Thoughts on the Current Outlook

January 14, 2021 Jon Zeschin

Three Key Thoughts:

1. A Blue Breeze Moves In

2. Will Inflation Return?

3. Looking Through the Chaos

A Blue Breeze Moves In

In last quarter’s Thoughts, we called out the possibility of a “Blue Wave” in the November election that could fundamentally change the “lower taxes, less regulation” mantra of the last four years. We can’t really call what has now transpired a Blue Wave – it is more like a Blue Breeze that has descended on Washington DC. In December, stock markets cheered the prospect of a divided government, as it appeared that the Republicans would retain control of the Senate so long as they won at least one of the Georgia Senate run-off elections. However, mishandling of the latest stimulus bill, the President’s bizarre election-related behavior, and an enormous turnout effort by the Democrats allowed them to win both Georgia seats. The resulting 50/50 split gives control to the Democrats as the Vice President can cast the tie-breaking vote, if needed. With this narrowest of margins, the Democrats will be able to control the agenda but compromise will likely be needed on major initiatives.

Surprisingly, stock markets cheered this result as well. However, they did so with a twist as the leadership switched from technology and consumer discretionary stocks to energy and banks. We wonder how long this leadership shift will last under a Biden administration which will undoubtedly be in favor of phasing out fossil fuels and more regulation for the banks and other financial companies.

For right now, the market is focusing on the likelihood of far more stimulus to help the unemployed, small businesses and state and local governments which have been devastated by the pandemic. In addition, the market is expecting the vaccination rollout to accelerate, allowing the economy to reopen somewhat faster than it would on the current pace. Combined with the support of the Federal Reserve (low rates and bond purchases) and the new Treasury Secretary (former Fed chair Janet Yellen), it is clear that stimulus will be the order of the day for some time to come. With this backdrop, we expect the economy to bounce back strongly in the second half of 2021.

Beyond the two main initiatives noted above, we don’t know what the Biden administration’s priorities will be. With the shift in Senate control, it will be much easier to get new cabinet appointees confirmed. So the new administration should be able to articulate its plans relatively soon. We will be particularly interested in tax policy as this has the potential to negatively affect financial markets.

Will Inflation Return?

If there is a dark cloud on the horizon for investors, it is the prospect of higher inflation returning faster than expected (and hoped for, by the Federal Reserve). We have been living in a relatively ideal environment for stocks with earnings growing (at least in several key sectors) and interest rates at extremely low levels. This combination makes high price/earnings ratios tolerable. But if inflation returns – and if inflation expectations and interest rates move higher – then we can expect that stock prices will get marked down harshly. Historically, these kinds of adjustments tend to come quickly as investors who had previously ignored small increases in interest rates suddenly realize that higher rates have a real impact on stock prices.

We believe there is a risk that we could apply too much stimulus to the economy and create an inflation problem where one doesn’t exist today. However, we are far away from that right now, with recovery from the pandemic a huge hill yet to climb.

Looking Through the Chaos

To say that the last twelve months have been chaotic would be a colossal understatement. Yet we sit here with stock markets at all-time highs, seemingly poised to go higher by the day. The recovery in employment from the initial pandemic shock has stalled, the vaccine rollout in going slower than expected and, at least for another week or so, we have chaos in Washington. Stock markets even rose when rioters attacked Congress on January 6th! How do we make sense of this?

Stock market trends are about one simple thing: are the drivers of value (economic growth, earnings, taxes) getting better or worse? If the answer is better, then stock prices go up. If the answer is worse, then prices go down. We see this pattern repeated over and over. Yet it is difficult for us to understand when we see so much chaos in the daily news.

Right now, the markets are seeing progress on vaccine distribution (though slower than we all would like), leading to a reopening of the economy and an unleashing of a great deal of pent-up demand. On the political front, markets are expecting more stimulus, a more rational approach to government and relatively benign tax and regulatory policy. These expectations reinforce the bigger reopening story and make today’s bad news far less important.

Investment Implications

We have long discussed the three themes that have been prevalent for more than a decade now: US stocks over foreign stocks, growth stocks over value stocks and US dollar denominated assets over non-dollar assets. In the fourth quarter, these trends reversed and that reversal has continued into the new year. We will be looking at ways to adjust portfolios if we believe it is warranted. To a great degree, we are already positioned for an international stock turnaround, which is further benefited by dollar weakness.

Thoughts on the Current Outlook

October 13, 2020 Jon Zeschin

Three Key Thoughts:

1. Like Trump, COVID Wants the Headline

2. Post-Election Prep: Blue Wave Alert

3. China’s Recovery Continues

Like Trump, COVID Wants the Headline

Perhaps we shouldn’t be surprised that President Trump and COVID-19 would one day meet face to face. Ever since his improbable run for president began, Trump has done his best to always “be the headline.” And so it has proceeded throughout the Trump presidency that he has always strived to deliver the biggest, the best or the smartest, regardless of whether those claims had any support. Ironically, it was in those moments without much fanfare that he actually had some notable achievements.

Then along came COVID-19, a challenge unlike any other Trump, or our country for that matter, had faced in modern history. Defying conventional wisdom about viruses, it spread asymptomatically. As we scrambled to ramp up the supply of ventilators, it proved that ventilators might be more harmful than helpful. COVID even tricked our own immune systems to attack so virulently that patients were killed by the immune response. All the while, COVID kept coming back to the headline, and it hasn’t really let up since February.

Last quarter, we coined the phrase that we are starting the “learning to live with COVID” phase. Just like we adjusted to intrusive new security measures after 9/11, we are gradually adjusting to a new environment in which we are all more cautious about how we go about our daily lives with COVID always in the background. We believe this phase will continue well through the time when vaccines are widely available.

Today, we have two major concerns about the ongoing economic impact of COVID. The first is with small businesses, thousands of which are struggling to stay positive and stay afloat. If their progress is interrupted, the economy will have a very hard time mounting a sustained recovery. Our second concern is with school re-openings. While local districts and regional politicians control the decisions, we cannot expect our economy to get back to normal until schools are fully re-opened. That doesn’t mean we advocate opening them at all costs – it is just a fact that so many parents’ work lives revolve around their ability to have their children in school, those parents will not be fully productive workers until their children are safely attending school. We don’t have answers or predictions about either of these concerns – we will just be watching them to see how or whether they can be resolved over the coming months.

Post-Election Prep: Blue Wave Alert

The markets, meanwhile, have focused on the improvements in the economy, coming out of the major shutdowns in the second quarter, with stocks reaching new highs in August. The enormous stimulus programs from the Federal Reserve and Congress have helped the markets stay optimistic about continued recovery. September saw a bit of a hiccup as further stimulus plans stalled in Congress. While both sides have an interest in reaching an agreement, the Democrats believe they have the upper hand because they are pretty confident of a “blue wave” that will sweep them into the presidency and control of Congress. Right now, the markets seem to agree that more stimulus is coming, whether before the election or soon after.

If the blue wave becomes reality, we will need to consider the kinds of changes that may take place in Washington that could impact the economy and corporate earnings. In very broad terms, higher taxes on corporate earnings and a less friendly regulatory environment are likely to be negatives for the stock market. However, more stimulus will be positive in the short run unless it becomes a source of inflation that drives interest rates higher. Bottom line, it is time to be thinking about the possible policies and their implications but not a time for drastic changes to portfolios. We have warned on several occasions about the danger of making investment decisions based on political outcomes. The US economy is driven mostly by strong, fundamentally positive factors that are more powerful than the marginal changes politicians can make.

China’s Recovery Continues

In China, the success of their harsh, swift shutdowns and the government’s use of technology to control the spread of COVID-19 are sources of national pride. And President Xi has seized on this pride to launch new initiatives focused on making China more self-sufficient. In particular, he is focused on building technology capabilities that China currently must either import or license from the rest of the world.

Meanwhile, the economic data coming out of China points to the continuation of a strong recovery from the COVID-induced slowdowns of early this year. And their stock market also continues to do well, with the second best performance of any country in the world so far in 2020.

Last quarter, we mentioned Xi’s move to place Hong Kong under full control of the Communist Party. Apparently, his bet is that more closely aligning Hong Kong with the mainland will help its economy grow more than it would by being a unique standalone entity. Certainly, this also fits with his plan for China self-sufficiency. What remains to be seen is how the rest of the world responds to a much less free Hong Kong.

Investment Implications

We have long discussed the three themes that have been prevalent for more than a decade now: US stocks over foreign stocks, growth stocks over value stocks and US dollar denominated assets over non-dollar assets. There have been a few hints at change recently, but the actual shifts have been small. We will continue to look for signs of changing currents that would cause us to reconsider asset allocations.

