Quarterly Investment Letter

 

2nd Quarter 2018

Global equity markets overall closed 2018’s second quarter with a slight gain. Intensifying trade tensions and their potential to slow global economic growth weighed on sentiment. Concerns also arose that the synchronized global growth story might be coming to an end. While the US economy looked resilient, pockets of Europe, Asia, and Latin America faced various challenges. The MSCI All Country World Index generated a 0.72% total return for the second quarter.1 Developed-market stocks advanced ahead of the global index and outperformed their emerging-market peers, who generally suffered fairly steep declines.1 

JUL letter 01 2018

The US economy appears to be accelerating from the modest first-quarter gross domestic product (GDP) growth as spending by consumers, businesses and the government has gained momentum.2 Faster growth has helped drive the US unemployment rate to an 18-year low and lift average hourly earnings.3 One of the larger investor concerns is that the economy could bump up against capacity restraints and overheat, as a 3.8% unemployment rate suggested the labor market was as tight as it was in the late 1990s.3 European equity markets showed optimism early in the period based on strong corporate earnings reports, but this gave way to worries about how US trade policy would affect the region. Political developments in Germany, Italy and Spain sparked apprehension at times, though these concerns appeared to be mostly shrugged off by equity markets before period-end.

 

 

In Asia, while the US-North Korea summit in June provided a temporary boost for some markets, ongoing trade tensions between China and the United States concerned many investors throughout the period. China’s economic data was somewhat mixed. 4  Japan’s unemployment rate fell to 2.2% in May, the lowest level since 1992.5 India’s GDP for the January–March quarter grew 7.7%, the fastest pace in seven quarters, on stronger manufacturing and investments.6 In Latin America ongoing fears of a trade war between the United States and China, which could dampen global growth, along with news the United States was considering tariffs on auto imports, which would directly affect countries in Latin America, took a toll on the region’s equities.

 

Looking Forward

Last quarter we discussed valuation and three approaches to determining stock market valuation. This quarter we will discuss the “trade war” and touch on two additional market valuation metrics.

As investors, we must put aside our positive or negative views of politicians and consider the impact of policies on confidence, corporate earnings, and the economies. This isn’t always easy, as everyone is biased to some degree. When Mr. Trump was elected, we opined about the potential good and the potential bad. While we hoped for just the good, it seems to all be coming to fruition.

The President has made good on his promise to reduce some regulations. Many of these regulations have been slowing down the American economic engine. The easy example is less restrictive banking regulation is now allowing more money to be lent which provides fuel for the economy. In manufacturing, a lingering Obama era regulation with significant implications for the health of our local manufacturing economy are quotas limiting refurbishing 18 wheel tractor trailers. Fitzgerald Glider had been producing 3,500 trucks a year; the quotas have trimmed this down to 300. With the company employing over 700 people in quality jobs, this is important to our local community. No doubt there are different examples impacting communities across the country. Another realized promise was for tax relief. Individual rates have decreased some while corporate taxes have been slashed. With corporate rates falling from 35% to 21%, locating a global business headquarters in America has become more attractive than it used to be.

Our main fear was that Mr. Trump would follow through with his campaign rhetoric and reduce trade and free trade treaties. While we don’t like trade wars, tariffs, or the sound and fury of the presentation by Mr. Trump, there are strong fundamental points about current imbalances which it would be beneficial to correct. This does seem to be a good time to attempt to fix some unfair trade practices due to the strength of the US economy. The billion/trillion dollar question is can the correction be accomplished without causing a global slowdown or a tit for tat escalation which runs out of control?

International trade is not as simple as the sound bites make it out to be. Currency devaluation illustrates there are a lot of moving parts to global trade.  As shown below the Chinese currency has been dropping since the trade war began. This is an active move by the Chinese and softens the effect of the tariffs by keeping Chinese goods sold to America cheap. The point is, there are more responses available to countries than just responding with tariffs. 

JUL letter 02 2018

Another example is nations could improve trade treaties while leaving out the US, or a rise in protectionism could slow global trade. In the long run, the importance of bilateral trade for both China and the US should ensure they maintain stable relations. Without stable relations, it would be more difficult for Chinese or US companies to navigate complex international supply chains. 

Whether Mr. Trump can improve the terms of our trade treaties is still a very open question. In his book, "The Art of the Deal" he suggests asking for everything on the front end of negotiations and then being willing to settle for something good. Will this work on a global stage is an open question for now. If better terms are ultimately extracted, then all of the theatre will have been worthwhile, but if the result becomes less global trade, then American industry and the economy might well be harmed.

