiples down to more reasonable levels.

To some extent, stocks are levitating based on a lack of alternatives (many perceive a higher risk in bonds) and a general skepticism that the bull market cannot last much longer. How long this will go on and how it will be resolved only time will tell. For now, we are paying very close attention to individual stock values, relative to the earnings growth expected.

Outside the US, valuations are much less challenged so we added significantly to international stock fund positions earlier this year. This proved premature this quarter as the dollar strengthened dramatically and international stocks, with the exception of a few markets, slumped. However, leaving China aside, prospects for better economic growth are good in the coming year and this should provide a positive environment for stocks.

In China, the gradual growth slowdown continues, making it hard for investors to handicap the stock market. As a result, valuations remain low. We believe China is heading for mid-single digit GDP growth with a greater share of its economy comprised of consumer spending. What we find hard to discern is how the dichotomy between the government’s more market-oriented economic policies and crack down on political freedoms will play out.

Finally, we continue to increase positions in hedged investments which provide some exposure to equity and debt markets but with lower market exposure. Fortunately, more successful hedge fund managers are bringing their strategies to mutual fund form, providing us access to a much broader array of managers and strategies than ever before.

October 8, 2014

Thoughts on the Current Outlook -- July, 2014

July 9, 2014 Jon Zeschin

Volatility in Surprising Places

With two major bear markets in stocks within the last 15 years seared into investors’ memories, we have come to expect high volatility in stock prices. Conversely, we tend to view the US economy as a lumbering giant, moving slowly but constantly forward, with only something as large as the Great Recession able to throw off its trajectory.

Lately, we have seen volatility in the stock market decline rather dramatically. Actually, this is pretty typical of a sustained run of positive returns like we have had since the middle of 2011 and we also saw in the mid 2000s. However, we have seen the opposite in reported GDP over the past year. The quarterly numbers have bounced around a lot (+4.1%, +2.6%, -2.9% and +3% estimated for the last four quarters). If we just look at the year over year increase though, we find that GDP has grown at less than 2%.

This raises a couple of questions. Is 2% as good as it gets, now that the economy seems to be hitting its stride in this long recovery? Does 2% growth really support the kind of rally we have had in stocks?

We believe there are a number of structural reasons why this 2% level of growth may be closer to the economy’s new growth potential, down roughly a third from the 3% we became accustomed to for several decades. Productivity growth has slowed for at least two reasons: (1) chronic underinvestment in business capital equipment in the post-Great Recession period and (2) changes to the size and composition of the labor force occasioned by demographic shifts. While productivity will be boosted somewhat by advances in mobile technology, these other factors will likely offset that boost, holding our growth back.

There is both good news and bad associated with lower potential GDP growth. The good news is that we need fewer new jobs to sustain employment at a relatively high level (we are seeing this play out in the rather quick drop in the unemployment rate over the last 18 months). The bad news is that we could be much closer to triggering a bout of renewed inflation from wage pressures than the Federal Reserve currently believes. And, on a cyclical basis, we are getting close to a point on capacity utilization that typically results in inflation pressures.

From an investment perspective, this result is by no means terrible. Growth at this new potential with renewed wage inflation will mean higher nominal GDP growth. Corporate profits and stocks can likely grow at that nominal rate. Interest rates on bonds will drift up to at a more normal spread to long term inflation expectations (elimination of Fed buying will let rates seek this natural level). Overall, we should expect returns to be lower than those of the last three years, when both stocks and bonds did quite well.

Returning to the second question of stock prices relative to growth prospects, we view US small cap stock valuations as very stretched and US large cap stocks as fully valued. As we look at individual companies, we often see valuations that reflect a great deal of optimism about earnings growth when the reality is that earnings will likely grow slowly. It takes a great deal of searching to find growing companies at reasonable prices. We are much more positive about the prospects for non US stocks as growth is beginning to accelerate and prices are lower.

