3RD QUARTER 2018
- MARKET COMMENTARY
- CAPITAL MARKETS OVERVIEW
- SECTOR OVERVIEW
- FIDUCIARY CORNER
- PLANNING CONCEPTS
- OPA NEWS
Lions and Tigers and Tariffs…Oh My!...
Although we’re reasonably certain that Dorothy, the Tin Man and the Scarecrow were not likely referring to the U.S. trade legislation nine years prior that exacerbated the post-1929 market crash’s Great Depression, but the Smoot-Hawley Tariff Act of 1930 certainly contributed to the continuing presence of “bears” in the global economy during the early part of the decade that was bookended with their cinematically iconic “Wizard of Oz” in 1939. What’s also notable about that time period is that as occurred the last time we succumbed to short-sighted protectionist fervor and wrestled with an array of international tariffs, like we appear to be doing again now, the outcome was more about political rhetoric than the intended economic expansion. Between 1929 and 1932 trade with Europe dropped by two-thirds, while a similar decline in global trade existed for the 4-year “skirmish” which ended when FDR signed the Reciprocal Trade Agreements Act in 1934. To say the least, tariffs did not prove to be a Yellow Brick Road leading to any Emerald City, but instead had the world embroiled in tit-for-tat trade-policy war that crippled global economic activity for years. History, as we know from Spanish philosopher Santayana, is something we should learn from, otherwise we’ll be destined to repeat it.
Our current batch of Washington politicians are using a similar trade-deficit mantra to support our Chief Executive’s unilateral actions, but caution should be heeded lest we suffer the law of unintended consequences as we did during the early ‘30s with its protracted global economic collapse. Trade deficits are not necessarily a bad thing but are situationally dependent on the condition of the country in question’s foreign reserve surpluses.
“Why can’t we make T-shirts in the US? Because they will cost more, which means consumers will buy fewer, which means a smaller economy with fewer jobs.
But running a trade deficit, when you can get away with it, also has advantages. It’s the reason the US dollar is the world’s reserve currency. We ship enormous quantities of greenbacks overseas to pay for all the stuff we import. Our trade partners have to accept them (as opposed to some other currency) because the US is such a large customer. We carry a big stick.
Better yet, all those dollars eventually come back home because they are of limited use to the foreigners upon which we force them. Chinese investors use them to buy our Treasury bonds or other purchases. The money flows to other countries and companies and eventually back to the US.”
Mauldin Economics, 10/6/18
Not that the capital markets don’t already have enough to contend with, but ill-conceived trade policies that hamper economic activity are not constructive from a macro perspective. Ten years on from The Great Recession, and the Lehman Brothers collapse in the throes of it at that time, the prospect of rising interest rates (which are totally justified given our current level of economic activity) is but one of the headwinds facing the stock and bond markets. The Fed-constructed low interest rate environment of the last decade was designed to, amongst other things, allow for the recovery and repair of the residential real estate market that has been so near and dear to the American Dream.
“In actuality, the greatest beneficiary of ultraeasy monetary policies, which have been the central aspect of the recovery, has been the stock market. In the second quarter, equities surpassed real estate as the biggest source of households’ wealth for the first time since the dot-com boom late in the last century…That’s a reversal from the last decade during the housing bubble and during the 1970s, ‘80s, and ‘90s, when the notion that home prices only went up became seared into America’s consciousness.”
R. Forsyth, Barron’s, 10/01/18
Within this run in the equity markets, the primary beneficiary has been the technology sector (often at the expense of other more traditional investment sectors), which has pulled the indices higher for the last several years. And given its stretched valuations that we’ve discussed previously in this space, it is also the most exposed to rising rates as they negatively impact future value calculations, causing a compression in price-earnings ratios. This dynamic was evident in the recent early-Q4 market volatility as technology shares led the declines, something that will need to be monitored going forward given the possibly outsized expectations retail investors have at this stage in the economic cycle for future market returns. Perspective, after the market’s run would also be helpful, as was pointed by a colleague in Chicago:
“The last 24 months the market (DJIA) is up 47%. We were at all time market highs. Today’s decline (October 10th) takes the market averages back to where they were this summer. Five percent market corrections are normal, historically occur every six months on average and are considered a healthy component of a market cycle.”
