French critic Jean-Baptiste Alphonse Karr’s famous quote, “the more things change, the more they stay the same,” rang true in the 2nd quarter of 2018. Despite the return of volatility to the markets in 2018, after an unprecedented year of record low volatility in 2017, the 2nd longest economic expansion post World War II remains intact. The quarter was not without unnerving headlines, whether it be concerns about North Korea or a brewing trade war with China. This did not stop the S&P 500 from moving higher. While we realize volatility can be unsettling for investors, we believe volatility creates opportunity and is thus beneficial to our style of investing. When we look at the macro economy, we see synchronized global growth, coupled with items that warrant caution moving forward.
As the 9+ year-old bull market marches on, there are headwinds forming that may threaten the expansion. While tax reform has served to boost short-term growth, it remains to be seen what impact it will have on the long-term health of the economy. Mounting federal debt levels look set to increase with higher federal deficit forecasts. The Congressional Budget Office is currently forecasting debt/GDP to reach nearly 100% by 2028, levels last reached in 1946 following the conclusion of World War II. Federal Reserve Chairman Powell has moved forward with the Fed’s plan to normalize monetary policy, raising the federal-funds rate again during the quarter and continuing to taper bond purchases. Higher interest rates could put pressure on a private sector that is heavily indebted compared to historical levels. In fact, U.S. nonfinancial corporate debt finished 2017 at an unprecedented 45.4% of U.S. nominal GDP, which is higher than the previous record of 45% set in the 2nd quarter of 2009. Historically low interest rates have made higher debt levels manageable. However, this is something we are keeping an eye on as rates rise and the ability to service high debt levels might be pressured. Higher interest rates not only increase borrowing costs, they also pressure asset prices. Market participants value securities based off the current risk-free rate (generally U.S. Treasuries). As the risk-free rate rises, the hurdle rate required to earn an adequate return on risk assets increases. This could be problematic for a market that by some measures looks to be fully priced, if not somewhat expensive.
As the adage goes, the stock market always climbs a wall of worry. Despite the concerns we have, there are many reasons to be optimistic about the future. To start, the Tax Cuts and Jobs Act passed in December 2017 appears to have been very stimulative to U.S. businesses, which subsequently, should be beneficial to U.S. consumers. Businesses are comfortable enough with their economic position that hiring has increased, leading to an unemployment rate hitting an 18-year low. In fact, the Bureau of Labor Statistics reported that as of April, there were more job openings than unemployed people. Additionally, outside of the U.S., many other large economies continue to see positive growth. We expect this to continue in the near term absent any geopolitical shocks or setbacks from an escalating trade war. We believe the U.S. and China are aware it is in the best interest of the global economy not to engage in a full-blown trade war. While we have no way of knowing the outcome, we feel there is a lot of posturing going on between the U.S. and China, and we are hopeful this will eventually be resolved. Finally, deflationary forces, such as globalization, shifting demographics, technology, and the “Amazon effect,” have given us persistently low inflation. This combination of low inflation and accelerating GDP growth has served as a strong foundation for the economic expansion. Should the expansion continue through the summer of 2019, it will become the longest economic expansion post World War II.
The market never provides us with a black and white picture, and today’s market is no different. We think it is reasonable to say that today’s economic picture does not portend a sudden slowdown, but we believe the best stance is to remain cautious and seek investments that we feel offer attractive risk/reward profiles. We have been trimming positions where we feel valuations are full and adding to our best ideas whenever the opportunity arises. Over our 60+ year history, our investment philosophy has remained the same: We seek to hold securities where we feel the underlying company has strong competitive advantages, maintains a solid balance sheet, and generates durable cash flow streams. We take pride in working with our clients to help them achieve their financial goals, regardless of the macroeconomic environment.
Gamble Jones Capital Management