Quarterly Letter – Third Quarter 2019

So far, 2019 is shaping up to be a very good year for investors with both equities and bonds generating positive returns. A brief look at market returns would suggest the world at large is in great shape, but investment markets have shrugged off several not-so-positive developments in recent months. These include a persistent, if not expanding trade war, decelerating global economic conditions, gathering political intrigue and sparks flying in the Middle East, just to name a few. In the meantime, the S&P 500 set another new record high. In our comments below, we address the factors that we believe are contributing to the current favorable market environment despite only lukewarm fundamentals.

U.S. Equity Markets
U.S. stocks continued to climb with the S&P 500 generating a return of 1.7% in the third quarter, which places the year-to-date return for this index at 20.6%. Corporate earnings are positive and consumer sentiment and spending, which account for roughly 70% of the U.S. economy, are robust. Companies and consumers have managed to absorb the negative impact of trade tariffs by switching products and suppliers where they can, or adjusting for costs and prices. U.S. small-cap stocks did not fare as well as large-cap stocks with the Russell 2000 dropping -2.5% during the third quarter, but still registering a year-to-date return of 14.1%. In a trade war, we would expect small stocks to fare well given a much lower share of revenue derived from outside the U.S. compared to larger and more global companies. However, falling market rates and a corresponding reduction in debt costs have benefited large U.S. companies where debt levels are much greater.

International and Emerging Markets
International and emerging markets continued to struggle in the third quarter with decelerating economic growth and growing concerns over the trade war. While equities in these parts of the globe are trading at favorable values compared to U.S. equities, the fundamentals are less attractive. The MSCI EAFE index, which reflects developed country stocks, lost -1.1% during the third quarter. Emerging market equities continue to be most impacted by trade war factors and concerns with the MSCI Emerging Markets index falling -4.2% during the quarter. Foreign markets are still in positive territory for the year with the MSCI EAFE index up 12.8% and the MSCI Emerging Markets index up 5.9%. We still believe supportive monetary policies, generally low inflation, and steady consumer demand should allow for global economic stability. However, increasing tariffs and decelerating growth place global markets in a less stable position.

Bonds generated another quarter of positive returns as market interest rates moved lower and credit markets were healthy. For the second time this year, the Federal Reserve cut the federal funds rate by 0.25% and indicated it may reduce rates one more time before the end of this year. During the third quarter the Barclays Bloomberg Government/Credit Intermediate Term index gained 1.4%. This is shaping up to be one the best years for bond returns over the past decade with most intermediate-term bond funds registering year-to-date gains of better than 5%. If economic conditions remain steady and price inflation subdued, we believe bonds should continue to generate positive returns.

Investor sentiment and the economy
We believe capital markets and investor returns are being driven as much by investor sentiment as by underlying fundamental factors. Since the end of last year, investment markets have focused on the direction of the Federal Reserve with regards to monetary policy and direction of interest rates. When it appears that Chairman Powell and company might be less accommodative than desired, investors have responded very negatively. December of last year and May of this year are examples of this dynamic as markets sold off when the Fed seemed a step behind market wishes, only to rally once the Fed struck a more dovish tone. This sentiment can result in sometimes counterintuitive market reactions when poor economic news causes equity and bond prices to move higher on the prospect the Fed will lower rates further or offer the market greater liquidity by retaining or increasing its bond holdings (also known as quantitative easing). From this perspective, investors are probably better off hoping for only muted economic conditions and inflation, which gives the Fed enough discretion to act as the market seems to prefer. In our view, this arrangement could pose greater long-term risk. If a truly negative catalyst were to jolt the economy and investment markets, the Federal Reserve may find itself with fewer options to stem the tide. On the other hand, if economic conditions accelerate to the upside, investment markets might be, at least temporarily, unsettled by the prospect of a Federal Reserve that no longer appeases its appetite for lower interest rate. Perhaps we should wish for economic conditions that don’t get too hot or too cold as investor sentiment should be well served.

The present ‘goldilocks’ environment so favored by investors could persist for longer than many expect. There is much debate among economists, market watchers and the media about whether the U.S. and the world are about to fall into a recession or if the Fed is being too accommodative for an economy that is in generally good shape. While we can’t rule out the potential for a negative event to rapidly spoil the present environment, we believe there are enough positive factors at play (a vibrant U.S. consumer, ample employment and corporate earnings, subdued inflation and low interest rates) to support mediocre economic conditions. And as investment markets have so kindly demonstrated over the past year, mediocrity can be great for investors.

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