D. Pequet, MPI Invest. Mgt., 10/10/18
Given the narrowness of the indices advance over the last several years, we feel being prudently defensive, as well as truly diversified, will be reasonable antidotes to the risks currently facing portions of the capital markets.
“You won’t earn a lot owning equities over the next 10 years, especially if you’re a passive investor in index funds. It will be a much better time for traders and active investors who pick stocks and sectors and do exactly what hasn’t worked for the past 10 years.”
F. Zulauf, Barron’s, 10/8/18
We will continue to focus on balanced, income producing portfolios, that focus on lower valuations and higher yields to navigate the near-term landscape where yield curves are normalizing and valuation excesses are being corrected.
Domestic and Global Market Recap...
The third quarter of a midterm election year customarily is a tough period for the US stock market, but that was not the case in Q3 2018. The S&P 500 rode the surge in the US economy to a 7.7% gain, significantly outperforming other countries. The strength of the domestic economy was seen in consumer confidence, which hit its highest level since 2000; jobless claims, which are at 50-year lows; the strongest wage growth in 10 years and robust earnings reports. This continuing growth allowed the Fed to raise the federal funds target rate by 25 basis points. More on that later.
Outside of the US, political trade uncertainties held down market returns. Eurozone equity gains were modest, with a 0.4% return in the MSCI EMU. Worries over potential US tariffs on cars were a feature of the period as BMW warned that it would miss its Q3 profit margin target, due in part to the trade war between the US and China. Consumer confidence is declining in Europe, particularly France.
The fear of a “no deal” Brexit hurt share prices in the UK as the FTSE All-Share fell 0.8%. Investors are coming around to the conclusion that the possibility of a botched Brexit will not be a positive for the stock market. The negative outweighed the good news of a near term recovery in domestic growth.
Japanese equities saw strong gains with a total return of 5.9% for the quarter. Outside of the automotive sector, where the possibility of US tariffs curtailed results, company profits have continued to improve. The political picture was clarified following Prime Minister Abe’s re-election as his party’s leader.
Chinese equities were affected by trade issues and declining fundamentals. Government leadership conceded that growth was slowing and began a round of lowering interest rates to support domestic demand.
Emerging markets were impacted by the economic news out of China and tariff confusion out of Washington as the MSCI Emerging Markets index dropped 1.1% in a volatile quarter.
Government bond yields rose over the quarter due to positive economic data from the US. As mentioned above, the Federal Reserve implemented its third rate hike this year and also dropped references to “accommodative” policy. Ten-year U.S. Treasury yields reached 3%, the highest levels since 2011. Amid current economic policy uncertainty, bond returns are seen as reasonable and a viable alternative to equities.
The most obvious near-term risk to the global economy is an escalation in US tariffs and subsequent retaliation. Global economic projections activity must also factor in the damage of the confusion over US tariffs which currently apply to $250 billion of imports from China. The tariff rate is scheduled to increase from 10% to 25% in January. To date China has imposed tariffs of their own on $110 billion of imports from the US. This positioning is happening before tackling the issue of intellectual property; a battle that could have huge consequences for technology markets and Chinese investment in US tech concerns. The trade war has already escalated beyond what was expected and will remain a headwind for global growth.
The downside risk to the performance of U.S. equities is that, at these levels, they are expensive, with a Shiller cyclically adjusted price-to-earnings ratio of 33 times earnings. Likewise, while company earnings growth in the U.S. has exceeded industry analysts' expectations, the hurdle for U.S. earnings to surprise on the upside is now very high. The impact of corporate tax cuts on earnings is dissipating while borrowing costs and wages are headed higher for the time being. A slowdown in earnings growth will take away one of the main supports for U.S. outperformance, rising rates take away another.