Thoughts on the Current Outlook

July 10, 2020 Jon Zeschin

Three Key Thoughts:

1. Markets Ignore COVID Resurgence

2. Election Cycle Heating Up

3. China Flexes its Muscles

Markets Ignore COVID Resurgence

COVID-19 is demonstrating that it intends to be with us for a long time. As we emerged from the lockdowns of March and April, it was certainly reasonable to expect that we would see some increase in the number of cases. However, the volume of cases in certain states has been surprising, prompting many cities, counties and states to re-establish restrictions or closures. While these measures will most certainly delay the economic recovery to some extent, the financial markets have yet to react in any meaningful way. Indeed, US stocks have recovered almost all their losses from the first quarter as have the credit markets.

We think there are several possible reasons for this. First, the Federal Reserve has launched an extremely strong response, intended to stabilize the credit markets and provide liquidity to the economy. And they have said their programs will continue for as long as needed. That is about as supportive as a central bank can get! Second, the initial economic reports – jobs and consumer confidence, for example -- have been surprisingly positive so even if they become a bit less so, the trend remains in the right direction. Third, the stock market’s more recent gains have been focused on stocks that are seen as winners in “a living with COVID” world. Fourth, the choice between Joe Biden and Donald Trump for President may be perceived as less threatening to the markets.

Looking forward, the Federal Reserve’s stance is not going to change anytime soon so the course of the virus and its impact on our daily lives remains the biggest wildcard. It really is impossible to predict how this will play out over the coming weeks and months. Progress has been made in treating serious infections more effectively and unprecedented work on a vaccine continues. But we think the market is increasingly focused on what happens as we learn to live with this threat for some time to come. Some of the early winners in this world are already apparent but there will be profound changes to how we live and work that will take time to understand and play out.

The Election Cycle Heats Up

As if we do not have enough uncertainty in our daily lives, we are facing very important national elections in November. The participants in the presidential race are largely decided and battle lines are being drawn. Usually, an incumbent president has an enormous structural advantage over any challenger but two partially overlapping developments have diminished the advantage this time. First is the economic devastation created by the pandemic – in just a few months, we went from a strong economy and extraordinarily low unemployment to a tumbling economy and record joblessness. The second is the discussion surrounding systemic racial injustice and the appropriate policy responses. We believe that both issues will dominate the campaigns, not only for president but also many congressional races.

We said these issues are partially overlapping for two reasons: (1) COVID-19 infections have hit minority communities harder and (2) the economic impact from the shutdowns and restrictions have also been felt disproportionately by minority and lower wage workers. Income inequality has been a lurking issue for some time and the pandemic has blown it wide open. We expect to see civil unrest continue as politicians search for policies to address the problems.

More broadly, the markets will certainly be watching for specific policy proposals from Mr. Biden and gauging those against the odds of his winning election. Of special interest will be his stance on corporate tax rates.

China Flexes its Muscles

As the source of the COVID-19 pandemic, China is hardly held in the highest esteem by the rest of the world. However, to the Chinese, the success of their harsh, swift shutdowns and the government’s use of technology to control the spread of new cases are sources of national pride. The economic data coming out of China supports their view of a successful handling of the crisis. Correspondingly, their domestic stock market has been on fire. Of course, like any good autocratic leader, President Xi has been quick to seize on the national pride theme to expand his power and influence.

Most notably, Xi has effectively torn up the handover agreement regarding Hong Kong and is moving to place it under full control of the Communist Party. It is not yet clear what impact this change will have on Hong Kong as a financial hub. Regardless of the specifics, we do not think it is a positive for international companies doing business there. With the rest of the world pre-occupied with their own pandemic-related problems, there is no one to challenge Chinese assertiveness.

It is no surprise that China, having come so far economically in the last 30 years, would be in the position of challenging the US for global economic influence. But President Xi’s strategy of combining continued market reforms with ever tighter controls over the personal lives of Chinese citizens is puzzling, even to many students of the country. As China continues to build its economic power and influence, and Xi consolidates his domestic power further, we should expect more clashes with the rest of the world. But that does not necessarily mean we should avoid investing in a market that is growing and increasingly innovative.

Investment Implications

The investment lesson of the 2008-2009 bear market was to stay invested, while harvesting tax losses to the maximum extent possible. This is a playbook we followed over the last few months but most important was staying invested to take advantage of the bounce. Expecting a difficult road ahead for the economy, we have yet to add exposure to “early cycle” investments like US small cap and lower quality credit and will look for signs of more sustainable recovery before doing so.

Thoughts on the Current Outlook

April 12, 2020 Jon Zeschin

Three Key Thoughts:

1. COVID-19 24/7

2. Deep Recession but How Long?

3. Stocks for the Long Run

COVID-19 24/7

From the earliest signs of the outbreak of a novel coronavirus in China in December to the full lockdown across Italy to hundreds of thousands of cases in the US, the last four months have been a blur. Seemingly in an instant, we went from prosperity to despair. What made this threat so devastating psychologically is that it was unpredictable, uncontrollable and of unknown duration.

As we deal with what we hope are peaks in infection rates and deaths, our daily lives are filled with news about COVID-19 and new routines spawned by the need for social distancing. We are just beginning to see the effects of a nearly complete stop imposed on major portions of our economy. Millions have lost their jobs and thousands of small businesses are failing. While we hope the good news about the near term course of the virus continues, we know that the devastating economic effects will be with us for a while.

The Federal Reserve acted very quickly in cutting interest rates and starting a number of programs intended to stabilize the financial system and credit markets. And, fortunately, the Federal government has stepped in with unprecedented relief. In a shockingly bipartisan effort, Congress enacted new programs to provide lifelines to millions of people in need and incentives to businesses to keep people on their payrolls. They are discussing plans for more stimulus, as it becomes clear that the scope of the damage to jobs and economic activity is astounding.

Deep Recession but How Long?

With major parts of the economy simply shuttered indefinitely, there is no question that we are now in a very deep recession. The unemployment rate will go from historic lows to Great Recession highs in a month. Businesses of all sizes will struggle to survive as their revenues have plummeted. The service industries – particularly those in travel, leisure and entertainment, which have become such an important driver of our economy -- will take a long time to re-open and return to some sense of normalcy. Many will take this opportunity to re-think their business models and adjust them to a different future.

On the positive side, many of us have discovered just how productive we can be WFH. It used to be that “working from home” was a pseudonym for mostly taking the day off. In the last month, it has become normal for so many of us – even TV news anchors and late night talk show hosts – and we have discovered that we really can get a lot of work done. We suspect these new experiences will accelerate changes that were in their infancy across a wide range of businesses and education providers.

We expect the technology and health care sectors to continue to lead the US economy forward, even as many other service industries struggle to right themselves. Just as BYOD (bring your own device) revolutionized business communications over the last decade, we believe WFH will drive a faster move to the cloud and a focus on the infrastructure needed to support a geographically dispersed workforce.

Right now, our health care system is in crisis mode, dealing with the critically ill while working furiously on treatments and vaccines. Once the immediate crisis has passed, we expect to see changes in methods and regulations that will allow our health care delivery system to become much more efficient and allow development of new tests and treatments in a more timely manner.

One of the great marvels of our economy is its ability to adapt to rapidly changing conditions. We will see that phenomenon play out over the coming months and years. In the short term, the pain will be great but we are optimistic that the future will be brighter.

Stocks for the Long Run

Market reactions to the shutdowns necessary to try to control the spread of COVID-19 were swift and fierce. From their record high on February 19th to their low on March 23rd, US stocks dropped 34%. The speed of this decline was without precedent. Investors in bonds had a similar reaction as anything but US Treasury bonds sold off harshly. Even high quality municipal bonds and short term investment grade bonds fared poorly as only the safety of US Treasuries would suffice. Ironically, long term US Treasury yields were also exceptionally volatile so investing in these was treacherous as well.

A combination of three important ingredients has buoyed the markets since March 23rd. First, the Federal Reserve’s various programs have calmed the fixed income markets significantly, allowing more normal market relationships to be re-established. Second, there is confidence that the Federal government will provide a great deal of relief to those individuals and businesses most hurt by this crisis. Finally, and perhaps most importantly, there is an emerging view that we are near or perhaps even past the peak in new COVID-19 infection rates.

We are confident that the Federal Reserve will continue to be effective within its limits. And, if bipartisanship can be sustained for a while longer, the Federal government does seem focused on many of the right priorities. We are less confident in the course of this virus and how changes in its course might affect our ability to re-open the economy. For right now, optimism has allowed stocks to regain more than half their losses. We will be surprised if this holds through the dire economic news we expect to see reported for the next several months.

That said, interest rates are once again at or near zero, providing no return to conservative savers. With values having declined substantially from their peak, we believe stocks will likely be the better place to be for those with a longer term investment horizon.

Investment Implications

The investment lesson of the 2008-2009 bear market was to stay invested, while harvesting tax losses to the maximum extent possible. This is a playbook we are following once again. In addition, we will carefully evaluate expanding exposure to “early cycle” investments like US small cap and lower quality credit, where the potential rewards may now outweigh the risks.

Special Update and Viewpoint - March 13, 2020

March 13, 2020 Jon Zeschin

What Has Happened So Far?

