December 2017 – Monthly Commentary

December 2017

While the team at Halyard evaluates the economic and market backdrop on a daily basis, we like to commit those thoughts to paper periodically, and especially so as we kick off the new year. Our starting premise this year is that the United States economy closed out 2017 with unmitigated strength. From a sector by sector perspective, we’re delighted to find the strength was broad based and not concentrated in any one sector or industry.

While too early to tally the result of the just ended holiday selling season, it’s seems likely that retail sales set a record with internet sales clogging the delivery channels late in December. Holiday shopping seems to have been forever changed, as the madness of black Friday has decidedly been replaced by cyber Monday which really was more like cyber December. Many of the individuals with whom we spoke said they happily avoided visiting the mall altogether this year. Nonetheless, sales were strong and UPS, FedEx, Amazon, and Walmart took an outsized share of the spoils. The very high level of consumer confidence and the robust jobs market were directly responsible for the success of the season as consumers felt confident about their prospects for job retention and wage growth.

Consumer confidence also benefited the housing market as new home sales sold at a pace not seen since pre-crisis. Despite the uptick in sales, new home construction is still well below the peak rate registered in 2005, which should be supportive of further industry gains. Moreover, the builders have carefully managed inventory to avoid a repeat of the oversupply witnessed during the peak. Similarly, the inventory of existing home sales continues to dwindle as sales outpace offerings. With the relative tightness of inventory, home prices, as measured by the Case Shiller index, closed the year with a 6.3% annual rise in price. The phantom wealth gain of rising home prices is contributing to a virtuous circle of ebullient consumer confidence and their propensity to spend.

Manufacturing continued its renaissance as the sector continued to grow, adding 79,000 new employees in the fourth quarter and registered employment gains in every month of 2017 save one. That’s a pleasant change from the month after month job cuts witnessed in the 2000’s.

With the backdrop of full employment and strong consumer confidence we believe the economy will continue to expand at least at a moderate pace. Moreover, as the Trump tax cuts work their way through the economy, the potential exists that the moderate growth could expand into a consistently greater than 3% annualized GDP growth. That’s a scenario that we believe would alarm the Federal Open Market Committee and perhaps cause them to consider more aggressive tightening. For the foreseeable future, however, we expect they will continue on the path of slow and steady rate hikes with three or four hikes in the coming year. Similarly, we expect that their bond purchase tapering will continue at the stated pace. One nuance that could be changed is the mix of asset purchases related to the recent flattening of the yield curve. Much talk has focused on the yield curve flattening as portending a recession or at best resulting in a drag on the financial sector. In thinking about the flattening, it’s important to keep in mind that it’s a direct result of the Fed’s manipulation of interest rates in the open market. It’s also important to remember that the Fed has an open dialogue with the money center bankers and considers their concerns when developing monetary policy. Given those considerations, we would not be shocked if the Fed decided to buy less of the longer maturities and allow that rate to drift higher, thereby steepening the yield curve. The challenge they face, should they decide to follow that course of action would be the size of the reduction and to what level they would like to see the yield curve move.

As for our portfolio construction, we continue to be of the mind that interest rates are too low and long duration exposure should be avoided. Currently we’re keeping maturities under three years and focusing heavily on floating rate notes. With the expectation that the Fed will continue to tighten, floaters will perform well as their coupon adjusts higher with each rate hike, thereby anchoring their price at close to par. Finally, given the relative expensiveness of riskier assets, we are limiting our exposure to investment grade corporate and municipal issuers while avoiding European banks, emerging market debt, and high yield issuers.

November 2017 – Monthly Commentary

November 2017

In 2004, an acquaintance left his job as a banking clerk to become a real estate sales agent. Almost overnight his income doubled as the homes he represented sold briskly. The market was so hot that he was working seven days a week and his income soared well over $200,000. However, in 2006 sales began to slow and buyers were grumbling that home prices had grown out of reach. Builders continued to build new homes, albeit at a diminished pace, and realtors aggressively argued that all was well in the market. The neophyte real estate broker, in an effort to sustain his business added a “click-through” to his website entitled the “anti-bubble argument.” When clicked, a series of charts popped up comparing home prices to a number of measures, concluding that not only was real estate not in a bubble, but the opposite was true. To not buy would be to miss out on the next leg of another profitable run in home prices. His logic was that if he could convince his clients that U.S. home prices were going higher, he’d be able to ensure that his recent uptick in income would continue. Of course, that wasn’t to be and he is now blissfully, though less profitably, operating a boutique organic vegetable farm. I was reminded of his anti-bubble argument as I listened to the parade of investors and traders on the financial news program one recent morning. One after another, the experts agreed that stock prices are expensive and the risk level elevated, but each suggested looking past valuation so as to not miss the next leg up in prices. They are engaging in the same attempt at deception as the real estate agent. The profitability of their employers depends on investors remaining invested in their funds. When pressed on the matter of valuation, the usual retort is to say that they mitigate the downside by focusing on high growth stocks or defensive stocks, or some combination of both. We see many similarities between the current stock market and the 2006 Real Estate market. It impossible to know for how much longer the stock rally will last, but by nearly every measure, stock prices are expensive.