Global Growth Takes a Positive Turn

Globally, we see economic growth trending more positively with renewed contributions from Japan and Europe offsetting lower growth in China and many other emerging markets. In Japan, the long-awaited, third and critical arrow of Abenomics will soon be announced. It will be interesting to see how bold Mr. Abe will be in his proposals for labor market reform and, if he is bold, whether the Japanese people will continue to support him. Please see the previous blog post on this website to read our publication about Japan entitled Big Change in the World’s Third Largest Economy?

Continental Europe is still struggling to emerge from recession. The process is slow and central bank stimulus continues to expand. Without a strong central force for fiscal stimulus, the European Central Bank’s monetary stimulus is the only game in town. The ECB is still fighting off the effects of fiscal austerity plans put in place across southern Europe several years ago. Those economies are now bouncing back after severe recessions. On the other hand, the UK, which retained control of its own currency and fiscal matters, has recovered well from recession and is now looking at monetary restraint to make sure inflation doesn’t become an issue.

China continues to forge ahead on its economic and market reforms at the same time it seems to be going in reverse politically. Numerous incremental changes have been made in the financial markets that all point to a more market-oriented approach to economic policy. A series of important domestic policy initiatives have been announced that will allow more individual economic freedom. However, censorship is as strong as ever and China is flexing its military and political muscle on regional territory issues, including most surprisingly Hong Kong.

Cautiously Overweight US Stocks, Aggressively Overweight Non US Stocks

In most portfolios, we hold the maximum weight permitted in international stocks, particularly smaller company stocks, as we believe valuations are more compelling and better growth lies ahead. We have increased our weightings in hedged equity and continue to be underweight in fixed income, with a relatively defensive stance within those holdings.

July 9, 2014

Big Change in the World's Third Largest Economy?

June 19, 2014 Jon Zeschin

We recently had the opportunity to spend 11 days in Japan, our first trip to a country that boasts the world's third largest economy. Honestly, we weren't sure what to expect because Japan has spent much of the last 20 years wrestling with recessions and deflation. And, if a two decade hangover from the 1980's party wasn't enough, the country is also recovering from a devastating tsunami that has shifted their entire energy policy away from nuclear energy.

Viewed from this side of the Pacific, the launch of Abenomics 18 months ago is having a positive impact on economic growth and inflation. But the history of Japan's government stimulus programs over the past 20 years is littered with failures. So the question is: is it really different this time?

Certainly, in structure, scale and scope, Abenomics is much greater than prior efforts. The three "arrows" -- fiscal stimulus (deficit spending), monetary stimulus (quantitative easing) and structural reforms to boost competitiveness -- are designed to be mutually reinforcing (a Japanese folk tale says that three arrows held together cannot be broken). The first two were readily implemented and are producing results. The third is very much a work in progress, requiring both legislative action and great deal of change to Japanese work life.

So what did we observe in our brief trip? First, we were consistently struck by the great deal of pride each person we encountered took in their work. As we settled into our first taxi ride -- with an extraordinarily polite, uniformed driver and an immaculate vehicle -- we could only imagine the horror of a Tokyo native who hails a cab for the first time in New York or Chicago. This pride was evident everywhere we went and in every service provider we encountered. So refreshing and so different than the US!

Second, we sensed real optimism about the direction of the economy. Having family in Michigan, we have seen the impact of pervasive economic devastation first hand. We sensed none of that in the three cities we visited. On the contrary, the people we encountered were upbeat, welcoming and focused on their work.

Our visit came on the heals of the consumption tax increase from 5 to 8% that took effect on April 1. Japan's retail sales reports for March and April showed the impact (a big pull forward increase and then a large decrease). However, we found retailers to be sanguine about the changes, even if they were acutely aware of its short term impact. We came away thinking that Prime Minister Abe must have done an excellent job of communicating his policies. People understood and seemed to accept the tax increase as part of a bigger plan.