On February 19th, the S&P 500® peaked at a value of 3,386. Since then, it has fallen precipitously, reaching 2,480 at yesterday’s close, a decline of about 27%. For the year to date, the US large cap market, as measured by the S&P 500®, has dropped about 23%. Small cap and European stocks have fallen more, while stocks in Asia have declined less. The swiftness and severity of these declines is reminiscent of prior big market shocks like 2008, 2000 and 1987.

Why Has This Happened?

We believe there are two primary causes.

First and most obvious is the potential impact on the economy due to COVID-19 virus mitigation. As this novel virus hit both US coasts and then spread relatively quickly across the country, we have seen wave after wave of cancellations and closures. Governments and private businesses have moved to limit large gatherings. A new term has been coined -- social distancing – to describe the behavior each of us should practice in order to prevent the further spread of the virus. As testing ramps up, we should expect to see the number of reported cases continue to rise sharply for several weeks.

The secondary cause is a dramatic drop in the price of oil which was precipitated by the failure of OPEC and Russia to reach an agreement on production cuts in response to lower demand, primarily from China as it dealt with COVID-19. Instead, the Saudis and the Russians launched a price war, driving oil prices sharply lower. This immediately led to concerns about the ability of energy companies to service their debt.

Where Do We Go From Here?

The negative impact on the US economy in the short term will continue to grow as more cancellations and closures take place Fortunately, prior to this outbreak, the US economy was in good shape. But there is no doubt that the economy will take a very significant hit as a great deal of economic activity comes to a sudden stop. The most important financial question is: how long will these restraints stay on the economy? Or said another way, when we will get past the peak virus spread? No one knows how this will play out in the US but lessons from China are at least directionally instructive. With strict limits on activity in the “hot zone,” China’s new cases are now negligible, about 3 months after the infection became known.

As we ramp up testing and quarantining, we will certainly see the number of reported cases jump very dramatically in the coming weeks. At the same time, we believe that the effects of closures and cancellations, personal hygiene improvements and social distancing will begin to have an impact on the spread.

Finally, the pharmaceutical industry is working furiously on treatments (for short term assistance to the sick) and vaccinations (a long term prevention mechanism). But this is a difficult problem so we need to temper our expectations for quick progress. While we can now cure or effectively treat killer viruses such as hepatitis C and HIV, we don’t have an effective cure for the seasonal flu.

What Are You Doing in Portfolios?

In the early stages of the downturn, we added modestly to stocks, expecting that this would be the type of correction we typically see once or twice a year: a 5-15% pullback. As it became clear over the course of this week that the damage to the markets and the economy would be deeper, we have become very selective in making additions to client portfolios.

We are closely monitoring developments in the fixed income markets. We have seen some dramatic and unusual movements that are indicative of liquidity pressures, as investors have scrambled to raise cash. As prices on closed end funds have reached highly distressed levels, we have started to add these to client portfolios for which they are suited.

Finally, we have also started to realize tax losses on certain positions and are generally reinvesting the proceeds as we do not know when the market will turn around. History teaches us that it will but the timing is uncertain. We continue to be diligent in monitoring the markets and client portfolios, looking to take advantage of short term dislocations for long term benefits.

Thoughts on the Current Outlook

January 15, 2020 Jon Zeschin

Three Key Thoughts:

1. Consumers March On

2. US Growth Stocks Lead the World

3. China: A Shifting Role

US Consumers March On

In the fourth quarter of 2019, the markets decided that the “growth scare” we spoke of in last quarter’s Thoughts was not real. Led by consumers, the US economy continues to grow at a reasonable pace, with low inflation and a strong job market. Stocks love this environment – they have defied the skeptics and marched to all-time high after all-time high. Meanwhile, bond yields rose a bit off of their pessimistic lows.

The US consumer continues to be in excellent shape: well-employed with a growing wage, low indebtedness and a solid housing market. Of course, there are geographies and demographics that aren’t doing as well as the overall averages. However, we believe the consumer is likely to continue driving the economy forward at least through 2020.

The weak link today is business investment. While hiring is strong, businesses have not had the confidence to make major new investments in property, plant and equipment. Indeed, current statistics show that the manufacturing sector is bordering on recession. We believe that some of this reticence to invest is fallout from trade policy uncertainty. With a “phase one” deal with China due to be signed shortly, and a path for Brexit more settled, we hope to see business confidence recover somewhat.

US Growth Stocks Lead the World

One place where confidence isn’t lacking is at US technology companies. Their businesses are growing quickly and their stock prices have been leading the markets higher. Unlike the late 1990’s, when technology valuations reached absurd levels on nascent business models, today’s leaders are delivering real cash earnings that are growing consistently, leaving their valuations relatively more attractive than many so-called defensive or low volatility stocks.

This dominance of growth companies over traditional value stocks is one of three major trends that persisted throughout the decade of the 2010’s. The other two are: (1) the strength of the US dollar relative to virtually all other currencies; and (2) the higher returns posted by US domiciled companies, compared to their non-US counterparts. Each of these trends has persisted for an unusually long time, leaving the gaps in each case at historically wide levels. This has defied our expectations (and many, many others) and the simple law of regression to the mean. For the last decade, the best thing an investor could have done was to buy a US large cap growth index fund or ETF and hold it. The only thing we can say with some degree of certainty is that this is not likely to repeat for another full decade!

China: A Shifting Role

Shifting gears, with all of the news about trade negotiations with China, we think it is important to comment about the shifts we see in the world’s second largest economy. For the last 30 years, China has been nothing short of an economic miracle. As its leaders recognized the opportunities a market-based economy could bring, they transformed the country into the manufacturer and supplier to the world. Hundreds of millions of people were moved from abject poverty to a middle-class lifestyle. Unburdened by legacy systems and infrastructure (and a democratically elected government), China has advanced at a breathtaking pace. In many ways, if you want to see how technology will change our lives in the near future, visit China – they are often far ahead of us.

As wages have risen dramatically over the past couple of decades, their people now have greater resources and are demanding more and more services. And, China is no longer the low-cost manufacturer. So the Chinese economy is becoming increasingly like the US: driven by consumers and the products and services they demand. This sets up a competitive, rather than cooperative, future relationship with the US.

Given the sheer scale of China and the willingness of their government to tip the scales in their favor, China will be a formidable competitor. For example, if China wanted to lead the world in EV (electric vehicle) production, its government could support the research necessary to advance battery power significantly. Once that research was ready for commercialization, the government could declare that internal combustion engine cars could no longer be sold after a certain date, creating the world’s largest EV market for its domestic companies in short order. As far as we know, this is a hypothetical example but you can imagine this same blueprint being applied in many other markets.

If you combine this potential market power with an increasingly nationalistic government (as President Xi’s is), it is easy to envision a China wanting to play by rules it establishes, rather than those developed by other, lesser powers. In this context, we think a trade deal that reduces tensions and supports cooperation is an important achievement. We have no idea whether this deal will pave the way for better returns from non-US investments, but we expect that it should improve sentiment, both here and abroad.

Investment Implications

We have made no major changes to our “late cycle” asset allocation approach, maintaining an overweight to US large cap stocks and an underweight to fixed income, particularly low-quality credit exposure. Our approach to investing in US stocks has a strong “quality growth” bias. To balance this, we have held more value-oriented funds in the international portion of client portfolios. Over the last quarter, we have shifted those international holdings to be more balanced between growth and value. And, we have added a significant position with a global equity manager with the flexibility to shift between markets at attractive opportunities arise.

Thoughts on the Current Outlook

October 17, 2019 Jon Zeschin

Three Key Thoughts:

US Growth Scare
Central Banks to the Rescue?
Self-inflicted Wounds

US Growth Scare

Over the past twelve months, long term bond rates have fallen precipitously. After peaking at around 3.2% a year ago, the rate on 10-year Treasury bonds has been cut in half, to around 1.6% at quarter end. While there could be several factors contributing to this sharp decline, the primary culprit would seem to be a foreshadowing of much slower economic growth. The US economy stayed reasonably strong over the first half of the year (2.6% growth) while the rest of the world appeared to be weakening. However, a number of recent indicators have shown signs of a weakening economy.

This is not really surprising. The short-term impact of the 2017 tax cuts has largely worn off so the economy is likely just moving back toward its long-term growth trend rate of 1.5-2.0%. But, in the process of slowing the growth rate so much, there is a bigger chance that we overshoot and end up with a recession (typically defined as two consecutive quarters of negative economic growth).

At this writing, the US stock markets are trying to sort out how real this growth scare is. We went through a similar exercise in the fourth quarter of last year, with the markets declining quite quickly on concerns that a recession was imminent. We expect more volatility ahead as we observe how consumers and businesses react to a slower growth outlook. For now, the consumer is leading the parade. If this continues to be the case, then this growth scare will prove fleeting as well.

Central Banks to the Rescue?

The self-described “data dependent” Federal Reserve will likely reduce interest rates further, in response to the weakness already reported. The target Federal Funds rate peaked at 2.5% for this cycle (so far) and we expect it to be reduced to 1.75% by year end. Unfortunately, by waiting for the date to appear before they act, the Fed will be behind the curve, reducing the potential impact of their actions.

