Benchmark Returns through 3/31/2017
T-Bill 1-3mo (Cash): 0.10%
Barclay’s Aggregate Bond Index: 0.82%
Barclay’s Municipal Bond Index: 1.58%
S&P 500: 6.07%
Russell 2000: 2.47%
MSCI EAFE (International Stocks): 7.25%
MSCI Emerging Market Stocks: 11.45%
Credit Suisse Hedge Fund Index: 1.67%
Data provided by Orion
FINANCIAL MARKET PERFORMANCE
The first quarter of the year offered very attractive returns across most equity markets, but performance in international and emerging market equities were particularly impressive. Fixed income markets recovered partially from the rough fourth quarter last year which saw fixed income assets falls as interest rates rose rapidly into the start of the new year. Publicly traded Real estate investment trusts reported a slight decline in the quarter as expectations for rising rates weighed down on valuations. Indexes representing broad commodity prices fell broadly in the first quarter, which was led by a meaningful decline in crude oil prices. West Texas Intermediate Crude, the primary benchmark for domestic oil, finished the quarter slightly above $50 a barrel. The fall in oil prices during the quarter still leaves oil prices far above the lows of February 2016, which saw the price of crude falling as low as $26.19 a barrel.[i] Gold performed very well during the quarter, outpacing the performance of domestic equities.
FULL EMPLOYMENT AND NEAR TARGET INFLATION
The expected U.S. and world economic growth rates are still below long term averages, and companies are struggling to drive growth in operating profits. This low growth environment continues to send companies searching for earnings growth through acquisitions or share buybacks. Equity valuations are currently priced near the higher end of the distribution, but the cause is different than the expectations for rapid growth in profits, as was the case during the tech bubble. The high current earnings multiples are primarily due to the low interest rate environment, as low interest rates tend to push the prices of all financial asset higher.
Mergers and acquisitions can generate higher earnings growth by purchasing businesses and cutting the overhead costs associated with redundancies in management. This typically means consolidating the purchased business into the purchaser’s organizational structure, and laying off the excess employees from the purchased company. When two companies merge into one, the combined company doesn’t need two corporate headquarters, or two human resources departments. This generates immediate cost savings, but this type of business activity doesn’t generate higher growth in the overall economy.
Share buybacks are a simple way for companies to increase earnings per share, because they simply reducing the number of shares outstanding. If a company with no actual earnings growth reported earnings per share in 2015 of $100, and the in 2016 repurchased 5% of their outstanding stock, then they would generate 5.26% earnings per share growth because that same $100 is now attributable to 95% of the stock compared to the previous year, allowing this fictitious company to report earnings per share in 2016 of $105.26. However, this achieved earnings per share growth zero revenue and operating profit growth. In periods of low economic growth, share buybacks require very little skill and only excess cash. Thankfully in this low interest rate environment companies can issue bonds for very little cost and raise substantial amounts of cash to repurchase shares. While this strategy drives stock prices higher, it does nothing to improve the fundamental business operations of the company. It also does not increase economic growth in any direct capacity.
Companies that are capital intensive are those that require large investments, or capital expenditures, into their business to operate. These companies generally continue to reinvest over time to maintain their operating assets and enable future growth. Capital intensive companies invest in these capital expenditures with funds generated from either bond issuances or the earnings remaining after dividends are paid out to shareholders. Since the global financial crisis, the combination of higher than average profit margins, easily accessible funds available from the bond market, and the expectations of lower economic growth has driven companies to focus more on share buybacks to fuel earnings per share growth rather than reinvesting in their business to grow operating profits. This activity is typically easier for large companies with more access to bond markets when compared to small and mid-sized businesses. Many investors tend to focus on large U.S. companies for evidence of an improving business environment, but small and mid-sized businesses drive a significant amount of U.S. economic growth. With such a large segment of corporate cash focused on these activities which do not contribute to GDP growth, the effect on the margin likely has a slight decline in GDP growth where real investment in the economy has been eschewed in favor of this simple form of financial engineering.
