4th Quarter 2020

At the dawn of a new decade, the global economy is changing rapidly with the rise of the services sector. The world’s Gross Domestic Product (GDP) accounted for by services is experiencing a sharp increase in developed regions and especially emerging economies, such as Sri Lanka and Brazil. This growth in services has not only transformed the make-up of the world’s economic production but has altered trading patterns. In the U.S. economy, the services sector (a broad category of the economy that includes technology, media, financial services and transportation) is, by far, the largest contributor to GDP, accounting for nearly 70% in 2018. This contribution has rapidly accelerated in recent years as value added by service producing industries now accounts for 79% of total growth in GDP.

The fusion between mature manufacturing and service companies with intangible assets, such as digitization and software, are creating new and accelerated growth opportunities and value
to shareholders.

Even more transformative is the growing nexus of physical (tangible) products and digital (intangible) technologies, which is revolutionizing what manufactured products can do and contributes to a renewal of their value and place in the economy. Examples abound and include Smart TVs that are networked for streaming, exercise equipment that comes with videos or live streamed instructions, cars with navigation systems, printers with ink jet replacement subscriptions and so on. The takeaway is that investors have a much broader choice in incorporating technology into their portfolios and, as a result, it is a misappraisal to define technology representation as consisting exclusively of companies in the tech sector. Traditional companies with dynamic management have embraced this paradigm shift, reversing and extending the lives of their maturing products and creating new shareholder value. Companies that embrace the rise of services are creating jobs and wealth, and they are making products we rely on more efficient.

3rd Quarter 2020

This year, the U.S. federal government’s debt relative to gross domestic product (GDP) is expected to be at the highest level since World War II. This rise is due to the major fiscal response by the Administration and Congress to the COVID pandemic coupled with deficit spending trends in recent years. The Federal Reserve Bank of St. Louis projects this year’s level will be well over 100%. Only a handful of economies such as Greece, Italy and Japan have debt loads that exceed their economies. The last year U.S. debt exceeded GDP was in 1946, when it was at 106% after four years of war. 

The novel coronavirus that swept the globe in early 2020 also compelled the Federal Reserve to intervene in an unprecedented fashion. Its aggressive and swift action calmed financial markets, which led to a rebound in many asset prices. The Fed lowered its main interest rate back to near zero in March. It has ramped up its bond buying programs – known as quantitative easing – to pull down long-term rates. Between mid-March and mid-June, the Fed’s portfolio of securities held outright grew from $3.9 trillion to $6.1 trillion. The Fed introduced multiple temporary lending and funding facilities to help institutions with borrowing needs. It has indicated its easy money policy, with low interest rates, will continue for the indefinite future.

2nd Quarter 2020

The global economy is forecast to contract 5% in 2020; yet, paradoxically, a number of investors are worried about inflation since the Federal Reserve and other central banks began flooding the markets with stimulus. At the same time fiscal expenditures have soared to help alleviate the effects of the coronavirus pandemic, while tax revenues have plunged.

In May of this year, the U.S. deficit widened to $424 billion, double what it was in May 2019. The Congressional Budget Office (CBO) estimated that the federal deficit for the first eight months of the fiscal year, which began in October 2019, totaled $1.9 trillion – that’s 157% higher than the same period last year. The CBO estimated the 2020 deficit could reach nearly $3.7 trillion, easily surpassing the previous peak during the last downturn. The deficit, as a percent of GDP, is projected for the year at 18%, the highest level since the last recession.

Even modest inflation can have a deleterious effect on retirees’ savings and fixed income. A 3% inflation rate over 10 years will reduce purchasing power by approximately a third.   

In addition to expansive fiscal policy, the Federal Reserve is injecting substantial liquidity into the economy by purchasing bonds. By the end of the year, the Fed is projected to purchase $3.5 trillion in government securities. The Fed’s goal is to provide liquidity to credit markets in times of market stress and to support a market recovery. In the past, large scale government spending and an expansion in the money supply have often led to bouts of inflation that were difficult to tame. 

1st Quarter 2020

Since our letter on the coronavirus and the markets in mid-March, unprecedented and quick action from the Federal Reserve System and Congress, temporarily at least, has instigated a stock market rally in late March. Although any news and data put to print quickly becomes outdated, our original perspective on the virus’ impact on the market remains the same. (See “Coronavirus and the Markets” )

The key to recovery with any natural disaster is enabling businesses to survive until the crisis has subsided.  