So what was negative? You have to look beneath the surface to find it. First, unemployment is very low and many people are employed in ways we would not conceive of here. At department store elevators, we encountered three elevator ushers, assisting shoppers to the next available car, when we wouldn’t even have one here. In our eleven days, I can’t remember ever having to wait to be assisted – there was always some one ready, willing and able to help. (Mind you, we scrupulously avoided the queues at the most popular outlets – the first “street” queue we encountered was for Garrett’s Popcorn. Those of you from Chicago will instantly remember the Garrett’s lines on Michigan Avenue – the same situation exists at Garrett’s near Harajuku in Tokyo.)

Second, the lack of immigration is painfully obvious. The elevator ushers, the hotel bell persons (many female) and the cab drivers were all Japanese. The corollary is that the workforce is not growing, either by birth rate or by immigration, and this will work to limit the growth in the economy. It also implies that while unemployment is low, many workers are performing far below their potential. As part of his structural reforms, Mr. Abe wants to encourage greater female participation in the labor force. However, that would at best provide a one time boost to the work force, likely in the service sector.

Finally, with the first two arrows of Abenomics firmly in place, the government is showing some success in creating economic growth and inflation. However, the third arrow – labor market reform is critical for several reasons. First, with little slack in the current labor force, even modest raises in wages could easily ignite a labor cost-driven inflation cycle that would be difficult to contain. Worst case, Abenomics could give rise to a stagflation situation – high inflation and low growth. Second, for the labor market to be more productive, employers need to be free to hire and fire. Third, to have sustained growth in the labor market (and, by extension, the overall economy), some immigration will be required, as the domestic population simply isn’t growing on its own. And boosting it with female participation won’t be sufficient.

With difficult structural reforms ahead, Mr. Abe has his work cut out for him to establish a long term platform for growth. Our observation was that people are optimistic about positive change. Whether Mr. Abe will have the will to propose sweeping labor and immigration reforms is an open question. Assuming he does, then we will see whether the people will continue to be supportive of him and his policies. Only time will tell.

Thoughts on the Current Outlook – April, 2014

April 10, 2014 Jon Zeschin

The Weather Strikes Back!

It seems a bit ironic that we used a weather analogy as the framework for our 2014 outlook because the weather itself was the biggest economic story in the first quarter. East of the Mississippi, from Minneapolis to Washington DC, record cold and snow were served up repeatedly.

Against this frigid backdrop, retail sales slowed, car sales stalled and hiring took a hit. About the only thing contributing positively to a growing economy was the big increase in consumption of natural gas for heating! We don’t have a preliminary read on GDP for the first quarter yet but we expect it will be significantly slower than the fourth quarter’s 2.6%.

The weather-induced slowdown in the economy had another surprising effect: the bond market did better than stocks in the first quarter. By the end of 2013, bonds were all but given up for dead with most predicting that interest rate rises were imminent and a bond bear market was about to start. And, conversely, conventional wisdom was that stronger economic growth would help stocks. As is usually the case when a trend is so universally expected, something else happened.

The bond market seems full of surprises these days. Even with new Fed Chair Yellen signaling that interest rate hikes are likely to begin next year, longer term bond yields have barely budged. To be fair, intermediate term rates moved up and mortgage rates continue to creep up. But, the worst performing part of the bond market in 2013 – long term municipal bonds – were the star of 2014’s first quarter.

But Change Is in the Air

Despite all of the uncertainty created by the weather, there is one thing that is certain: the weather will change. And, with it, we expect that economic activity will resume at a respectable pace. Respectable is the key word here. There are many factors that will keep the economy from accelerating too quickly.

First, we believe the snapback in housing is now over and the future gains in home prices will be driven by longer term supply and demand dynamics. While those dynamics are favorable, double digit price gains are likely behind us and more consistent, inflation plus 1-2% gains are more realistic.