In shifting toward an expansionary policy, the US Fed is joining central banks throughout the world in expanding policies they hope will stimulate growth. In Europe and Japan, the central banks have been at this for a long time with limited success in Japan and virtually no success in Europe. The European Central Bank has targeted negative interest rates now for some time but there is no evidence that this experiment is working to stimulate growth. Given the relatively low rate at which the US Federal Funds rate peaked for this cycle, there is increasing chatter that the US might also enter the negative interest rate world.

Self-Inflicted Wounds

As we have said several times in the past, we believe the trade war narrative initiated by the Trump administration was built on faulty economic premises. So far, the use of tariffs has done nothing but stoke uncertainty both in the business community and in the halls of foreign governments, at a time when more uncertainty is not needed. We already have the unsolved Brexit puzzle, Europe’s bureaucratic quagmire, Japan’s structural problems, the China/Hong Kong strife and Iran trying to create middle east conflict. Here at home, the impact of the tariffs on the prices of imported goods has at least partially offset the benefits of the 2017 tax cuts.

If all that weren’t enough, we now have the President and the House of Representatives engaged in a shooting war over a pending impeachment inquiry. We offer no predictions on the outcome – the best we can say is that both sides want it to end quickly. While this drags on, the dysfunction in D.C. does nothing to help US consumers to feel more optimistic about their futures. Therein lies the concern: that we could develop a negative self-reinforcing cycle that drags us into recession.

On the positive side, consumers are still spending and businesses are still hiring. And, for the most part, they view Washington antics as a side show, not something that affects their daily lives in any significant way.

Investment Implications

Clearly, the best place to have invested for the last twelve months was long term bonds, which surprisingly posted double digit returns. Many other parts of the fixed income markets also had strong returns, beating the returns of stocks, both domestic and foreign. However, having taken these big steps down in yield (and up in price), we view the fixed income markets with a great deal of caution as small absolute moves in yields will have an outsized effect on prices. In addition, yields on lower rated bonds don’t provide a generous cushion, should the economy deteriorate and cause those companies financial stress. On the other hand, should economic data stabilize or improve, we could easily see rates on longer term bonds jump up quickly.

Overall, we have kept asset allocation relatively stable, making modest adjustments in individual positions. For example, we have reduced our dedicated Asia exposure in favor of a global equity fund, a much broader growth mandate. We have not changed our “economic weakness” positioning of lower investments in small cap stocks and high yield bonds, with greater holdings of short term, high quality fixed income funds.

Thoughts on the Current Outlook

July 18, 2019 Jon Zeschin

Three Key Thoughts:

US Economy Grows; Rest of World Slows
Rates Move Lower Still
Trade, Trade, Trade

US Economy Grows; Rest of World Slows

While we haven’t seen an official estimate of US growth for the second quarter of 2019, we think it is very likely to show a continuation of solid, if somewhat slower, growth. At least as importantly, inflation has remained muted, with wage gains consistently in the 3% area. This is good but not a sign that broader inflation pressures are sufficient to get to the Federal Reserve’s 2% target.

As we discussed last quarter, the Fed has shifted its stance toward supporting growth, which it too believes may be weakening. The markets believe that the Fed will cut short term rates a couple of times before 2019 is over, leading the stock market to new all time highs and bond yields to multi-year lows. This has led to a short-term conundrum where bad news on the economy means more rate cuts, which are good for the markets. This likely won’t stay the case for long – either bad news becomes worse (with the economy and the markets turning sharply lower) or it turns to better news (and we keep the economy and the markets rolling on).

Meanwhile, Europe is back in a slowdown, mired down with changes in the European bureaucracy following the elections, an unresolved Brexit and the German growth engine stalling. The European Central Bank believes it has the tools to re-ignite growth and inflation but there is little to show for their efforts so far.

Uncertainty over trade policy with the US is definitely a headwind in China, which ripples across Asia. The Chinese government is trying targeted stimulus efforts to offset the impact of trade-induced weakness but the Xi administration doesn’t have a great record when it comes to economic policy decisions.

Rates Move Lower Still

The first half of 2019 was a rare period in which US stocks reached new highs and bonds of all types rallied right beside them. The yield on the 10 year US Treasury bond dropped to 2% before leveling off – a very sharp drop from the 3.3% we saw just nine months ago. We believe there are three factors that led to this decline: (1) inflation is low and expectations are that it will stay low, despite a tight labor market; (2) the US economy is likely to weaken from its 2018 growth rate as the initial effects of the tax cuts wear off; and (3) US yields look positively rich compared to yields on sovereign debt issued by other developed countries.

We don’t know which of these three factors is the most dominant but we expect they will all stay in place for the near term. We are more concerned about the very narrow spreads on lower quality corporate debt, which could expand rapidly if the US economy slows more than expected.

Trade, Trade, Trade

Several quarters ago, we raised the concern that, having achieved its tax cut goal, the Trump administration would move onto trade policy, where things might get unpredictable. That unpredictability has become a hallmark of US trade policy, making it extremely difficult to discern where we are headed next. The US/China trade relationship is the most important because of its worldwide impact. Despite both Presidents Trump and Xi needing to get a trade deal done for their own political reasons, the need for a “win” by both sides has made real progress elusive. It is entirely possible that the current tariff situation drags on for some time.

Also left undone are new trade deals with the UK (post-Brexit) and the European Union. So far, threats of more egregious tariffs against the EU have not come to fruition. Unfortunately, we have also seen this administration use tariff threats for other purposes, which we believe adds to our reputation for unpredictability. The US and Chinese economies seems robust enough for now to withstand these tariff spats. Europe’s economy hardly needs another source of uncertainty.

Investment Approach

From an investment perspective, we have largely held asset allocation steady, with a modest overweight to US large cap and a substantial – but less than market – weight in international stocks. We remain underweight in longer term fixed income, with an offsetting overweight in hedged equity strategies. In lieu of holding low yielding cash, we have added significantly to short term bond funds or exchange traded funds, which deliver an attractive yield and lower risk of market value changes.

Thoughts on the Current Outlook

April 18, 2019 Jon Zeschin

Three Key Thoughts:

1. The Gloom Has Lifted for Now

2. Falling Long Term Interest Rates: Good or Bad?

3. China and Europe: Moving in Opposite Directions

The Gloom Has Lifted for Now

A bit more than three months ago, the markets were obsessed with the possibility of a global recession. The US had reported some slightly weaker numbers, while Europe and China were definitely slowing. Combined with open-ended trade disputes with China, a potential Brexit mess, falling oil prices, a government shutdown and the Federal Reserve continuing to hike interest rates, the outlook was gloomy.

Now, it seems that all the gloom is forgotten, as stock markets have recovered most, if not all, of their losses from the fourth quarter of last year. But how much has really changed? The US economy is likely slowing from last year’s pace, Europe and China are slowing (although each has announced some modest stimulus plans) and Brexit is a mess growing by the day.

The biggest change is that the Federal Reserve has abruptly changed plans, effectively putting off any interest rate increases for the remainder of this year. Some pundits even expect the Fed to cut rates, should US economic data weaken any further.

Looking out over the next 18 months, the 2020 election will come into increasingly sharp focus, with the posturing by both sides eventually reaching a fever pitch. More importantly, little will get done as compromise has become a four letter word in Washington. That said, it is usually a good thing for the markets when nothing is getting done in DC.

Falling Long Term Interest Rates: Good or Bad?

We believe long term interest rates are an excellent barometer for the future health of the economy. The rate on the US Treasury 10 year bond has fallen from 3.3% in October to about 2.5% now. While you can argue that the fall in interest rates will stimulate some parts of the economy like housing, you can also argue that it is foreshadowing that growth will not be strong enough to generate much inflation. Our best guess is that we have slower growth but no recession in the near term.

If the Fed stays on hold, we could very well stay in this “Goldilocks” environment where economic growth is consistent – not too weak or strong – and inflation is low – but not too low. This would likely allow corporate earnings to grow at a reasonable rate and stock markets to continue to prosper. In this type of environment, our focus on individual stock selection should be helpful, as we concentrate on those companies which can deliver good results despite a more challenging “macro” outlook.

China and Europe: Moving in Opposite Directions

Outside the US, the Brexit battles have laid bare the fragilities of the Eurozone structure. We believe that part of the world will stay weak for the foreseeable future. That doesn’t mean there aren’t interesting investment opportunities – it just means the environment will be a headwind rather than a tailwind.

In China, the stock market has rallied very strongly so far this year on the back of government stimulus plans and hope of a comprehensive trade deal with the US. The outcome of the trade negotiations is very difficult to predict as the Trump administration has been inconsistent in its trade negotiations with other partners. That said, we believe the President really wants to complete a deal this year, so it can be used in his re-election campaign. And, we believe that President Xi also wants to do a deal so he can reinvigorate the mood of the Chinese people, which will help his stimulus plans. But each side wants a “win,” so a substantive deal is not assured until the negotiations are over.