THE FOCUS SHIFTS FROM MONETARY TO FISCAL POLICY
The median estimate for U.S. economic growth in 2017 is 2.1%, according to economic projections released by the Federal Reserve Board members and presidents during their March meeting.[i] The estimate for long term growth in the US economy has simultaneously been falling over the past several years according to the economists at the Federal Reserve. The March 2013 estimates for long-term growth forecasted a range of 2.3% to 2.5% compared to the March 2017 release which now estimates the range of long-term growth at 1.8% to 2.0%. Long-term economic growth rates are difficult to forecast, but this downward shift also indicates that growth near the pre-recession average of 3.5% is unlikely without a significant catalyst. Some economic data suggests that the US economy is moving into the latter segments of the business cycle, such as annual vehicle sales, total nonfarm payrolls, as well as some credit market statistics.[ii] Economic growth above the long-term rate is more difficult to achieve during the latter portion of a business cycle without a new tailwind. Monetary policy since the recession has been extraordinarily accommodating, providing a tailwind for economic growth, since the decision was made to move the short-term interest rate to a targeted rage of 0 to 0.25%. The Federal Reserve’s mandate of full employment and stable prices as defined by 2% annual inflation are both within grasp. Subsequently, the Federal Reserve continues to communicate its desire to steadily remove the accommodating monetary policy and increase short term interest rates towards a more neutral level.
The market’s expectations for a catalyst providing a higher economic growth trajectory are now focused squarely on the pro-growth policies of the Trump administration. The trend of political polarization continues to develop, especially in the United States. Polarization often incentivizes political opportunists to spread provocative rhetoric rather than offer measured and reasonable policy solutions, effectively gumming up the cogs of an effective democratic government. President Trump and Republicans in the House of Representatives presented a replacement for the Affordable Care Act, frequently referred to as Obamacare, in the form of the American Health Care Act. The AHCA received sharp criticism not only from Democrats, but also from across the Republican majority in Congress. The bill failed to achieve a simple majority in the U.S. House of Representatives despite the majority held by the Republicans of 237 seats.[iii] Moderate Republicans called the bill too aggressive in cutting coverage for the elderly and low-income, while Republicans further on the right remarked that the legislation didn’t go far enough to remove Obamacare. President Trump’s claims on the campaign trail of large scale reform are increasingly under pressure from his own party. The proposed tax reforms, regulatory reforms, healthcare reforms, and infrastructure investment programs that were expected to push growth higher, are now faced with increased scrutiny as investors doubt the Trump administration’s ability to enact these reforms.
Our investment outlook is primarily shaped by the two major factors of the Federal Reserve tightening monetary policy, and the ability of the Trump administration to enact effective fiscal policy that can boost economic growth. Although domestic equity valuations remain high compared to historical norms, they are cheap compared to most fixed income investments. As interest rates rise to higher levels, domestic equity valuations will likely come under pressure. Corporate profits may continue to be pressured as profit margins are still near historically high levels. Fortunately, revenue growth and share repurchases are expected to continue which will be supportive for valuations on an earnings-per-share basis. Emerging markets face pressure from slowly rising interest rates, and the commensurate appreciation in the U.S. dollar. Recently Emerging market assets have performed well as the dollar has failed to make new highs. If the pace of tightening by the Federal Reserve does not generate significant currency volatility, then emerging markets may be able to continue to perform well through the rising interest rate environment. European stocks are more attractive from a valuation viewpoint and offer potentially higher upside as Europe has further ground to regain in its own recovery. Fixed income will continue to be a more difficult asset class to navigate over the next 12 to 24 months, but our focus remains on managing the overall risk of the fixed income segment of the portfolio allowing it to provide a degree of stability while still generating current income.
These are the opinions of Newport Advisory and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is not a guarantee of future results.