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Investment Outlook – JULY

The World, the U.S. and the Markets

Overview

  •   The U.S. economy is in divergence from the economies of Europe and China.
  •   Europe is growing more slowly than the U.S. and now faces the added stress of the   British exit from the EU.
  •   China continues to slow and is now beset by institutionally driven over-capacity.
  •   The U.S. consumer should keep the U.S. economy moving in a positive direction.
  •   The markets were shaken by the news of the “Brexit” vote, but were not crushed.Volatility should continue at a high level.
  •   Stocks are not cheap, but are also not wildly overpriced.
  •   Bond yields are extremely low and long dated fixed income asset prices are particularly vulnerable to potential increases in interest rates.
  •   Cash equivalents provide stable value, but little or no yield.

  The stock market shows resiliency, bouncing back from stressful events like the “Brexit” vote. It may be the most attractive of the investment choices. However, we recommend employing cash and short to intermediate term bonds to dampen volatility.

There once was a time when all we needed to know about the economy occurred within the confines of our national borders. Then, the free world was rebuilding itself from the devastation of World War II and the U.S. was the building supply company, bank, grocery store and general merchandiser to the world. There was no U.S. trade deficit. That was over fifty years ago and the global economy has changed dramatically. The U.S. is no longer the sole driver of economic growth, not because it has stopped growing, but because the rest of the world has recovered from the war, developed and learned how to compete. Today, the three largest world economies are the European Union, the U.S. and China, in that order. Over the last forty or so years, the domestic U.S. economy has become increasingly linked to the economies of its trading partners, both overseas and across borders. Despite the entangling nature of this process and the inevitable economic correlations that occur on a global basis, there are always divergences. The major divergence that exists today is between the U.S. economy and the rest of the world. While the U.S. economy appears to be somewhat healthy (despite a looming debt burden and entitlement liabilities, we do have low unemployment and positive GDP growth), the economies of both China and Europe face serious stress.

The news from Europe that the United Kingdom has voted to leave the European Union is a particularly distressing development in a region that has already experienced its share of challenges. Although GDP in Europe has been increasing for over three years, it has been at a slower pace than that of the U.S. and has required the European Central Bank to maintain interest rates at even lower levels (zero to negative) than has the U.S. Federal Reserve. Most of the growth has come from Germany and France while Greece, Italy and many of the peripheral members of the EU have been languishing in recessions. Terrorism and the flood of migrants from Syria and Africa have strained the budgets of many of the weaker nations, many of whom were already weakened by the raft of austerity measures imposed by budget hawks in Brussels. The news that the U.K. is giving up on the EU has a profound psychological effect on the continent and the world. The actual exit cannot occur for at least two years and there are many negotiations that must occur before anything becomes final. But, since one interpretation of economics is mass psychology expressed through markets, the “Brexit” vote itself may be enough to depress global and European growth.

On the other side of the world, China’s GDP has grown almost eightfold — about 9% a year — over the last twenty-five years. Nevertheless, the People’s Republic of China is now facing some of the paradoxes inherent in that almost oxymoronic state, a planned capitalist economy. In allowing some decentralization in its provinces, the central committee emboldened and monetarily encouraged local bureaucrats to develop infrastructure and products for China’s bright new future. This effectively created thousands of “capitalist roaders” without a market discipline to moderate their acquisitive instincts. The first result of this ill-conceived program was over production of housing, transportation, municipal services, infrastructure, capital goods, consumer products and debt. This, of course, led to the dumping of consumer products and capital goods on international markets. The next result has been high unemployment, intolerable in a worker’s paradise, and a restive population. A rebellion is highly unlikely, but there will continue to be corruption trials and other assignments of blame. In short, China’s growth rate will not return to 9% anytime soon and appears to be headed south of 6%. This retrenchment will continue to place downward pressure on the economies of the developed and developing world.