The US economy is strong, but the business cycle is becoming more mature as the Fed tightens. The gradual growth of the economy is reflected in the slow progress of the business cycle; the natural rise and fall of economic growth. A cycle has four phases: expansion, peak, contraction and trough. A business cycle peaks when the economy grows too quickly and overheats. The peak is characterized by rapid GDP growth, historically low unemployment, bubbles in asset values – all of which yield short term gratification. Very low interest rates are rocket fuel for economic growth. The problem comes when there is too much of a good thing; like giving a child too much sugar, a period of frantic activity is followed by an inevitable collapse. The length of the nap needed to recover is determined by the amount of sugar ingested. By gradually bumping up rates to control growth and inflation, the Federal Reserve is trying to bring the economy in for a soft landing.
Rates were dropped to near zero 10 years ago to help the global economy recover after the 2008 US mortgage crisis. In addition to lowering rates, the Fed also propped up the markets by buying up mortgage-backed securities and Treasury bonds. Their balance sheet now shows $4 trillion of these bonds and they need to be sold without harming the markets. The Fed is rolling off $50 billion a month so this will take a while (4 trillion = 4,000 billion).
Managing the situation unfortunately calls for more than simply cutting interest rates. The inescapable truth is that nothing lasts forever – bull markets or bear markets, global expansions or contractions. Rule number one is not to lose capital. You gain more by not being stupid than you do by being smart.
A booming US economy has driven US stocks higher this past quarter, leaving the US equities ahead of the pack globally. In September, US consumer confidence hit its highest level since 2000, while the monthly average of initial jobless claims fell to the lowest level since 1969. Wage growth rose to the highest level since 2009, supporting retail sales growth of over 7% year over year. The charge forward has been led by the Consumer Discretionary, Technology and Healthcare sectors.
First, I’d like to outline a very recent change to the Global Industry Classification Standard (GICS) structure. Specifically, on September 28, 2018 a new sector was born!!
On September 28, 2018, the Telecommunication Services sector is being replaced by a new Communications Services sector and expanded to include select companies from the Consumer Discretionary and Technology sectors. In addition, online marketplaces for consumer products and services will be moved from the Information Technology sector to the Consumer Discretionary sector. This is the first major change in sector configuration in almost 20 years, and long overdue.
NEW Communications Sector
The new Communications sector is replacing the Telecommunications sector, which only had three remaining companies. Those companies are being joined by 13 companies from the Consumer Discretionary sector and 6 from the Information Technology sector. Some of the largest companies from these sectors will be impacted, including the FAANG (Facebook, Amazon, Apple, Netflix, & Google (Alphabet)) stocks! Apple is staying in Tech. Facebook and Google (Alphabet) are moving from Tech to the new Communications sector and Netflix is moving from Consumer Discretionary to the new Communications sector as well. Amazon is staying put in Consumer Discretionary. A fan favorite, Disney is also moving to the Communications sector!
The Communication Services sector will represent roughly 10% of the S&P 500 Index compared with the less than 2% weight of the old Telecommunications sector.
Meant to reflect the economy’s evolution, the overhaul of GICS will cause fund managers to reallocate billions of dollars. Removing Alphabet and Facebook from technology indexes may lead investors to pay more attention to smaller, remaining technology companies. Chipmakers, cloud-computing sellers and even credit card payment companies will have a greater chance to stand out in the information technology sector next month following the largest-ever shakeup of Wall Street’s industry classification system.
Unfortunately, this sector revamp also means that bottom-up or top-down analyses will become more difficult. Historical values will look very different when comparing the last ten years with the next ten, given that 13 constituents of the Communications sector, rank in the top 50% of performers in this current year of 2018, while there were none in the former Telecommunications sector.