Investment Approach

Thoughts on the Current Outlook

January 16, 2019 Jon Zeschin

Three Key Thoughts:

1. US Economy: Weaker at the Margin

2. Impact of the Brexit Debate

3. China: Short Term vs Long Term

US Economy: Weaker at the Margin

In last quarter’s Thoughts on the Current Outlook, we stated our view that the strong rate of growth in the US economy was “unsustainable” and that in 2019 economic growth would begin to revert toward its long term potential of 1.5-2%. Because markets tend to move on the basis of the marginal change in the environment, this concern came to the fore in the fourth quarter as slightly weaker data coincided with the Federal Reserve’s interest rate increases. The result was a very powerful move lower, particularly in December.

A series of other concerns added to fuel to the markets’ dour view: ongoing trade disputes with China, weaker economic reports from China and Europe, the distinct possibility of a disruptive “no deal” Brexit in March, falling oil prices and the partial government shutdown.

At this writing, a strong December jobs report and news of progress on China trade talks has calmed the markets, which likely overshot to the downside. That said, it is likely that we will see US growth slow materially in 2019. And, any time that growth is slowing, there is a heightened risk that we tip into recession.

We think it is important to call out two particular risks. The first is the ever-changing story of US trade policy. In trying to re-write agreements with all of our major trading partners, we have created a great deal of uncertainty for international businesses. The result, not surprisingly, is that many of these businesses have been hesitant to make major investments in future growth. This has had the effect of limiting the positive effects of the generous business tax cuts that drove earnings dramatically higher in 2018.

The second major risk is complete dysfunction in Washington. We are currently in the midst of a partial government shutdown which is just beginning to have an impact on the real economy. The more important issue however is the continuation of extreme partisanship that prevents compromise. This is a movie we have seen before – when Republicans regained control of the House of Representatives in 2010 with a new class of representatives dead set against negotiating with President Obama. This time, we can add a special counsel investigation and other Congressional inquiries to the toxic mix.

Our concern from an investment perspective is that the consumer has been and will continue to be the key driver of economic growth. If Washington dysfunction reaches a point that it damages consumers’ confidence, we could inflict a recession on ourselves, where one would otherwise not have existed.

Impact of the Brexit Debate

In 2016, Prime Minister David Cameron fulfilled a campaign promise to hold a referendum on UK withdrawal from the European Union. Cameron believed that voters would certainly vote to stay and that this result would put an end to the debate within his own party about withdrawal. His bet proved disastrously wrong as voters approved Brexit and ultimately Cameron was replaced by Theresa May.

May has faced the task of negotiating the terms of an exit under impossible conditions: unrelenting criticism from various home factions and unbending demands by the European Union which has no interest in making Brexit good for the UK. These unyielding forces on each side are about to collide as May’s deal faces a final vote of Parliament, which is widely expected to disapprove it. This may set off several different courses of action, the outcome of which is completely unpredictable.

What is clear from this entire episode, however, is that political dysfunction is not limited to the US. Indeed, it has shown a light on the structural weaknesses of the European Union and the common currency in particular. It has also demonstrated that the rise of populism can lead to illogical and damaging results. (Who would vote to crater their own economy in order to preserve local border control? I wonder…)

Regardless of the Brexit outcome, we believe the concept of economic union in Europe is severely damaged and will need major changes to survive. We don’t know what form this will take but we expect that the economy will continue to be weak until a new generation of political leadership is identified and a decisive path forward is defined. This will likely take many years and success is by no means assured.

China: Short Term and Long Term

We have written extensively about our views on China, which are quite different than the prevailing “China bear” sentiment. There is no doubt that 2018 turned out to be a challenging year for China. The deleveraging policies that had been initiated in 2016 ran headlong into concerns about the impact of a possible trade war with the US. As a result, consumers in China became less confident and pulled back on spending. Not only did this impact local Chinese companies (where the stock market declined throughout the year) but also multinationals like Apple who saw their China sales affected significantly. The government has responded by easing up on the deleveraging program and becoming more amenable to a trade deal with the US.

We believe these are short term issues that don’t really impact the long term story of the rise of China. Now the second biggest economy in the world, China has continued on its slow path of opening up to the rest of the world. With a consumer population of a size that can only be matched by India, China understands that long-term, growth-oriented policies are critical to managing the prosperity of its people. And, importantly, it follows that the prosperity of its people is essential to the survival of the regime. This should be a hospitable environment for long term investors.

But what is troublesome is the increased focus by the Communist Party on censoring external views, forcing businesses to expand or contract “strategically” and embedding the party leadership for an undefined term. These contrasting themes of “opening up” and “shutting off” should give investors pause. Over the long term, we believe the growth need will outweigh the control desire but the path forward may be bumpy. Because China contributes so much to global growth, its development will be a key driver of global markets. In the near term, striking a reasonable deal with the US on trade will go a long way toward alleviating concerns about the Chinese economy, both at home and around the world.

Investment Approach

With the sharp market declines of the fourth quarter, we spent a great deal of time harvesting tax losses for taxable client portfolios. For the most part, we remained invested in both US and international equities. However, we have kept a moderate amount of cash on hand as we would not be surprised to see more market volatility, particularly in Europe and the US as economic reports weaken. We made a number of small changes to asset allocation in preparation for slowing growth as well: reducing investments in high yield bonds, eliminating direct commodity exposure and adding to municipal bonds, where appropriate, on the expectation of falling yields.

New Partnership Transaction Completed

January 4, 2019 Jon Zeschin

The combination of Maurer & Associates Capital Management into Essential Investment Partners, LLC was completed effective January 2, 2019. Michael Haines and Jon Zeschin are now equal partners in Essential. We are in the process of making a number of changes to this website to reflect the new business capabilities and structure. We expect to complete these changes over the first quarter of 2019.

Jon Zeschin and Michael Haines join forces in Essential Investment Partners, LLC

November 28, 2018 Jon Zeschin

Investment managers Jon Zeschin and Michael Haines announced today that Maurer & Associates Capital Management Inc. (MACM) will merge into Essential Investment Partners LLC (EIP). Haines, who is sole owner of MACM, will become a partner with Zeschin in EIP, with an anticipated effective date of December 31, 2018. EIP is an independent wealth management and investment advisory firm founded by Zeschin in 2001.

“This partnership is about ensuring that we can continue to serve our clients’ needs far into the future,” Zeschin said. “Michael and I share a common commitment to the values that have been critical to our success: independence, trust, transparency and professionalism.”

“When working with clients to help plan their financial future, trust and experience are invaluable sources of peace of mind. Jon and I share a long-term view of managing wealth prudently and maintaining close relationships through exceptional service. Our services go well beyond investing and include a very wide range of financial advice,” said Haines.

Haines started in the investment business as a financial analyst with Founders Asset Management Inc. in 1985. Founders was a no-load, growth equity mutual fund company. He was part of the team that grew the firm from $400 million in assets and 16 employees to $9 billion in assets with over 100 employees, prior to the sale of the business in 1998. Haines earned a master’s degree from The University of Denver with a concentration in finance after completing an undergraduate BA in Chemistry from The Colorado College.

Zeschin’s nearly 40 years in the investment business include executive leadership positions in virtually every aspect of investment management. He served as President of Foundars Asset Management prior to its sale. In addition to serving Essential clients, Zeschin is chair of the board of Matthews Asia Funds and a member of the Board of Governors of the Investment Company Institute. Zeschin received a master’s degree from Northwestern University’s Kellogg School of Management with majors in finance and marketing and a bachelor’s degree in accounting from the Ross School of Business at the University of Michigan. He is a CPA with the Personal Financial Specialist designation and a Certified Financial Planner certificant.

DISCLAIMER: This press release contains statements which constitute “forward-looking information” within the meaning of applicable securities laws, including statements regarding the plans, intentions, beliefs and current expectations of EIP and MACM with respect to future business activities. Forward-looking information is often identified by the words “may,” “would,” “could,” “should,” “will,” “intend,” “plan,” “expect” or similar expressions. Although EIP and MACM believe that the expectations reflected in such forward-looking information are reasonable, such information involves risks and uncertainties, and undue reliance should not be placed on such information, as unknown or unpredictable factors could have material adverse effects on future results. There is no guarantee that the business transactions described herein will be completed.

Thoughts on the Current Outlook - updated November 1

November 1, 2018 Jon Zeschin

Long periods of low volatility are often followed by short periods of very high volatility. Unfortunately, we never know when those spikes in volatility will occur – we just have to expect that they will inevitably happen. And, they are pretty normal at least once or twice a year.

October was one of those periods. So far, it seems quite similar to the experience we had in late January and February of this year. Remember? It is easy to forget once the market bounces back like it did from March through September.

You can find lots of pundits trying to explain what caused this pullback. As usual, it is likely a combination of factors – rising interest rates, China trade concerns, mid-term elections, late economic cycle - with no one really sure what kicked it off.

We believe that what we do have to be concerned about is the economic cycle. US growth is now solidly above our long-term growth capacity, the Fed is well into a rate increase phase, credit spreads are near historically low levels and the US stock market has hit all-time highs. These are all classic signs that we need to be on watch for recession.