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While we discuss the dangers of starting a trade war, it is important to note that what has gone on so far has not had an extensive impact on our economy. That being said, problems are viewed through the eye of the beholder. American farmers are feeling pain as the prices of their commodities, from soy beans to beef have all declined. Inventories of goods expected to be sold overseas are piling up in warehouses. Consider the potential effects of the tariffs on steel and aluminum. The increased cost of raw materials for making cars causes car prices to increase. This increase can lead to fewer cars being purchased which then can lead to layoffs in a sector which is a core part of the US economy. There are many other factors which contribute to car sales, but you get the idea of the potential harm.

We acknowledge the man behind this strategy, Wilbur Ross, is highly respected in the investment community. Noted emerging markets manager Mark Mobius concurs. “I agree with Trump completely. The U.S. has been taken for a ride over the last 20 or 30 years. It’s time to start saying, ‘Look, there has to be some reciprocity between these two countries because it’s just crazy to have this kind of deficit.' I think at the end of the day; the U.S. is going to win this one, because the U.S. is the biggest importer in the world, and China needs the U.S.  Winning means getting some concessions and a reduction in the trade deficit.” 7 

 

Turning toward valuation metrics, the next chart shows the value of the stock market compared to the value of the goods and services produced by the economy. Many refer to it as the “Buffet Indicator” as it is one of the sage investors’ favorite. It is yet another example of a historical measure which is advising caution.JUL letter 04 2018

Another interesting aspect of the current US markets is the discrepancy in valuation between “growth” and “value” stocks. (In general growth stocks are increasing their earnings faster than value stocks.) The growth stocks have been the darlings of the US market, and are now more expensive in relation to value stocks than at any time since 2000. We consider what emotions were like in 2000. Growth investors felt nothing could go wrong, and investors concerned with valuation were deemed foolish. Over the next few years in the bear market of 2000-2003, these views reversed. No one thought we could end up in this situation again, but here we are. It may be that investors and money managers alike will look back at these historical measurements and wonder "what were we thinking"? But so far these valuation based indicators have been neutered by the ultra-low interest rate environment. It’s certainly possible that interest rates will continue to be low and this has changed things to such an extent that we shouldn’t be worried. Or it may be that interest rates will normalize and return these measurements to respectability. These high valuations compel prudent investors to exercise some caution. So while we continue to participate in the market, we are not at our most aggressive stance. This leaves us some room to take advantage of prices if the market does decline.JUL letter 05 2018

In summary, with valuations stretched, and with the US administration walking a tightrope concerning trade, now is not the time to be our most aggressive. Additional concerns to be discussed in a future letter revolve around the impact of the Reserve Banks, including the US Federal Reserve of increasing interest rates. The global economy is more fragile than it was a year ago but should continue to grow and may even accelerate. When considering the sum of the evidence we believe now is the time to participate, but exercise some caution, though we continually evaluate what opportunities are available or if our concerns are misplaced.

 

 

 

If you have thoughts or questions about any of the information we’ve shared or on any other subject, please don’t hesitate to call us. We are grateful you allow us to serve you and your family and we will continue to make every effort to earn the trust you’ve bestowed on us.

 

Sincerely, 

Your CCA Investment Team 

 

 

 

Advisory services offered through Cravens & Company Advisors, LLC, a Registered Investment Advisory Company.  Securities offered through, and advisory services may also be offered through, FSC Securities Corporation, an Independent Registered Broker/Dealer.  Member FINRA/SIPC and a Registered Investment Advisor.  Not affiliated with Cravens & Company Advisors, LLC. 

Investing involves risk including the potential loss of principal. Investing involves risk including the potential loss of principal. International investing involves additional risks including risks associated with foreign currency, limited liquidity, government regulation, and the possibility of substantial volatility due to adverse political, economic and other developments. The two main risks associated with fixed income investing are interest rate and credit risk. Typically, when interest rates rise, there is a corresponding decline in the market value of bonds. Credit risks refer to the possibility that the issuer of the bond will not be able to make principal and interest payments. Investments in commodities may entail significant risks and can be significantly affected by events such as variations in the commodities markets, weather, disease, embargoes, international, political, and economic developments, the success of exploration projects, tax, and other government regulations, as well as other factors. No investment strategy can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary.  Therefore, the information presented here should only be relied upon when coordinated with individual professional advice. Any opinions or forecasts contained herein reflect the subjective judgments and assumptions of the authors only and do not necessarily reflect the views of FSC Securities Corporation. There can be no assurance that developments will transpire as forecasted and actual results will be different. Data and analysis do not represent the actual or expected future performance of any investment product.