The employment picture is still solid, if unexciting. Except in a few, high-skill, high-demand fields, there is still a great deal of slack in the labor markets, meaning income growth will be restrained and wage-driven inflation will be non-existent.

Finally, consumers continue to be financially conservative, taking on little debt and using their credit cards sparingly. This is one of the positive legacies of the Great Recession. But it also constrains growth in our economy.

More Excitement Elsewhere

Ukraine is in focus as the world ponders Russia’s next steps after its annexation of Crimea and troop build-up on Ukraine’s eastern border. We have long expected Russia to use its energy influence and the war-weariness of the US to expand its regional influence. We believe that the markets are Putin’s biggest adversary – the ruble has plummeted and, if oil prices follow, his ambitions will be diminished.

The more important European financial story is its emergence, albeit very slowly, from recession. The peripheral economies still have a long way to come before they can claim recovery. Indeed, central bankers are concerned that inflation remains too low, with talk of more stimulus creating news. Discussions about a possible break-up of the common currency, all the rage just a couple of years ago, are all but dead.

India, the world’s largest democracy is about to embark on its largest election (800 million prospective voters) ever. At stake is a renewed focus on the economy, which has struggled to post decent growth of late. India is in great need of more forceful economic leadership but we remain skeptical whether this election will provide it.

In China, concern has shifted to the magnitude of the debt build-up over the last few years, even as growth has slowed. From a very big picture perspective, this combination of factors is very similar to the US situation in the mid 2000s. As we know, that did not end well. However, there are many, many differences between how China and the US are able to manage these circumstances. We expect the Chinese to accept much lower economic growth as they shift toward a more sustainable growth model. And, they will use their unique “market-oriented” approach to gradually introduce freer float in the currency and more risk of default into the debt markets.

Finally, in Japan, Abenomics has accomplished its first task of shifting psychology away from deflation to modest growth and inflation. Salary growth, a critical element of the shift, is showing signs of taking hold. An increase in the consumption tax is just now going into effect so the next several months will be critical in seeing how this impacts the economy.

The Bottom Line

In client portfolios, we remain overweight stocks in a diversified set of strategies, including a high allocation to international markets where valuations are more reasonable. We have reduced our dedicated Asia investments but have increased the weightings in international small company stocks, expecting these strategies to perform well in a better economic environment. We continue to be underweight and defensive in fixed income, favoring flexible strategies that can adjust to changes in market expectations about the future course of interest rates.

2014 Investment Outlook

January 10, 2014 Jon Zeschin

Sun Breaks Through the Clouds

One lasting legacy of the Great Recession is our pre-occupation with concerns about new crises that will lead to a reprise of that terrible period. 2013 was chock full of crises that were supposed to derail us. We started off with the fiscal cliff (sooo 2012…) which gave rise to surprisingly positive new tax laws. Then came the sequester, the chemical weapons crisis in Syria, the debt ceiling showdown and the government shutdown. Let’s not forget China’s growth slowdown and the launch of Obamacare. And lurking in the background was the imminent demise of the Eurozone and the common currency! All of these bogey men turned out to be not so scary and the US stock market not only shrugged them off but surged to new all time highs.

The biggest surprises of the year turned out to be Fed “taper talk” – first came the too-early discussion of it by Chairman Bernanke in May and June. While shocking the bond market, equity markets barely flinched. And then there was the big “nevermind” in September and the bond market rallied while the stock market just kept plugging along. Finally, the Fed closed out the year with a modest start to tapering its asset purchases, setting the stage for the new Chair to implement it. How ironic that the one entity trying to prop up markets gets the credit for creating the most volatility!

As we look forward to 2014, there aren’t even any faux crises on the horizon to be worried about. Even Congress, the best at creating crises out of thin air, decided to patch up their budget differences before the holidays, leaving no real fiscal accidents waiting to happen in 2014. It is amazing how forthcoming elections can focus the mind!