Over the next year, we think the US economy will slow back down toward its expected long-term growth rate of 1.5-2%. The question will become whether the Fed can assist with a “soft landing” or whether we get back to that growth rate via recession (negative growth for two or more quarters in a row).

Either way, we think slower growth is ahead. We are beginning to express this view via a gradual addition of high quality, longer term bonds to client portfolios and a reduction in high yield bond investments. In addition, we are holding more cash than normal in our Essential Growth Portfolio strategy. Finally, we have used the October pullback to harvest tax losses in certain international stock and fixed income investments.

Stock markets have rallied strongly the last three days. This may mark the beginning of a return to all-time highs for US stocks. But we remain cautious about the staying power of these gains.

Thoughts on the Current Outlook

October 10, 2018 Jon Zeschin

Three Key Thoughts:

1. Is the US Economy Doing Too Well?

2. Federal Reserve is Still on Track

3. International Markets Trip on Trade Policy and Dollar

Is the US Economy Doing Too Well?

The US economy is running on all cylinders, growing far above its long term expected rate. Much of this extra growth can be attributed to the large corporate tax cuts that were put into place at the beginning of the year. So far, the US stock market has been tightly focused on these benefits, driving prices to all time highs.

An economy’s growth potential is pretty easy to define. It is simply the sum of the growth rate of the labor force and the rate of productivity growth of that labor force. Labor force growth is relatively predictable because it is driven mostly by demographics and, to a lesser extent, by immigration. Productivity is harder to measure and even harder to predict. But, looking back at history, it is hard to get sustained productivity growth over 1.5%.

For the US economy, this leads us to think that our long term growth potential is likely 1.5-2.0%. This is comprised of 0.5% of labor force growth and productivity growth of 1-1.5%. So the growth we are now seeing, well in excess of 3%, is far above potential. At some point – we suspect in 2019 -- the short term effects of the tax cuts will wear off. And the impact of higher interest rates will begin to take hold. Both of these factors will cause our growth to slow. The questions will become how much will we slow and when?

In a typical business cycle, strong employment markets lead to rising wages, which lead to inflation and higher interest rates. Eventually those higher rates choke off growth, leading to a recession. But this has been anything but a typical business cycle. The real estate debt bubble that burst in 2008 gave way to a long period of very slow growth and a weak employment picture. Only very recently – nearly nine years after the recovery started -- have we seen signs that low unemployment is driving up wages and inflation.

Bottom line, we view the current rate of US growth as unsustainable and, increasingly, the focus will be on the whether the Federal Reserve can engineer a slow down without a recession. We believe this so-called “soft landing” will start to be a concern in 2019.

Federal Reserve is Still on Track

Cautious optimism well-describes the Federal Reserve at this juncture. The Fed continues on its gradual tightening path, raising short term interest rates by another one-fourth of a percent and reducing its bond holdings. We, like most investors, expect the Fed to continue raising short term rates quarterly, as they have long telegraphed, so long as employment is strong, the economy is sound and inflation is around their 2% goal.

Combined with higher readings on economic growth and wage inflation, rates on longer term US Treasuries ticked up a bit in September. Rather suddenly, investors have become concerned that longer term interest rates might jump up quickly as inflation pressures are building. The actual rate increases so far are modest but enough to get stock markets’ attention. After such a long positive run, it would not be unusual to see a significant, but short term, correction in US stock prices.

We would become far more concerned if we were to see rates on lower rated (“junk”) bonds jump up quickly, while Treasury rates stayed stable or fell. In our opinion, this so-called “spread widening” could be a more definitive indicator of an upcoming recession. For now, these spreads remain very tight, reflecting the fact that investors believe the credit problems of a recession are well off into the future.

International Markets Trip on Trade Policy and Dollar Strength

In contrast to the US market, international equity markets have stumbled as investors have been concerned about the impact of a stronger dollar, higher oil prices and weaker overseas growth. We had thought, incorrectly, that the positive sentiment shift toward international markets in 2017 would continue for some time as the fundamental economic stories were still quite good. Instead, this sentiment sharply reversed as a couple of emerging markets (notably Turkey and Argentina) faced currency crises and investors became concerned about contagion risks.

Despite the isolated nature of those countries’ problems, broader concerns came to the fore as the Trump administration has embarked on a series of trade forays, the outcome of which seems far from certain. A renegotiation of NAFTA with Canada and Mexico, new trade agreements with Europe, the UK, Japan and South Korea, maybe a reconsideration of the Trans-Pacific Partnership and, most importantly, a complete redo of our trading relationships with China, are all on the agenda. While all of the efforts are cast in terms of “getting a better deal for the US,” it is not clear what we really are hoping to achieve.

The USMCA (US, Mexico, Canada Agreement) that was announced on October 1 may provide a template. This NAFTA replacement has lots of details to be reviewed and analyzed. Initial reaction is that the agreement has been modernized from an information technology perspective, some domestic content and wage restriction provisions have been added and the Canadian dairy market modestly opened. In sum, it doesn’t seem like a lot has changed. Perhaps the best that can be said is that draconian tariffs were avoided and the noise around these negotiations will now stop.

Maybe we are seeing the faint outline of a strategy forming: put in place new deals with all of our major partners except China, getting them lined up to provide unified pressure on China. We don’t know if this is actually administration strategy but it does seem clear that a near term deal with China is unlikely. This has important implications for any US business depending on China imports or exports.

Investment Approach

Our long term belief in the growth opportunities outside the US continues to be put to the test as international market returns were negative, against a strongly positive quarter for US stocks. We have taken some tax losses on certain emerging market positions and are in the process of deciding if, how and when to re-establish those investments. At some point, the long period of underperformance by international stocks will end – we just don’t know when.

We have held onto US stock positions as the US economy and corporate earnings continue to grow. However, we recognize that the US is likely in the latter stages of this cycle so some caution is warranted. Finally, we remain underweight in fixed income because that strong growth will likely cause rates to bleed higher, hurting bond prices.

Thoughts on the Current Outlook

July 11, 2018 Jon Zeschin

Three Key Thoughts:

New Terms of Trade: Policy, Fiasco or Both?
Markets Diverge (Again)
All Quiet on the Fed Front

We try to tune out the constant drone of noise coming from Washington, for the most part. Only when a policy change might or will have a fundamental impact on the economy, businesses or individuals, do we take notice.

The Tax Cut and Jobs Act, enacted last December, has had an enormously positive impact on corporate bottom lines. By lowering the corporate tax rate by about 40%, corporations now have more cash to pay employees better, invest in business expansion and return more capital to shareholders. These are all positive changes for companies, workers and investors. Estimates for growth in the economy have been marked up as have earnings estimates. And the stock market has reacted as you might expect, boosting prices higher.

The ride got bumpier in the second quarter, however, as the Trump administration rolled out its new approach to trade in full force. No country — no matter how close an ally — was immune from the prospective imposition of sizable tariffs. The biggest target of all is of course China, with whom we arguably have some legitimate reasons to be negotiating better trade terms. But the apparent scattershot approach being taken is problematic on a couple of levels. First, with the only discernible rationale for the tariff talk being domestic political gain, negotiations with our trade partners would be difficult because they can’t tell what we really want. Second, because companies aren’t sure how long these tariffs will be in place (maybe they will change with tomorrow’s Twitter feed…), they are hesitant to invest in or make changes to their global supply chains. So what we end up with is a state of confusion, which isn’t positive for any economy.

Maybe, as some including the President himself, have suggested, we are ultimately targeting a world in which tariffs are very low or zero. If so, that would certainly be a welcome outcome. Another positive result would be a deal with China on intellectual property protections and further opening of their market to US exports. For now, our concern with the trade tactics is that they may offset many of the positive effects of the corporate tax improvements. We aren’t concerned about this in the very short term, as the US economy seems to be running on all cylinders. However, if we look forward a year or two, when our economy is likely to be growing at a slower rate, nearer the long term average, then these trade policy effects could be more detrimental.

While we are sorting out noise from real change, we view the second quarter’s market divergence as akin to the knee-jerk reactions that took place immediately after the election in late 2016. Those reactions were reversed in the first half of 2017. This time, reactions to prospective trade policy, drove US small cap stocks to even more extremes of valuation, while emerging markets were driven down by a stronger dollar and tariff concerns. Yet, the fundamentals in many emerging markets — which are largely driven by growing middle class consumers and supportive government policies — have not changed at all. These domestic consumption stories are largely unaffected by US trade policy and they are likely to persist for many years to come.

The Federal Reserve continued on its gradual tightening path this past quarter, raising short term interest rates by another one-fourth of a percent and continuing to reduce its bond holdings. The bond market took this all in stride, as the Fed’s moves were just as expected. We, like most investors, expect the Fed to continue raising short term rates quarterly, as they have long telegraphed, so long as employment is strong, the economy is good and inflation is around their 2% goal.

