Quarterly Letter – Second Quarter 2019

Volatility was back in force during the second quarter with sizeable gains in April and June, offset by a short-lived equity market route in May. We believe all this jostling can be ascribed to shifting monetary policy as well as geopolitical and economic events, including the trade war between the U.S. and China. In our view, the economy and corporate earnings should continue to grow through the second half of the year. Overall, the first half of 2019 has been very rewarding for both bond and equity investors. Market volatility is likely to persist as we round the back half of the year but should remain an investor-friendly period overall.

U.S. Equity Markets
U.S. stocks closed the first half of the year on a high note. As a matter of fact, the S&P 500 hasn’t experienced a better June since Eisenhower was President and Ford introduced the first Thunderbird, back in 1955. If not for the market swoon in May, it might have been the best quarter in some time as well. Still, the S&P 500 managed to generate a very respectable return of 4.3% during the second quarter. This places year-to-date returns for this index at 18.5%! Small-cap stocks also moved higher with the Russell 2000 up 2.1% for the quarter and 17.0% for the year so far.

International and Emerging Markets
With the U.S.-China trade war intensifying and economic growth sputtering in various parts of the globe, international and emerging market stocks generated gains, but continued to lag U.S. stocks in the latest quarter. The MSCI EAFE index, which reflects developed country stocks, gained 3.7% during the second quarter and is up 14.0% year-to-date. Emerging market equities have taken the brunt of the trade war impact, gaining only 0.6% in the latest quarter, but still up 10.6% in the first half of the year. Although economic growth has slowed abroad, it doesn’t appear that any major developed or emerging market countries have slipped into recession territory. We believe supportive monetary policies, generally low inflation and steady consumer demand should allow for global economic stability. From a growth and valuation perspective, we believe emerging market stocks may have the greatest potential for long-term gains over the coming decade.

Bonds
After several years of meager returns, 2019 is shaping up to be a great year for bond investors. Falling market interest rates and strong investor demand for credit risk have been the primary tailwinds driving bond returns. Both factors have resulted in generally higher bond prices, augmenting returns from income. With the Federal Reserve shifting its stance from hiking rates to potentially cutting rates before year-end, market interest rates have fallen quite significantly since 2018, resulting in higher bond prices and returns for investors. Short-term and intermediate-term bonds have gained nearly 3.0% and 5.0% over the first half of the year with returns evenly spread out over the first and second quarters. If bond returns generate nothing more in the second half of the year, we would still enjoy one of the best years for bond returns in the past ten. Low inflation and a tepid, but still growing economy, may reflect a best-case scenario for bond investors. This may still allow the Fed to follow through on a rate cut while credit risk remains contained. In our view, this is a likely scenario for the remainder of 2019.

Answers To Common Questions
How is the economy doing, and are we headed for a recession? Economic growth in the U.S. and abroad remain positive but are decelerating. The U.S. economy seems to be in a gliding pattern, so the risk of a recession within the next year appears to be low. Because forward looking data has been mixed, economic visibility beyond a year out is less clear. Suffice it to say, we’ll experience another recession at some point, but not likely this year. While an ongoing trade war doesn’t help anyone in the near-term, this shouldn’t be enough, at least on its own, to force a recession. And lastly, keep in mind that even if a recession were to occur in the next few years, historical market returns have been quite favorable in the year or two preceding a recession.
Are we due for another market correction? As the end of last year demonstrated, we don’t need a recession to have a significant market downturn. On average, the stock market falls by more than 10% about every 18 months. This is just normal market behavior. Given that equities are back to near all-time highs, don’t be surprised if we experience a near-term market set back or two. That said, the path of least resistance seems higher. If you’ve considered reducing your level of investment risk, the current environment may be ideal for a prudent downshift. Sometimes it’s easy to feel that risk is diminishing as the market marches higher, yet the opposite is true.
Will real estate be okay? We believe housing and real estate market dynamics should remain positive to stable over the foreseeable future. Lending standards are still stringent, yet borrowing rates are low. The existing inventory of homes for sale are at or below normal levels, which reflect limited supply and support a seller’s market. Meanwhile homebuilders and most commercial real estate developers are adding new supply at a cautious pace, as the number of new home builds is still below the 30-year average. The promiscuous lending and overbuilding of 10 years ago are not with us today.
Is there too much debt? Debt levels are best measured from both an absolute and ‘cost-of-debt’ standpoint, as reflected by market interest rates. When considering government, consumer and corporate debt, consumers may be in the best shape with disposable income levels moving higher and relative debt levels falling. On the other hand, government and corporate debt is swiftly rising. If economic conditions and market interest rates remain stable, these debt levels may not become problematic. However, if the economy falters and/or interest rates spike, the federal budget would likely get pinched and corporate profits could quickly recede; neither scenario would be ideal for investors.

Conclusion
Investor sentiment seems to hinge on the direction of interest rates and monetary policy with loud cries for the Federal Reserve to cut rates. When the Fed heeds investor wishes, the equity market rallies and when the Fed appears more ‘hawkish’ (favoring higher rates), the market expresses substantial discontent. With U.S. stocks near all-time highs, we don’t believe values are as compelling as earlier this year. But if the Fed feeds investor sentiment, and the world avoids any major negative surprises, the trend of the market should remain upward.
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