Of course there are lingering concerns in Europe, Japan, China and other emerging markets. But after six years of prospective crises, we find ourselves a bit uncomfortable with a moderately sunny outlook.

How Sunny Is It?

Let’s not get too excited. While the outlook is improving, it is hardly perfect. Here in the US, the employment picture continues to show resilience as the jobs reports have shown consistent, if uninspiring, strength. Stock market gains and home price increases have restored consumers’ net worth to pre-2008 levels, while debt service costs have dropped to a very low percentage of income. We are seeing this positive backdrop show up in solid gains in retail sales and strength in automobile sales. Housing continues to recover but a sharp back up in rates could well slow that recovery.

We expect that this consistent growth path will lead the Federal Reserve to wind down its bond purchase program in 2014. This will likely be coupled with repeated statements about holding short term rates low. That long term interest rates have stayed as low as they have might be a bit surprising. We think this is a function of low and contained inflation. Without labor cost pressures, we expect inflation to stay low for some time to come. The ten year Treasury bond yield was in a range of 2.50-3.0% for the second half of 2013. Over the course of 2014, we expect that range to move up to 3-3.5%.

But we also expect volatility in rates to be the norm as markets try to figure out how the Fed moves away from its bond purchases. It is certainly possible that long term rates could move up much farther and faster than anyone expects, tanking the bond, stock and real estate markets all at the same time.

Still Cloudier to the East

In Europe, we are now past the German elections so we would hope to see continued progress toward solidifying a Eurozone bank regulator. Austerity and, more importantly, labor and tax reforms in southern Europe are finally beginning to have an impact on those economies. But we are hardly out of the woods. While the recession has technically ended, growth is very anemic and there is a real risk of backsliding into another recession.

Much further east, Japan’s Abenomics program is having the desired short term impact: modest growth and inflation. However, big challenges lie ahead. For progress to be sustained, fundamental changes need to take place in the labor market. Companies need the flexibility to hire and fire according to market needs, rather than providing lifelong employment. And workers need to be rewarded for increased productivity so that sustained growth in wages can take hold. Finally, there is an enormous demographic problem building which will likely require new approaches to immigration and labor rules. Progress on these difficult structural issues is by no means assured.

And Just Plain Hazy in China

Meanwhile, China, the bigger growth engine of Asia, has completed its leadership transition and the Third Plenum. Billed in advance as reforms comparable in importance to those of the late 1970s, the high level plans that came out of the Plenum are important evolutionary steps. Whether they turn out to be revolutionary will depend on the implementation. Loosening of the one child policy, changes in land rights for farmers, reform of the household registration system and a definitive statement that market forces should guide resource allocation are just some of the key provisions of this new plan.

While we view these changes as quite positive, they will take some time to play out. In the meantime, China is still burdened by an economy too-dependent on fixed investment, financial and labor imbalances and strong state-owned enterprises. Perhaps most important for long term investors, China’s new leaders understand the problems they face and have crafted a plan to deal with them.

Other major emerging markets face issues unique to their own situations. One common thread is high inflation and low growth, a combination not likely to inspire investors’ confidence for some time. Relatively cheap stock prices in these markets reflect these poor fundamentals.

Thoughts on the Current Outlook – October, 2013

October 7, 2013 Jon Zeschin

All of the buzz in the financial markets since May has been about the Federal Reserve and the rise in interest rates in the wake of the expected “tapering” of their bond purchase program. But in fact the real “rising” story has been stocks. Hurdling a wall of worry that included higher interest rates, possible use of force in Syria and an impasse over the federal budget and debt ceiling, stocks have shot up this year. For the year to date, US stocks have gained nearly 20%.

Not to be outdone by the US, developed international markets also rallied strongly, gaining more than 16%. However, emerging markets continued their lagging behavior as concerns about less Fed stimulus led investors to withdraw investments from emerging markets bonds and stocks. Those economies with high inflation and slowing growth (think Brazil, India and Turkey) were particularly hard hit.