The only real excitement in the bond market has been whether we are going to see the yield curve “invert” anytime soon. Often used as a early indicator of a coming recession, a yield curve inversion happens when short term rates are higher than long term rates. Typically, this happens late in an economic cycle when the Fed is raising rates quickly in an effort to slow the economy. Eventually, they are typically successful, inducing a recession.

This time may be a bit different: the Fed is hiking rates slowly, just trying to get them back to a normal level. We believe long term rates are being held down as demand for US Treasury bonds remains high because US yields are the highest among major developed economies. We would be more concerned if we were to see rates on lower rated (“junk”) bonds jump up quickly. In our opinion, this so-called “spread widening” will be a more definitive indicator of an upcoming recession this time around.

For now, investors are getting close to earning a positive real (after inflation) return on short term bond investments. We may yet see the day when holding cash in a money market fund is no longer a losing proposition, but rather a reasonably attractive investment!

In client portfolios, we have maintained our significant weight in international stocks, with a preference for Asia over Europe, because of the better growth characteristics of many Asian economies. And we have held onto US stock positions as the US economy and corporate earnings continue to grow nicely. Finally, on the flip side of this, we remain underweight in fixed income because that strong growth could lead to higher interest rates, which would hurt bond prices.

Thoughts on the Current Outlook

April 13, 2018 Jon Zeschin

Three Key Thoughts:

1. Tech and Trade Tantrums

2. Bonds Riskier than Stocks?

3. Bumpy Road Ahead

Facebook went public in 2012 with revenue around $5 billion. By 2017, just five years later, its revenue had increased eight fold, to more than $40 billion, generating profits of nearly $16 billion. Yet somehow it escaped the public consciousness that Facebook was selling users’ personal data to generate this enormous profit, sometimes to people who did things we wouldn’t approve of. To paraphrase Meredith Wilson: Trouble, oh we got trouble/Right here in River City!/With a capital T/That rhymes with “FB”/And that stands for Facebook.

Since peaking on February 1, the value of Facebook stock has dropped more than 20%. Surveys show trust in the company has plummeted as well. The stock of Alphabet, parent of Google and YouTube, also peaked around the same time, amid concerns about new taxes from European regulators. And lately, Amazon has become President Trump’s favorite Twitter target. Bottom line, these big cap tech stocks, which had led the market up throughout 2017, have now led it down, about 10% off the peak. That we had a significant correction coming was no surprise to any serious investor – we had recently set records for low volatility and length of time without a correction. But questioning the future prospects of these tech titans was real news.

Unfortunately, tech woes weren’t the only things upsetting the markets. Interest rates on Treasury bonds jumped in the January causing investors to wonder whether stock prices should be ratcheted down because higher rates mean future earnings are worth less.

And, finally, we come to trade. Like many a Trump position, it is difficult to separate real policy from posturing for negotiating purposes. At this writing, the markets are rightfully concerned about the prospect of a growing trade rift with China. China appears to be taking a measured response to Trump’s planned tariffs but where this will lead is anyone’s guess. At the same time, the US is attempting to re-negotiate NAFTA with Canada and Mexico.

Our concern is that the administration is apparently basing its positions on a false premise, i.e., that trade deficits with any country are inherently bad for the US and must be the result of poor trade terms. Trade deficits are a function of our consuming more than we produce at home. It’s that simple. Shifting the terms of trade through tariffs is likely to drive up prices for imports, costing US consumers more and slowing the economy. Not only is this counterproductive but it takes away some of the benefits of the lower corporate tax rates that were just put into place.

Meanwhile, the trade issues also add to concerns about inflation, as tariffs on imports drive up prices. With the unemployment rate already at a very low rate (4.1%) and likely headed lower as job growth remains strong, it is just a matter of time before wages begin to rise more strongly. And with them will come higher inflation expectations and higher interest rates.

Gradually rising interest rates are generally okay for investors. For stock investors, this usually means the economy is doing well and earnings will likely rise, buoying stock prices. If rates rise too quickly, stock prices typically get marked down as investors are willing to pay less for future earnings as their present value is reduced. For bond investors, gradually reinvesting their interest payments at higher rates produces higher future income. The problem arises when rates rise suddenly or unexpectedly. It’s important to remember that the absolute level of interest rates is still quite low (30 year US Treasury bonds yield about 3%) so bond prices are extraordinarily sensitive to changes in interest rates. For example, a 1% rise in 30 year Treasury rates from their current level would cause their value to fall about 17%. We aren’t saying that bonds are necessarily riskier than stocks but, if we were to wake up to markedly higher inflation reports and interest rates, both bonds and stocks could be in for substantial declines.

One final point about US stocks. The combination of (1) the recent market correction and (2) the substantial mark-up in earnings estimates due to lower future tax rates makes it look like stocks are trading at close to an average multiple of future earnings. Indeed, we have been able to find some individual stocks trading at quite reasonable prices that we have added to client portfolios. However, we hasten to point out that those upcoming earnings are benefitting from lower taxes, a weaker dollar, higher energy prices and stable wages. It is certainly possible that a year from now, none of these factors will be tailwinds.

On a longer term basis, we are concerned that the recent tax cuts and spending bills enacted by Congress will add very significantly to the budget deficit. At a time when the economy is growing pretty strongly, we should be looking to reduce the deficit, not add to it. But in Washington, no one wants to make the hard choices. And no one gets re-elected by saying we need to make them, either. The deficit numbers are just too big for us to grow out of them and, ultimately, they make it more difficult for the government to respond to downturns in the economy.

In 2017, sentiment turned in favor of many international stock markets, particularly those of emerging markets. The better growth, better earnings and reasonable valuations of these markets had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for several years, perhaps making up much of their poor performance relative to the US since 2011. That said, we have some concern that investors will get too excited and push prices to unreasonable levels too quickly.

While 2017 was a cautionary tale about not letting politics color one’s investing approach, we could be entering a period where government policies have more impact on the investment landscape than they have in the recent past. Markets usually move on the basis of the expected marginal change in the environment and, so far, that judgment has been that the environment for investors has gotten better. Lower taxes and less regulation are generally good for companies’ bottom lines. Uncertainties created by shifting trade, immigration and foreign policies are much less business friendly, and may be less market friendly.

In client portfolios, we remain underweight in fixed income as we believe the risks far outweigh the small potential rewards. We have maintained our substantial weight in international stocks and have held onto US stock positions while carefully minding valuations.

Thoughts on the Current Outlook

January 12, 2018 Jon Zeschin

Three Key Thoughts:

Markets Rally on Tax Rate Cuts
Fed Speeds Ahead
Where’s the Inflation?

Twelve months ago, our heads were spinning from a 2016 filled with surprises, culminating in the election of Donald J. Trump as president. What has been most surprising about 2017 is that the financial markets and the economy greeted the Trump presidency with optimism, good results and low volatility, despite daily headlines filled with plenty of potential distractions. For now, the markets have focused on the marginal change in direction in Washington: away from more regulation and higher taxes and toward less regulation and lower taxes.

The tax bill that President Trump promised before Christmas became a reality, to our surprise. The big headline for the markets is the corporate rate cut from 35% to 21%. While there are an enormous number of details to work through, this cut will clearly benefit the earnings of a large swath of US public companies. Perhaps more importantly, it makes the US far more competitive on the world stage and will allow a redirection of resources away from tax avoidance to more productive ends.

In the near term, there will be some accounting shakeout as companies adjust to changes in deferred tax assets and liabilities and book tax liabilities associated with future repatriations of cash held overseas. But we expect the bottom line impact on corporate earnings will be very positive. If this number is, as some have predicted, 10%, then the US equity market got cheaper by that amount overnight. Of course, since the market looks ahead, it has more than fully discounted all of this improvement in the rally we have had since the middle of 2016.

We are not as sanguine about the potential benefits of the tax law changes for individuals. First and foremost, the changes are not permanent – they expire at the end of 2025 – which we think is generally bad policy. Second, the changes are complex so they will take some time for the professionals to fully understand and translate. Third, the changes will affect consumers across the country in wildly different ways, depending on their personal circumstances. For now, all we know for sure is that the tax accountants and lawyers will be working more overtime for a long time to come.

While the stock market proved positively exciting in 2017, the bond markets just let out a big yawn. The only commonality between the two sets of markets was the lack of volatility. Comparing year end 2016 to year end 2017, rates on the US Treasury ten year note were flat and the thirty year bond yield actually declined a quarter of a point. The action was at the short end, where the two year note rate rose nearly three-fourths of a point, in line with the Fed’s three interest rate hikes.

So long as the Federal Reserve’s three boxes remain checked, we expect it will continue to raise rates consistently throughout 2018 and reduce its balance sheet at a deliberate, well-publicized rate. Strong economy: check. Solid employment numbers: check. Inflation at target: mostly a check. As the stability in longer term rates demonstrates, the bond market doesn’t seem as convinced as the Fed, particularly about inflation.

