First Quarter 2017
Reflation! The industrialized world and some emerging markets are benefiting from reflation. There has been a concerted effort by major central banks around the world to push for greater growth. It has worked and we are seeing benefits; inflation is rising, corporate investment is improving, and GDP growth around the world is quickening.
The stock and bond markets both responded to this. Stocks moved higher and so did bond yields. Stocks had a very nice quarter and a very good start to the year (see the Major Indices section of this report). Higher interest rates were welcomed as a sign of a healthy economy. Investors largely ignored the heightening of political tension here and around the world. Policies to further growth prospects would be welcomed, but the economy is already responding.
Certain changes in U.S. policy, often referred to as “Trumpenomics,” such as reducing regulation, infrastructure spending, and lower corporate taxes, would further improve growth. Reducing regulation is underway. Infrastructure spending and tax reform might be some ways off. Thankfully, current momentum is healthy.
We are just beginning to see the first quarter’s earnings reports, so it is too early to comment, but we expect healthy reports. We shall see and may make any required adjustments as a result.
The political backdrop occasionally unnerves some investors. Domestically, we have a new and untried administration that may take time to find its rhythm. The country is still divided and not much seems to have changed. Internationally, so many new challenges keep appearing that one can wonder where the next crisis may erupt. All this may seem very important, but not usually to stock evaluations.
As investors, we call this noise. It is not generally a reason to value a company more or less. However, there are times when the political does cross over into economics. It’s just a lot rarer than most people believe. Investment focus should always be on the economic.
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Reflation; what does it really mean? It is not just the opposite of deflation. It really is a process. It is the concerted effort to break the spiral of deflation and prevent it from taking too strong a hold on economies.
Deflation is insidious in that once it takes hold it’s extremely difficult to break. To a large part, this caused the intensity of the great depression. Deflation means that prices and asset values go down instead of up. This decline destroys collateral values for loans and usually brings about a financial crisis.
The financial crisis of 2008-2009 was largely caused by the collapse in home values. This made many of the loans on the houses across the U.S. worthless. As a result, bank balance sheets were impacted, people lost their homes and the financial pain spread.
Governments and central banks saw this taking place and sought to counter these forces before they became so imbedded that whole economies would be dragged down into wholesale depressions. Our Federal Reserve promptly reduced interest rates, lent money to banks, raised FDIC insurance, backed money market funds, and took other steps to maintain liquidity in our financial system. The Federal government put together a stimulus package to restart demand.
During a deflationary cycle, demand usually drops. Loans are difficult if not impossible to get. Why buy something today when it will be cheaper in the future? Our economic system simply cannot handle deflation. That is why having some inflation is so important. It shouldn’t be so high as to run away, but having prices and values modestly increasing helps keep our economic system moving forward.
So, since 2009, reflation has been the effort of many governments around the world. The effort really intensified again over a year and a half ago. Europe doubled down on its efforts, China sought to turn its economy around and Japan took serious measures to raise its growth rates. In the U.S., we delayed normalizing interest rates. We are now seeing benefits from these efforts. That is why economic growth is accelerating, corporate earnings are growing, and stock markets around the world are doing well. Talk with Us.
From the prior comments, it is obvious that we foresee good economic and earnings growth. The U.S. economy, since the financial crisis, has been growing around 2% or less. We now expect acceleration to 2½ to 3%. With further stimulus from policy changes that might continue to climb toward 3 % or even higher. It is just difficult to estimate the prospects and timing for those.
What has happened in the general economy is that sectors such as manufacturing and construction are doing much better. Allied with those, materials, finance, and technology are also in upswings. Energy is also slowly improving after the collapse in oil prices. This however, will take some time.
Some sectors, especially retail, are going through a difficult period. This is more than cyclical forces; the sector is undergoing major shifts in distribution. Online sales are replacing bricks and mortar. Over capacity is also gradually being wrung out. This is a long-term change and we are still at the beginning. In the meantime, this sector is virtually uninvestable.
Conditions continue to be favorable for equities. Interest rates are still low, the economy is growing, corporate profits are expanding, and business opportunities, both domestically and internationally, abound.
The political environment also favors corporate profits. Regulations may be reduced, profits taxed less and corporate activity generally encouraged. Therefore, we have no reason but to expect another good year for returns.
Many investors have been expecting a correction. It has been some time since our stock market has had one. Time is never a sufficient reason to have one. Corrections come about because expectations get out of line and a catalyst comes along that makes this patently obvious.
So far caution is more the prevailing sentiment rather than euphoria. This has helped keep valuations in line and made the market less vulnerable. Surely, we will have a correction at some point. It just doesn’t need to be now.
Interest rates should continue to climb. The Federal Reserve has signaled that it will continue to raise rates. Expectations are for 3 to 4 rate increases this year. The economy can certainly stand higher rates. To a large degree, higher rates are helpful. Savers and entities with cash balances should get a return on their money. This return is income to many and to the economy in general. Income leads to growth, more jobs, and more growth. We are glad to see the Fed finally moving to normalize interest rates.
The Federal Reserve directly influences short-term rates. Longer-term rates are influenced by what happens at the short end, but inflation and overall demand also play a role. So far this year, longer-term rates have had a very choppy advance; two steps higher and then one lower. There is still much concern, if not doubt, about the sustainability of the current economic improvement. This is nothing new and has existed since the beginning of the rebound from the financial crisis in 2009.
Have no doubt; the interest rate trend is for higher rates.
As investors, we invest where we see favorable conditions. That includes the strong, favored sectors of the present economy along with a sprinkling of positions where we feel conditions are misunderstood or changing. As always, there is an art as well as a science to the process; experience is the best teacher.
Our portfolio strategies are overweight in materials, industrials, energy, and financial sectors. Others are either equal or underweighted. A couple of sectors have no weighting as we do not see opportunity there, only risk.
So far, results have been quite good this year. We are hopeful that continues.
We are finding a few bonds in which to invest. Opportunities are still far and few between. Hopefully, as the Fed continues to raise rates, we will find more of these opportunities. It will still take some time before rates approach what should be normal levels for our economy. Until then, we will go slow in rebuilding fixed income allocations.
We have not made any allocation changes to our asset allocation strategies. So far, returns have kept up with benchmarks. As always, we continue to monitor this to ensure good performance with low risk. The last big change was to include a larger allocation to developed international markets. This had added to our performance this year.
as of 3/31/2017
|Large Cap Stocks (S&P 500)
|Dow Jones Industrial Average
|Mid Cap Stocks (S&P 400)
|Small Cap Stocks (Russell 2000)
|Barclay Aggregated Credit Index
“We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful.”
— Warren Buffett