The speed of events that took the U.S. economy from its longest expansion in history – with low inflation and a 50-year low in unemployment – to an economic disruption of a potentially deep recession is without modern precedent. Unlike previous shocks to the economy, the Federal Reserve has reacted with far greater speed and scope than ever before. The Fed quickly cut rates to near zero, purchased huge quantities of debt to generate liquidity and provided a backstop to money market funds. These moves reassured the equity and credit markets of sufficient liquidity. In addition, the fiscal response by Congress and the Administration has been unparalleled. 

While cancellations and postponements of public activities and curtailment of leisure and business travel may slow the coronavirus, it is taking its toll on consumer spending and general economic activity. These restrictions will force exposed businesses to curtail operations, lay off workers and possibly strain to service debts. The coronavirus shock has raised the specter of a recession for the first half of this year. Economists at JPMorgan Chase expect output to fall by an annual rate of 2% in the first quarter and another 3% in the second quarter. The reality is that the necessary steps to slow and/or contain the virus restricts economic activity and dampens consumer confidence.

Central banks, the Treasury and Congress have an array of tools to soften the impact. Although interest rates are near or below zero with not much bandwidth for further cuts, low yields will help national governments borrow to expand their fiscal stimulus. The purpose is to offset as much contraction in demand as possible. As of this writing the Fed added $500 billion to each of its one-month and three-month repurchase operations, is committed to buying $700 billion in Treasury bonds and mortgage-backed securities, on top of additional funding for overnight and two-week repos. This addition is a substantial injection in short-term liquidity. The Fed has also promised significant purchases of longer-term maturities across the yield curve, which in effect is a reintroduction of Quantitative Easing, a tool where the Fed purchases bonds with cash providing banks with additional money supply to make loans.

4th Quarter 2019

Finance and politics converge every four years as Americans go to the polls to elect the President of the United States. Since the early 1950's, the Dow Jones Industrial Average has gone up 10% on average during presidential election years when an incumbent president is up for reelection. The purported rationale is that first-term sitting presidents tend to go into campaign mode to earn votes with economic stimuli, such as job creation and tax cuts. As a result, the third year has often been the strongest of the four-year cycle; and the fourth year is the second strongest. A recent notable exception is 2008, when the Dow sank nearly 34% as the Great Recession unfolded.

True to historical pattern, recent stock market performance has been robust with indices repeatedly meeting new highs helped by the tax overhaul in late 2017 that lifted corporate profits and by an aggressive push to cut regulations by the current administration.

Investors who remain invested through economic and political cycles and stick to their investment plans have the best chance of earning or exceeding market returns.

A new report from economist Matthew Higgins of the New York Federal Reserve Bank suggests that the U.S. effective corporate tax rate at 15% is now the second lowest among the global top 20 economies. The new tax law has encouraged business investment, which has in turn improved employment and wages. 

3rd Quarter 2019

Stock buybacks hit a record in the U.S. last year, surpassing $800 billion for companies that comprise the S&P 500, eclipsing the previous high of $589 billion in 2007. With sustained low interest rates that are partially tax deductible, companies have an incentive to borrow funds to finance share repurchases. In 2018, it is estimated that 56% of the year’s record buybacks were funded by debt. Another catalyst of last year’s record buyback was the U.S. tax overhaul in 2017. Tax reform increased corporate cash flow by cutting taxes and letting companies repatriate their cash held overseas by paying a one-time tax rate of 15.5%. It is estimated that companies repatriated $730 billion in 2018. The readiness of companies to buy back their shares has contributed to the decade-long bull market. Since 2013, companies have spent $4.2 trillion on stock buybacks. Yet a number of critics and politicians from both parties have railed against the practice, particularly given the recent scale of repurchases.

The basic allegation is that buy-backs divert cash flow from investment in new plants, equipment and higher wages. The controversy was heightened after the passage of the tax cuts
whose authors promoted it as a boon to productivity and  investment. Another criticism is that stock buybacks favor corporate executives who elect to cash out of their shares.
Managers who initiate buybacks are obviously privy to their timing and scope. An analysis by the SEC showed that in the eight days following a buyback announcement, management teams, on average, sold five times as much company stock as on an ordinary day. If there is a short-term bounce in the stock price from an announcement, executives will benefit, though they still must comply with SEC insider trading rules.