For those old enough to remember Clara Peller and the Wendy’s tagline “Where’s the beef?”, bond investors may be applying to same level of disdain in asking “Where’s the inflation?” With unemployment low and the employment market strong, economic theory and history tell us that we should be seeing much higher wage inflation. Yet we haven’t seen it and the bond market is waiting for a clear signal on inflation before adjusting longer term rates higher. History also tells us that this adjustment could be swift and harsh when it does come. For now, we remain cautious on longer term fixed income investments, with the view that the primary risk is rising rates and falling bond prices.

As we have been have been saying for some time, international stock markets had everything going for them except sentiment. That changed in 2017, with many international markets outpacing the strong returns put up by the US stock market. Part of this story is currency – weakness in the value of the dollar has played a significant role in developed markets’ excess returns. But more important, we believe, is that these markets have found what they were missing previously: better sentiment. The better growth, better earnings and reasonable valuations pieces of the puzzle had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for some time. That said, some markets may have already gone too far in the short term.

Finally, 2017 was a cautionary tale about letting the divisiveness of politics color one’s investing approach. A year ago, a great deal of uncertainty reigned, with all sorts of wild predictions about the bad things that might happen. Yet, as usual, the institutions of our democracy and economy remained intact, if a bit shaken, and we are enjoying a strong economy, low inflation and relative peace. That is certainly not to say that there aren’t risks but it is important to keep them in perspective. Markets tend to move on the basis of the expected marginal change in the environment and, so far, that judgment has been that the environment for investors has gotten better. This phenomenon wasn’t limited to the US: one of the best places to invest in 2017 was South Korea, where the stock market gained more than 40%.

In client portfolios, we remain underweight in fixed income as we believe the risks far outweigh the small potential rewards. We have let our already substantial weight in international stocks continue to grow and have held onto US stock positions while carefully minding relative valuations. Finally, we are fine-tuning our line up of hedged strategies to focus on managers we expect to deliver better returns than bonds but with less risk than stocks.

Thoughts on the Current Outlook

October 10, 2017 Jon Zeschin

Three Key Thoughts:

Low Expectations for DC
Fed Scorecard: Three Pluses
International Markets Optimism

Stock markets around the world continued their rallies in the third quarter. The US was no exception, with major averages closing the quarter at record highs. Increasingly, investors are recognizing that better economic and earnings growth prospects are breaking out broadly. Correspondingly, the US dollar has weakened, enhancing the returns on non-dollar-denominated financial assets and improving the overseas revenues of US companies.

The bond market’s boring streak continued through the third quarter. Despite some intra-quarter volatility in longer term rates, spreads and rates ended the quarter pretty close to where they started. Credit spreads remain relatively tight, though not at record levels, reflecting a still-positive economic outlook.

It is tempting to let the state of US politics color our investing views but it is important to keep a long term perspective. For the most part, we believe the current dysfunction in Washington is just a continuation of the sharp divide we have seen for the last decade. The issues and debates have morphed – and seemingly change at the speed of Twitter – but the net result is largely the same: very little change on important policy matters and no effort to address long term fiscal problems.

This state of affairs informs our base view that nothing major will come out of Congress on Obamacare repeal/replace/repair (a zombie issue at this point), income tax changes and infrastructure programs. At this writing, tax “reform” is foremost on the Washington agenda. However, absent any savings from changes to Obamacare, the scoring of a “lower rates, fewer deductions” strategy will make it extremely difficult for Congress to enact as part of a budget reconciliation process. As a reminder, budget reconciliation only requires a simple majority to pass BUT the changes must be revenue neutral over the budget window of 10 years. Because bipartisan solutions are just not in the Washington playbook anymore, we expect a lot of discussion but very little action. Bottom line, we believe the only help the economy will get from Washington for the next few years will be a reduced focus on regulation, which can be done administratively.

Meanwhile, the moves by the Federal Reserve to gradually reduce its support for the economy have been met with guarded optimism. The Fed has raised the Federal funds rate very slowly and cumulatively we have now seen four quarter point increases in two years. And we could see a similar number over the next eighteen months, if things play out as the Fed expects. In addition, the Fed intends to stick to its plan to reduce its bond holdings by not reinvesting all of the proceeds of bond maturities each month, starting this month.

So long as the Fed’s three key boxes – reasonable economic growth, strong employment and inflation near target – remain checked, we believe they will continue to raise short term rates slowly and reduce their balance sheet deliberately. The bond market doesn’t seem as convinced as the Fed right now though. Longer term rates have stayed low, perhaps a sign that investors are concerned the Fed will tighten too much, bringing inflation and growth down. Complicating the picture is that, even at current low levels, US Treasury bond yields look attractive by comparison to rates on comparable European and Japanese debt. We aren’t sure how this will be resolved but we remain cautious on fixed income investments, with the view that the primary risk is rising rates and falling bond prices.

Finally, non US stocks have been a bright spot for investors this year, with developed market equities handily outpacing their US counterparts. Bigger gains were found in emerging markets, which have nearly doubled the returns of US stocks. Part of this story is currency – weakness in the value of the dollar has played a significant role in developed markets’ excess returns. But more important, we believe, is that these markets have found what they were missing previously: better sentiment. The better growth, better earnings and reasonable valuations pieces of the puzzle had been evident for a little while. Now that sentiment has been added to the mix, we could see good relative returns for some time. That said, some markets may have already gone too far in the short term.

In client portfolios, we modestly increased our already substantial weight in international stocks, funded by a small reduction in the weight assigned to US stocks. We also made several shifts in hedged strategies to focus on managers and strategies we believe can deliver attractive, but lower risk, return opportunities. As noted above, we remain underweight fixed income as we expect returns will be low while risk remains high. We are continuing to evaluate the role of fixed income in portfolios with very long term time horizons.

Thoughts on the Current Outlook

July 13, 2017 Jon Zeschin

Three Key Thoughts:

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

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

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

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

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

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

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

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

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

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

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

Thoughts on the Current Outlook

April 13, 2017 Jon Zeschin

Three Key Thoughts:

Markets Expecting Better Growth
ACA Fail, Taxes Next?
Fed on Target for a Change

Optimism about the potential positive impact of the Trump agenda continued through the first quarter. However, the impact was felt more broadly across the US stock market than it was in the two months immediately following the election.

The traditional growth sectors of the economy – technology, health care and consumer discretionary – led the stock market up in the first quarter. Stocks of financial, energy and industrial companies lagged the market. Small cap stocks also underperformed after a strong, quick run in late 2016.

Meanwhile, the bond market was positively subdued, compared to the fireworks than ensued immediately after the election. Even the dollar was a bit of surprise, giving back a good chunk of its post-election gains.

It would not be surprising to see volatility in the markets pick up from here. While the failure of the Republican effort to repeal and replace Obamacare didn’t set the markets back, a similar failure on tax reform could. We believe the markets’ current optimism is based partly on expected fiscal stimulus from lower tax rates.

In any negotiation of this magnitude there will be winners and losers. With Obamacare repeal and replace apparently off the table, keeping tax reform “revenue neutral” will be a much bigger task. And, if the so-called border adjustment tax proposal also falls off the table, then reducing tax rates in any meaningful way will become very difficult.

This assumes that some fiscal discipline is attached to the tax negotiations. 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.

As we have been saying for some time, there are some sobering realities that serve to limit the potential growth of the US economy. 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 well set for the next 5-10 years at around 0.5%, which leaves productivity as the wild card. Except 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 if inflation stays around the Federal Reserve’s 2% target.

Speaking of the Federal Reserve, we believe the other governor on growth will be tighter monetary policy. As we look at the Fed’s objectives, we see the table set for continued “normalization” of interest rates and the Fed’s balance sheet. The US economy is growing at or near its new potential rate, inflation is right around the 2% target and the employment picture is solid with unemployment under 5% and falling. As long as all three of these boxes stay checked, we believe the Fed will continue to raise rates gradually and will, with some advance notice, begin to reduce the size of its balance sheet. The Fed will be deliberate, however, erring to the side of more stimulus rather than less.

From the Middle East to East Asia, geopolitical events have grabbed the headlines. In particular, North Korea seems hell-bent on provoking confrontation with the US and its East Asian allies. It will be quite interesting to see if President Trump and his team can work with the Chinese to defuse this situation. Both sides have much to gain by working together.

There was very little reported immediately after the meeting between President Trump and President Xi but both North Korea and trade were on the agenda. It is certainly a positive sign that the two leaders met in person and have continued their discussions by phone. We also hope that the preparations for upcoming meetings will set the stage for a more nuanced set of trade policies from the Trump administration.

In Europe, the United Kingdom has kicked off the process of exiting from the European Union. It remains to be seen how much real impact Brexit will have on the economies of the UK and the European continent. Even while the European economy is showing signs of life, surprises in the upcoming elections in France and Germany this year could alter that course.

We have kept asset allocations relatively stable in client portfolios. While being cautious about deploying new cash, we have not reduced equity exposures meaningfully despite a strong first quarter. We continue to believe that non US stocks provide a more compelling value proposition than US stocks. Finally, we are re-evaluating fixed income investments as we believe that positive real returns will be hard to achieve in that space.