Unlike the U.S. of yesteryear, the domestic economy is not totally immune to these international stresses. Although the U.S. has run a trade deficit for most of the recent past, close to 50% of S&P 500 earnings come from non U.S. sources. Weakness in foreign demand and the relative strength of the dollar during the current period of international stress have taken a toll on corporate income statements. Though declines in corporate profits have no direct impact on GDP, declines in the international sales of large U.S. corporations do have a negative impact on capital expenditures, a component of GDP, and on hiring. Capital expenditures by non-energy companies have remained weak throughout the current business expansion. And payroll employment has recently slowed to an increase of only 38,000 in May from an average increase of 155,000 in the prior two months. Labor productivity — output per hours worked — is strongly influenced by corporate expenditures on more efficient capital equipment; in the first quarter of 2016 — the most recent report — productivity declined by .6%. It remains to be seen if the decline in payroll employment and productivity is only a statistical blip, a sign of an aging expansion or the result of an absence of capital investment due to corporate timidity. We prefer to believe in the latter explanation, but the current expansion is a little long in the tooth (eight years) and well past the time when corporations normally would ramp up capital expenditures. If the economies of Europe and China deteriorate and drift into recessions, it would increase the odds that the U.S. might experience a similar fate. We don’t believe that this will happen, at least not in 2016, even with the fear-inducing issues in Europe and China. The main reason for our optimism is the consumer.

Despite the benefits to the U.S. of improving foreign trade and the negatives associated with a shrinkage in international transactions, the U.S. is not an export driven economy. More than two-thirds of the U.S. economy comes from consumer spending, and the consumer is doing well: unemployment is below 5%, payroll employment continues to improve (despite a disappointing May number), salaries are finally growing, housing starts are averaging over 1100 per month, gasoline prices are almost 40% below where they were five years ago, interest rates continue to favor the borrower, retail sales remain strong and inflation is still quiescent. In the spirit of “it’s an ill wind that blows no good”, the “Brexit”-induced global angst has created some benefits: the Fed is likely to postpone again an interest rate hike and dollar strength has lowered prices on imported goods. The U.S. has its issues – an aging population, exploding national debt due to out-of-control retirement benefits – and the payroll employment numbers will bear watching, but as long as the consumer remains optimistic, economic troubles overseas should not derail the progress of the domestic economy.

In the financial markets, the news of the British vote hit like a bombshell. Despite warnings that the vote would be close, most investors believed that the British people would never do something so un-British as to jump off a cliff without considering the consequences. The vote was probably prompted by immigration concerns and fears of vanishing British sovereignty, but the result was a clear negative for those who support globalization and the expansion of world trade. On the day the results came in (Friday, 6/24), the S&P 500 dropped 3.6% and yields on U.S. Treasuries dropped to the lower levels of their recent ranges. The damage continued on the second day of trading (Monday, 6/27), but by the third day Tuesday (6/28), the markets began to recover. Despite all the excitement, trading remained orderly and there were few glitches in computerized systems. It was the worst one day decline since last August, but only brought us even with the previous week’s close. It certainly didn’t compare with some of the more horrific declines of the last ten years. And it was definitely not a “crash”. Nevertheless, dramatic market events usually produce aftershocks for days and weeks following the first impact: we expect to see heightened market volatility well into July.

It is difficult to muster great enthusiasm for any investment market as we approach the dog days of summer. Stocks, while not wildly expensive on a valuation basis, certainly aren’t cheap. Price/earnings multiples are high relative to the averages over the last ten years, but not when compared with the averages over the last sixty years. They certainly are discounting more earnings growth than is justified based on recent history: corporate profits have declined for each of the last four reported quarters and analysts’ expectations are for a decline in the quarter just ending (Q2, 2016). Dividend yields look very attractive when compared with the yields on ten year bonds, but most things do.

Bond yields are at absurdly low levels everywhere but in the higher risk categories. Despite our inclination to believe that interest rates will never rise again, we know they will. When they do, bond prices will plummet for even the highest rated bonds. (We should note, however, that if interest rates increase because of quickening economic activity, lower rated credits (junk bonds) may increase, instead of decline, in price.)

And what can we say about cash? As low as yields are on bonds, they’re even lower on cash equivalent securities. Central banks everywhere have pushed yields to zero and beyond in order to curtail savings and stimulate borrowing and spending. American investors can take some comfort in the knowledge that at least dollar denominated cash investments are yielding above zero.

It’s possible to make an argument that stocks, particularly U.S. stocks, are the most attractive investments among the three traditional asset classes. Despite all the clear evidence of stress and weakness across the globe, U.S. equities have generally held onto their somewhat elevated prices. Even the “Brexit” vote was not enough to shatter the optimism of investors, though it did cause many to doubt. There’s an old saying on Wall Street that one shouldn’t fight the tape. If it has any meaning, it is that the market has a better sense of where the future lies than pundits and opinion makers. We would agree that the market is prescient, but we also know that it’s not infallible.

