Equity and balanced accounts outperformed their respective benchmarks for the first three months of 2018. Relative performance was gained through both security selection and sector allocation. The largest individual contributor was a desktop publishing software developer which enjoys an impregnable position in the digital world and has yet to flex pricing power. Concentrations in two internet retailers yielded outsized gains as did a pair of semiconductor positions Within healthcare, an investment in a new product-driven company focused on cystic fibrosis added significant value in an otherwise lackluster group. Turning to sector concentration, our portfolio overweighted the two best performing areas (Information Technology and Consumer Discretionary) and largely avoided the underperforming defensive groups.
After showing mid-single digit gains through late January, equity markets are now roughly flat on the year. A logical question becomes what has changed and are those developments sufficient to derail the previous upward trend:
- The first change was volatility. The S&P 500 registered only 25 days of a one percent or more fluctuation in 2017, an atypically quiet year. (Ah, for the good old days). Since the market high on January 26th, volatility has returned to historic norms, probably above. The return of forgotten volatility triggered quantitative strategies to unwind long equity/short volatility positions, adding to the selling pressure. Volatility in and of itself is not necessarily a precursor to a bear market. Financial markets rarely offer straight lines. It becomes our job as active managers to make volatility work for us in terms of entry and exit points on individual stocks.
- Although stocks subsequently recouped the majority of their losses over the following weeks, the threat of a trade war with China emerged as the primary motive force. Without doubt, the immediate impact of a trade war would be negative; bad for the economy, corporate profits and equities (and the list goes on). Attempting to quantify the damage is futile since the final parameters remain undefined. That said, a significant amount of damage has already been “priced into” the equation. More importantly, a trade war is far from certain. An alternative is that the “Twitter Offensive” is a posturing tactic prior to serious trade talks that was taken straight from the pages of the “Art of the Deal”. Remember that after more than two decades in force, our NAFTA partners appear to be willing to renegotiate. The net is that policy has become a new risk but a negative outcome is not pre-ordained.
- The last environmental change is found in a subtle cooling of worldwide economic momentum. Some of the high frequency indicators such as purchasing managers’ indices have slipped from frothy levels. This does not suggest that economic growth will be soft or a recession imminent. Rather, growth has slipped from perhaps unsustainable levels. Interest rates have understandably declined from recent peaks but are far from collapsing.
The above issues may seem daunting but markets often need a wall of worry to climb. While these factors certainly create indigestion, we do not believe that the trend is broken. We retain our view that economic growth in 2018 will register well above the average seen in the post-2009 recovery. The domestic economy is creating jobs and incomes are rising. It takes time but the stimulus from the recent lowering of tax rates should kick in, particularly in capital spending. Corporate profits will grow both organically and from lower tax rates. The level of interest rates, considered a threat earlier in the year, has become less fearsome. Additionally, the decline in stock prices makes valuation more attractive. (It is easy to forget the adage of “buy low…”) With no recession in sight, it is premature to call for an end of the bull market.
Given our outlook, the composition of the portfolio has not been dramatically altered. Cash levels are a bit higher than at the beginning of the year but this has been a function of decisions on individual securities. Although internet-related properties, particularly social media, have experienced a bit of tech-lash, there is little evidence that the vibrancy of their businesses is significantly impaired. Self-policing and reasonable regulation will serve to limit the damage from headline scares.
While the rise in interest rates has taken a breather recently, many factors create upward pressure on a longer-term basis. For example, higher import prices, energy quotes, and wages are pushing up on inflation. Additionally, the fiscal deficit is scheduled to dramatically expand and the Federal Reserve is unlikely to alter its course of Fed Fund rate increases.
With open minds, we will be vigilant in detecting any significant deterioration in the fundamental outlook.