Healthcare was the top performing sector during the 3rd Quarter, led by Pfizer, gaining an impressive 14.5% which was almost all if it’s YTD return of 16.6%. Institutional money flows into the sector have been a primary factor in the push higher. Healthcare is considered a defensive sector, and as Technology pulled back, there was a rotation into Healthcare.
The Industrial sector was the second best sector in the 3rd Quarter, gaining 10.0% during the quarter to pull itself positive for the year. This sector was bolstered by favorable US Retail sales data, Manufacturing data, and a surging GDP. Inventories are also getting lean - this is a positive factor as well.
Consumer Discretionary & Technology
These two sectors continue to lead the way on a YTD basis, with both gaining 20.6% for the year compared to the S&P 500 at 10.6%. Both of these sectors gained 8% or so during the quarter, spurred on by the same favorable economic data that helped the Industrial sector. It remains to be seen if the escalating trade wars and tit-for-tat import tariffs will slow things down. Manufacturers are complaining of costlier raw materials as well as disruptions to the supply chain. Will these increased costs eventually get passed through to the consumer or do we see some trade agreements first?
Fiduciary Rule Rebirth?
After the appellate court split earlier this year which resulted in different interpretations of the DOL’s fiduciary rule, the DOL has indicated they are suspending enforcement of the rule pending a final (Supreme Court?) decision. Thus “ends?” one of the most brief, controversial, and volatile attempts at introducing a regulation in recent memory. The industry chaos it created was amazing.
Old-school brokerage houses (the targets of the rule, if we’re being honest) had mixed reactions to the initial regulations. Some sued, some changed their business model to be more fiduciary-centric and then changed back, others played “wait and see”, and yet others reaffirmed that they never want to be considered a fiduciary. Ever. By any measurement, the process was expensive.
Some interesting results to come out of the regulatory back and forth:
- A report by several professors at the University of Wisconsin – Oshkosh studied the stock market impact of the fiduciary rule on 36 mutual fund, brokerage and insurance companies. The report found that the 36 companies lost $14 billion in value as a direct result of the fiduciary rule implementation, a 2.5% drop in market capitalization for those companies.
- Those 36 companies saw a significant increase in market capitalization post-election, after then newly elected President Trump indicated he would do away with the rule.
- More concerning, the White House Council of Economic Advisors reported that there are $17 billion in fees collected from conflicted advice. If you assume a 1% fee for simple math purposes, that means that $1.7 trillion in assets nationally are managed, products sold, and accounts serviced, with advice that has potential conflicts of interest associated with it.
- The Securities and Exchange Commission is moving toward adoption of the so-called Regulation Best Interest standard, which is likely to cause even greater confusion about the roles and fiduciary responsibilities of broker/dealers and advisors.
- Adding to the confusion: in order to keep the fiduciary rule dream alive, several states are creating their own rules to protect their constituent’s best interests. Nevada and Connecticut have adopted legislation. New York, New Jersey and Maryland are considering it.
As always, if you want to be sure your advisor is managing your money in your best interest, start with a Registered Investment Advisor like Old Port Advisors. OPA is regulated as a fiduciary, something that many firms fight hard to avoid.
The Impact of Inflation on Retirement
One of the most difficult data points to get accurate in retirement planning is inflation. For most people they look at inflation as the Consumer Price Index for Urban Wage Earners and Clerical Workers (CPI-W). This is the index that Social Security is tied to and hence the cost of living increases (COLA) when they happen. As the CPI-W name implies, it is based on people working, not retired. Here in lies the problem. People working can absorb inflationary pressures better than most retirees. Most retirees underestimate inflation and perceived costs later.
Expenses That Grew Faster Than Social Security’s COLA since 2000
A recent report released by The Senior Citizens League (TSCL) found that the purchasing power of Social Security (SS) dollars plunged 34% between 2000-2018. Since 2000, TSCL added up the COLA increases as well as the inflation experienced by 39 items commonly purchased and used by retirees. The COLA increase was around 46% and the aggregate increase of the items was 96%. This is a stark difference if not planned for as it plays a direct role for one’s portfolio asset allocation and withdrawal rates.