We’ve written on several occasions about our frustration with government reported data and the release of the October consumer price index (CPI) is another stark reminder of why. The Bureau of Labor Statistics reported that headline CPI rose 2.0% year-over-year, decelerating from the 2.2% pace recorded the previous month. Often we’ve said that the muted CPI seems directly at odds with the rising cost of living of the average American. Digging into the details of the report offers a glance as to why and we reference several components to illustrate the point. The first is shelter, which constitutes 33% of the index. The economic profession looks to the Case Shiller national index as the definitive measure of home price inflation and the last reading was a 6.07% rise in home prices year-over-year. That’s far higher than the 3.2% change measured in CPI. Adjusting for the actual change in home prices would add approximately 0.71% to the top line inflation measure. The next items we question are medical care and health insurance, rising 1.9 and 0.2%, respectively. Unlike home prices, there is no definitive data to substitute for these items, but one can attest that when co-pay and co-insurance are factored in the cost of a visit to the doctor, and the staggering annual increase in insurance premiums, health insurance costs are rising far faster than the ridiculous rates suggested by the BLS. Finally, according to the BLS the cost of telephone and internet services fell -7.1% and -1.0% year-over-year, respectively. Regarding those two items, the BLS has said the move to unlimited data earlier this year would result in a falling adjusted price when the additional service is considered. In essence, they’re saying that you’re getting more for your money so that’s deflationary. I can tell you that neither the cost of our phone nor the cost our internet access has fallen. Ever! To solve for the inaccuracies presented by the BLS, we made a number of subjective statistical adjustments that are in no way definitive, but nevertheless, we believe are more reflective of price changes. Based on those adjustments we believe the year over year change in the cost of living is closer to 3.25% rather than the 2.0% report by the BLS. By that measure, the real return on the 10-year Treasury note would be -0.85%.

October 2017 – Monthly Commentary

October 2017

Last month marked the 30th anniversary of Black Monday, October 19, 1987, prompting us to take a look back at how the Dow Jones Industrial Average has evolved since that infamous day. Of the 30 stocks in the index at the time, Bethlehem Steel, Eastman Kodak, GM, Union Carbide, U.S. Steel, and Woolworths have all gone through bankruptcy. Some reorganized and reemerged, but most didn’t. Sears, which also was part of the index in 1987 is quite likely to be gone in the next six months. Digital Equipment Corporation (DEC) was not in the index, but as the leader in mainframe computer production, it was the premier technological company at the time. Unfortunately for DEC investors, the utilization of mainframes dwindled as minicomputers sales soared, and a significantly diminished DEC was bought by Compaq computer in 1998. At the time of the time of the DEC purchase, Compaq was a pillar of the tech industry, and together with Dell, Microsoft, Intel and a host of other tech companies were represented in virtually every growth portfolio. Four years later, Carly Fiorina, the one-time Presidential hopeful and then Chairwoman of Hewlett Packard engineered an $87 Billion “friendly” merger between HP and Compaq. The integration of the two companies did not go well and it wasn’t long before investors were punishing the stock which, in turn, led to the ousting of Ms. Fiorina.

One would think that such woeful performance would weigh heavily on investors as they evaluate the riskiness of the current stock market as it rallies to new highs on a nearly daily basis. Last month we wrote about Warren Buffet’s proclamation that the Dow index would probably hit 1,000,000 in the next 100 years. The “Oracle of Omaha” in his promotion of buy and hold investing, didn’t mentioned that the Dow Jones Index is not a buy and hold index and regularly drops underperforming companies. The theory of a buy and hold portfolio completely ignores what to do when a company starts to show financial strain or loss of competitive advantage. To hear Buffet tell it, investors would be best served by buying and never selling. However using the 1987 Dow Jones index as a proxy for a buy and hold portfolio, an investor in that index would have had 20% of their 1987 portfolio fall to zero. Of course that’s taking portfolio construction to an extreme and the investor would have been well served by simply rebalancing their portfolio to mirror the new index components. The point is, setting it and forgetting it, as Mr. Buffet suggested, is a perilous plan; and that goes for the bond market as well. With interest rates pegged at artificially low rates and credit spreads at the low end of their long term range, it’s easy to be lulled into a false sense of security. We see it in abundance across the various sectors, both domestically and internationally, high yield and investment grade, emerging market and sovereign debt. Driven by the incessant search for yield, appetite for return is forcing investors to take risks that aren’t commensurate with the measly returns offered. While it’s plausible that the low rate environment could last for the foreseeable future, we believe that investors will ultimately be punished for imprudent investing.

Turning to the economy, data reported during October painted a picture of unmitigated strength. The litmus test for economic health is the labor market and despite hurricanes Irma and Harvey-related hiccoughs, the economy continues to create jobs at a rapid pace. The unemployment rate fell to 4.1% as 261,000 new jobs were gained in October, and the prior month’s job figure was revised higher by 51,000. Equally encouraging was the 3.0% GDP growth rate registered in the third quarter. Economists had warned that the aforementioned hurricanes were likely to trim as much as one percent from that growth rate and were shocked to see the three “handle”. To summarize the state of the U. S. economy, the labor market is at full employment, manufacturing is booming as is the tech sector, inventories are lean, and home builders can’t build houses as fast as they’d like because of a shortage of workers. Historically, at this stage of the economic cycle, the Fed would have overnight interest rates at a level 75 to 125 basis points above inflation. That would translate to a short term rate somewhere between 3.00% to 3.50%, instead of the 1.25% level at which it currently stands. Our concern is that the economy is at risk of a spike in wage growth that spooks the Fed and it’s bevy of new governors and they respond by speeding up the pace of rate hikes or more sharply curtailing the quantitative easing still in place. That would undoubtedly destabilize stock and bond prices. As we said earlier, investors will ultimately be punished for imprudent investing.