2nd Quarter 2019

At the half-way mark of 2019, the U.S. is marking 10 years of continuous economic growth.   The current cycle of economic expansion is poised to become the longest ever recorded in this country’s history based on statistics from the National Bureau of Economic Research. The longer the current expansion lasts, the more commentary swirls that it will end soon, followed by an inevitable and deep recession. Such pessimism is likely a residual memory from the severity of the 2008-2009 financial crisis. But while it is true the economy may be in the later phase of expansion, there are a number of structural advantages and recent reforms in the U.S. economy that may lessen the degree or length of a future downturn.

Evidence of comparative advantages in the U.S. economy relative to other economies can be found in the performance of the global stock markets. Since October 2007, the beginning of the financial crisis, international stock markets (excluding the U.S.) remain approximately 25% below their previous peaks. The U.S. S&P 500, however, has gained about 80% over the same time frame. This disconnect between the U.S. and the rest of the world goes against conventional wisdom, given that globalization and trade has generally linked and synchronized economies. The U.S. has enjoyed a robust stock market, low unemployment, and gross domestic product (GDP) growth that is the envy of the rest of the world. 

Data from the National Bureau of Economic Research suggests that U.S. economic expansions are lasting longer, while economic contractions have become substantially shorter in duration.   

Outside of the U.S., it’s a different story. Since the beginning of the Great Recession, over 10 years ago, U.S. GDP has grown 34% in real terms versus -2% in the Eurozone, -15% in the UK and only 7% in Japan. In addition to the sovereign debt crisis and subsequent austerity measures, Europe’s economy has been shackled by substantial amounts of regulation, restrictive labor laws and a macro central bank dictating a one-size-fits-all policy for 19 separate economies. Japan has been in a deflationary cycle for decades due to a declining population, a high-debt burden and a static corporate environment that avoids restructuring. Investment in the UK has been stifled by the uncertainty over Brexit and the prospect of a decidedly anti-growth / free enterprise alternative should the opposition party win the next election.

1st Quarter 2019

After two seemingly polar-opposite quarters, one thing not in short supply is the number and diversity of market commentaries and outlooks going into 2019. Through February, the U.S. stock market had its best first two months of the year since 1991 amid mixed economic news following the worst December since the dramatic days of 1931.  The increase in volatility comes after a long period of ever-increasing valuations and steadily advancing markets. Many investors have become accustomed to the robust valuations and low volatility of an almost decade-long bull market. The sudden sharp volatility of a potential new “normal” calls for perspective, particularly for investors who feel nervous and compelled to act during such stress points.

The duration of this bull market has the potential to cause investors to make the wrong decisions, vis-a-vis their portfolios, when volatility reappears after a long hiatus. As we approach the 10^th anniversary of the second longest bull market in modern times, the phenomenon known as “recency bias” can be a dangerous trait for investors. “Recency bias” is a cognitive condition that lulls us into believing what has happened in the recent past will continue for the foreseeable future. Investors continuously fall victim to this bias during both positive and negative market cycles.

Our brains are conditioned in such a way that recent memories are more easily recalled. Thus, it is completely reasonable to think the market will perform well when we’re in a bull market, even though most investors are cognizant of the cyclical nature of the stock market. Alternatively, when the market turns negative, we may be inclined to think that these conditions will persist and reactively liquidate stock positions. Obviously, selling low is not a good long-term investing strategy. Markets recover and invariably those who have sold are likely to be still sitting on the sidelines.

4th Quarter 2018

Concerns of increasing debt levels, tightening monetary policy, technology stock valuations, potential trade wars and slowing eurozone growth coalesced in the 4th quarter to fuel a higher level of volatility. At nine-and-three-quarter years, the bull market is the longest on record and one of the best performing. The S&P 500 has risen 333% from its bottom in 2009 to its most recent peak before the 4th quarter turbulence.

Some market pundits question whether the bull market will make it to its 10^th birthday in March 2019.  Investors seem nervous about its longevity. A bull market doesn't technically end until there’s a bear market resulting from a 20% drop from its peak. This particular bull market is unusual in that it followed the 2008 financial crisis, which was so severe in that it was second only to the Great Depression in US history.

Extended volatility can offer a window to buy solid companies at reduced prices since the herd behavior of bear markets often depresses prices below their long-term economic value.

The good news is that the global economy still shows signs of robust health. Gross domestic product (GDP) growth topped 4% in the second quarter, the best expansion since 2014, and unemployment at 3.7% is at a 49-year low. Rising interest rates also indicate an increasing demand for funds. Rates tend to climb when the economy is humming. A recent bank study found that companies’ price/earnings multiples expanded during half of recent rising interest rate cycles and contracted during the other half, indicating that the market is agnostic about a gradual change in rates.