On the plus side, 13 of the 39 expenses examined did not out pace Social Security’s COLA. However, it also means that two-thirds of them did. Here are 9 items that had the highest rate of inflation over the last 18 years.
- Medicare Part B Premiums: up 195%
- Prescription Drugs (annual average out of pocket): up 188%
- Home Heating Oil: up 181%
- Homeowners insurance: up 164%
- Medigap Plans: up 158%
- Propane Gas (per gallon): up 157%
- Real Estate Taxes: up 129%
- Total Medical Expenses (out of pocket): up 117%
- Pet Services (including Veterinary): up 114%
As you can see, four of the expenses on the list are tied to health care in some form or fashion. Fidelity recently published their health care cost projections. They project that the average couple retiring in 2018 at age 65 will need $280,000 to cover health care costs over the life of their retirement. This includes premiums, cost sharing and out of pocket expenses. It does not include dental or long-term care.
There are ways to mitigate some of the rising health care costs. Besides being proactively healthy, one should make sure their financial plan is adequately reviewing these expenses. At OPA, we routinely increase healthcare costs, as well as tie in a higher inflation rate, as part of the planning process. Let us know if we can be of assistance with your plan.
OPA Out & About:
We’re continuing the time of year when a variety of non-profit organizations further their annual fundraising efforts so they can continue to enhance the fabric of our community. Although by no means complete, the events below are but a sampling of the organizations that our firm, employees, colleagues and clients are involved with, should you want to consider supporting their missions.
St. Lawrence Arts – OPA joined the host committee on September 12th for their Fall House Party fundraising concert featuring Portland’s own Charlie Brown and Andrea Re to support Munjoy Hill’s neighborhood art center. More information is available at http://www.stlawrencearts.org/
Maine Marathon – The 2018 Gorham Savings Bank Maine Marathon was held September 30th and benefited Ronald McDonald House, Greater Portland Health and The Locker Project. OPA was part of the sponsorship group, and had one of our own – Jason Foster – running in his first half marathon. Additional information can be found at http://mainemarathon.com/
A Pink Tie Party – We are part of the host group for the 3rd annual event, on October 18th at Vinegar Hill Music Theatre in Arundel, to support The Maine Cancer Foundation. Additional information can be found at www.eventbrite.com/e/pink-tie-party-tickets-49777235050
Wayfinder Schools – We are sponsors of two events they will be holding during the 2018-2019 school year to benefit its mission of providing pathways to opportunities for all Maine high school students. On October 13th a tasting and vineyard tour will take place at Willows Awake Winery & Vineyard, while the School’s annual author’s event with Richard Russo will take place April 11th 2019 at USM’s Hannaford Hall. Additional information can be found at http://wayfinderschools.org/
Portland String Quartet – OPA is one of the sponsors recognizing the group’s 50th anniversary season. Details on the concert schedule and, as well as the quartet’s history, can be found at www.portlandstringquartet.com
Dream Factory of Maine – This year we are kicking off the holiday season by being a segment sponsor for their Make Your Own Candy Cane Event at Haven’s Candies Factory in Westbrook on Saturday November 24th between 9:30 and 10:00 AM. Our office has some tickets, so please contact us, while additional information and tickets can be found at http://dreamfactoryinc.org/chapters/portlandmaine/
Old Port Advisors was founded more than 20 years ago as Investment Management & Consulting Group (IMCG), with a vision to create a boutique independent investment management firm centered on the best interests of our clients. Our principles were simple and still ground us today: a values-driven, personalized, collaborative, and strategic approach to investing, wealth management, and fiduciary consulting. We changed our name to embark on the next 20 years, but our leadership and our calling remain. We’re excited to build on our past experience and success to deliver on our promise of building a secure future for our clients.