A hallmark of Federal Reserve policy under Ben Bernanke has been open communication, making sure the markets know well in advance what the Fed is planning to do. This policy stood in stark contrast to the Alan Greenspan era when the former chair would go to great pains to ensure that whatever he said was indecipherable. The Bernanke approach was closely followed until the September meeting when the Fed surprised the markets by announcing a deferral of the tapering plans that the Chairman had carefully laid out in the preceding months. While not stated, we believe that the delay was less about economic data than a hedge against the impact of the impasse over the continuing resolution (CR) to fund government spending and the debt ceiling.

Negotiations over the CR and debt limit are noticeably more difficult this time around as the poisonous atmosphere in Washington has only grown worse with mid-term elections looming. Adding drama, if not substance, to the debate is the launch of the open enrollment period that kicks off Obamacare. At this writing, the government is in shutdown mode which we expect to continue until a longer term debt ceiling and full year CR are ironed out. We view all of this as political theater, with the resolution unlikely to have a lasting effect on the path of the economy.

The biggest impact, we believe, is that the Fed will sit tight until the show is over and then begin scaling back its bond purchase program. We believe the US economy is likely to continue growing at a below long term average rate (2-3%), but sustainably growing nonetheless.

With no structural changes happening, Europe remains in neutral, not going backward or forward. China is now well through its power transition and policymakers are clearly focused on the key issues of excess credit creation and conversion to a domestic oriented economy. Recent data from China has been more encouraging but we expect growth to be choppy.

US interest rates are settling into a new trading range reflecting low inflation, modest economic growth and little or no Fed buying. One thing clear from the Fed’s September announcements is that short-term interest rates are likely to stay low for at least two more years, particularly since inflation is well below the Fed’s stated 2% target.

Absent an external inflation shock, we expect inflation to stay low because of the slack in the labor market. The unemployment rate will keep falling from a combination of lower participation and steady employment growth. There has been much debate about whether the drop in the labor force participation rate is due to discouraged workers dropping out or baby boomers retiring. No one really knows how much each factor contributes but it is clear that new college grads are still having a hard time finding jobs. And the baby boomers are the first generation with two wage earners retiring, sometimes simultaneously. The debate about the cause is less important than the fact that the lower participation rate will keep the economy on a slow growth, low inflation path.

This kind of path should be good for stocks and that has certainly been the case this year. We think US stocks are on the expensive side right now and need a breather to allow earnings growth to catch up. International stocks had been cheaper but they too have rallied strongly of late. While we remain overweight stocks and underweight bonds, we are trying to keep a modest cash reserve that we can deploy if we see a significant pullback.

Within our general underweight in bonds, we believe there will be opportunities for reasonable total returns if we remain nimble. However, the general trend for rates will be up, toward a more normal long term structure, so minimizing interest rate risk remains a paramount consideration.

Explaining the Unexplainable: US Strategy toward Syria

September 17, 2013 Jon Zeschin

We have been baffled by the Obama Administration’s statements and actions over the last month in dealing with the Syrian chemical weapons situation. George Friedman, founder of Stratfor, a foreign affairs consultancy, penned an excellent article which we highly recommend. It lays out in simple terms why we are so conflicted and unable to articulate a clear path forward.

http://www.realclearworld.com/articles/2013/09/17/ideology_trumps_american_strategy_in_syria_105448.html

Three Key Thoughts:

Big rally in credit continues

Central banks stay at center stage

Slow growth begets low returns

Three Key Thoughts:

• Populism strikes markets

• Volatility almost everywhere

• Attractive returns hard to find

Three Key Thoughts:

Recession? What recession…

Dollar bulls run out of steam

Europe: Opportunity in chaos?

Three Key Thoughts:

A bear hug for oil

Collision of the economic and political in China

Higher risk, lower return prospects call for caution

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