Summer is in full swing, temperatures have risen and cities are a bit emptier with residents taking refuge to cooler locations. Wherever you find yourself, we hope that you are relaxing and enjoying time with friends and family. At Bainco, we are carefully navigating the shifting sands of the global equity and fixed income markets. This year has played out to our expectations with a modest increase in equity markets, elevated volatility, and higher interest rates coinciding with increased economic growth in the US. As we head into the second half of 2018, political headlines related to ongoing trade disputes, Brexit, and the mid-term elections are likely to buffet markets. We expect continued strong corporate results and are optimistic that underlying fundamentals will be able to push stocks higher.
“Corporate results are off to a great start this year with the S&P 500 delivering earnings growth of 23.9% and revenue growth of 8.2% on average for the first quarter.”
Corporate results are off to a great start this year with the S&P 500 delivering earnings growth of 23.9% and revenue growth of 8.2% on average for the first quarter. New lower tax rates have been additive to earnings but revenue growth has been an even larger driver due to strong consumer spending, corporate investment, and international sales. Five of the 11 S&P 500 sectors delivered double-digit sales growth led by tech and energy, each of which grew by more than 14%. From new drugs and therapeutic treatments to advances in aerospace and data analytics, the companies in our portfolio are well positioned to capitalize on many of the exciting trends of today which should continue well into the future.
New Markets to Consider, but is Now the Time?
With the strength in underlying earnings and the growth trends in many US companies, we continue to favor the US market. That being said, we acknowledge the changing global investment landscape and continue to review new opportunities being created. China is slowly opening up their markets to global investors and is becoming incrementally important to monitor. In May, a group of Chinese “A” share listed companies were added to the MSCI All Country World Index. It was a small percentage, but over the next few years that weighting will increase and likely become the largest weighting in the Emerging Market Index. When you include the nearly $12 trillion domestic Chinese bond market, which is also slowly opening to foreign investors, the investment landscape is changing quite dramatically. Therefore, the decision to invest in the US versus the rest of the world is more complex, with China now being a major investable world market. Strong valuations, decelerating economic growth, and the potential impact of newly imposed tariffs have given us pause in deploying capital abroad but we continue to review all available investment opportunities. Over time we expect to add more international exposure, but only when the investments offer the growth and quality attributes that we seek.
An Oil Boom Creates Challenges and Opportunities
An area of intersection between a cyclical trend, technological innovation, and a unique market dynamic is presenting itself in the energy sector. Due to the growing production from the various shale basins, the US has recently gone from a ‘net importer’ to a ‘net exporter’ of oil and natural gas. Unfortunately for US producers, the infrastructure is not in place to export all of the new production which has led to a glut in the US market. While infrastructure is being built to address this, it may take close to a decade to complete. The surplus is creating a price differential between domestic oil and natural gas prices compared to outside the US. Further, on January 1st 2020 a new rule will come into place restricting the amount of sulfur in fuel oil used by ships. This will dramatically impact the demand for various types of oil and in our analysis it makes oil companies outside of the US particularly attractive. As a result, we have recently added Total SA, a French oil company, to client portfolios. Total is the 9th largest oil company in the world by revenue with strong production growth, excellent cash flow and balance sheet fundamentals, a growing 4.5% dividend, and an excellent production mix that should benefit from these dynamics.
Positive Real Interest Rates on the Horizon
Beyond higher oil prices, we are starting to see economic indicators which tend to occur in a later stage economic expansion such as wage inflation. The United States Federal Reserve has been closely monitoring and reacting to many of these inflationary indicators, and in June increased the top end of their target range on the Fed Funds Rate to 2%. Since 2008, short term interest rates have been below inflation resulting in a situation economists refer to as ‘negative real interest rates’ defined as losing money on cash deposits when measured against inflation. This was the intended outcome as it was designed to incent investment, a clear desire of the Fed as they hoped to stimulate the economy. With the expectation of the Fed raising rates 2 more times this year and 3 more times next year, the period of negative real interest rates will end and the underlying strength of the US economy will be tested.
We continue to monitor fixed income markets and look for opportunities to responsibly increase the current income in client portfolios. As short-term rates have risen, our short duration positioning has benefited our client portfolios. If we see the yield curve steepen, we would be inclined to move our average maturity out beyond the current 3-4 years, but are waiting to be “paid” adequately for that risk. Currently the difference in yield between the 3 year and 30 year US Treasury bond is only 30bps, clearly not enough incremental yield to take the risk of owning long-dated bonds. In addition, we continue to invest in high-quality bonds as we believe that the role of fixed income in client portfolios is a counterbalance to the risk in equity portfolios.
A near-term risk we see in markets is the impact from the ongoing trade disputes with China, the EU, and closer to home with Canada and Mexico. We have not seen a significant impact as the initial ‘volley’ is only a few days old and fairly specific, but we are watching to see if it escalates further. We are also keenly interested in the data and guidance from companies on their upcoming earnings calls to see if they alter their spending plans and growth strategy. We have been optimistic that the increased ability to accelerate depreciation would increase capital spending and hiring, but we worry these headlines may give CEOs a bit of pause before green-lighting large projects. If CEOs can be emboldened to move forward with new projects and capitalize on the new tax incentives we believe there could be further acceleration in economic growth. Weaker than expected guidance is likely to cause concern and will be a challenge for equity markets which have expectations for earnings growth, particularly in the US.
After a quiet 2017 we have had a resurgence in news and volatility in 2018. Our outlook remains constructive as corporate earnings are strongly positive, however, we remain vigilant as there are risks to consider. From trade talks to mid-term elections, there will be plenty to analyze and consider. As new economic data becomes available, we will review our outlook and move to capitalize on the opportunities that develop. Our positioning near the mid-point of equity ranges with some put option coverage remains appropriate.
Bainco Company Update
Lastly, we hope you will join us in congratulating our CFO and Partner, Mark O’Keefe on being named CFO of the year by the Boston Business Journal. Mark has been an integral part of our firm for almost 20 years and could not be more deserving of the award. In addition, we are pleased to announce that Bainco has once again been named a Financial Times 300 Top Registered Investment Adviser in the US.
MARKET COMMENTARY DISCLAIMERS
This commentary contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This commentary has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Individuals will need to consider their own circumstances before making an investment decision.
Information contained herein, including market forecasts and forward-looking statements, are derived from proprietary and nonproprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness or accuracy of the information obtained from these sources.
Past performance is not a guarantee of future results.