Investors who remain fully invested in stocks will likely be rewarded with higher prices and better returns over the long run, but they will also experience a good bit of volatility and the fear that they might be wrong. Within the allocation guidelines that are appropriate for our clients’ long term goals, we recommend maintaining a meaningful equity position, but we also advocate a healthy dose of volatility dampening investments: cash equivalents and short to intermediate term fixed income securities. The weeks ahead could produce more fireworks than just those on the Fourth of July.

Not Investment Advice or an Offer This information is intended to assist investors. The information does not constitute investment advice or an offer to invest or to provide management services. It is not our intention to state, indicate or imply in any manner that current or past results are indicative of future results or expectations. As with all investments, there are associated risks and you could lose money investing.

For more information about the commentary found in this post, please contact a member of the investment committee.

INVESTMENT OUTLOOK – First Quarter 2016 Heritage Market Brief

SECURITY SELECTION COMMITTEE VIEWPOINTS

First Quarter 2016

THEMES

  • The Federal Reserve raised rates by 25 basis points in December 2015 for the first time in nearly 10 years, signaling confidence in the U.S. economy.
  • Despite recent interest rate increases, the FOMC remains committed to gradual increases while balancing long-term goals of maximum employment and inflation of 2%.
  • Inflation remains below target as indicated by the year-over-year core Personal Consumption Expenditures Index (PCE less food and energy) reading of 1.33%.
  • The U.S. economy added 292,000 jobs in December, and the unemployment rate remained unchanged at 5%.
  • While wage inflation moderated some in 2015, wages still advanced a respectable 4.5%.
  • Consumers appear healthier as year-over-year real disposable income increased 3.1%, and consumers are saving income at a 3-year high of 5.5%.
  • While consumer health has improved, declining consumer confidence from 99.1 in October to 90.4 in November has kept consumers from spending discretionary income saved from lower oil prices and higher wages.
  • In November 2015, manufacturing entered contraction territory for the first time in 36 months as the strong dollar continues to weigh on exports.
  • While interest rates remain range bound, individual bonds held to maturity should continue to provide downside protection.
  • It is likely that volatility will continue as the Federal Reserve is expected to continue raising interest rates, S&P 500 stocks no longer appear cheap relative to earnings, and revenue growth remains challenging.
  • Emerging market economies remain at risk to rising U.S. interest rates; however, the asset class should be additive to long-term returns as demographics are favorable and the sub- asset class remains attractively valued at under 11 times next year’s estimated earnings.
  • Structural unemployment as well as a slow recovery from a severe recession may be playing a key part in the lowest labor force participation rate in nearly 40 years.

ASSET ALLOCATION

Even after the Federal Reserve raised interest rates for the first time in nearly a decade in December 2015, we expect the central bank to remain committed to an accommodative monetary policy which should keep current yields low relative to historical levels. Thus, we believe an overweight in stocks relative to bonds is appropriate from a risk/return perspective. Our focus on valuations

has led us to believe that U.S. small-cap stocks are becoming more attractive
after underperforming their large-cap counterparts for the last two calendar years. We are still maintaining our underweight to U.S. small-cap equities
but to a lesser degree than over the past couple of years. Despite weaker growth outside the U.S., we remain disciplined and maintain a strategic allocation to foreign markets, especially emerging markets where valuations appear much more attractive. Foreign small-cap stocks should be additive to the portfolio return in the long-run as small-cap companies tend to enjoy higher earnings and cash-flow growth relative to large-cap companies. Since, much of our small-cap exposure is in European small-cap companies, European accommodative policy should prove to be beneficial in the long-run as well. While our fixed income exposure remains underweight due to the current risk/return profile, we continue to purchase individual fixed income securities as bonds play a vital role in the portfolio.

We believe alternative exposure remains vital to portfolio diversification. While
we maintain a position in U.S. REITs, we have taken the opportunity to trim where necessary due to our belief that the asset class has potentially reached overvalued territory after outstanding growth throughout the recovery.

These views represent the opinion of the Security Selection Committee which are based on qualitative as well as quantitative factors. These quantitative factors are primarily driven by valuation research which then forms our subjective assessment of the relative attractiveness of asset classes and subclasses over a 3- to 5-year time horizon.