RCM Wealth Advisors Quarterly Newsletter – Q4 2017
Current Market Environment
By George Tkaczuk, MD, MPH
In our last quarterly letter (October Q3 2017) we warned our audience to “get ready for a huge surprise.” And, on schedule, Washington delivered a tax reform package. President Trump signed the “Tax Cuts and Jobs Act” into law on Dec. 22. In 2017, the market was skeptical of any tax reform passing and this created the proverbial wall of worry to climb. The market did climb and the market continues to hit new highs on an amazingly consistent basis. Thus, the question remains now that the tax reform package has passed, what’s left? Is everything priced into the current stock market? Are there anymore catalysts? What will it mean for the economy and or market?
At this time, it does not appear the market is totally convinced that the tax reform package will result in a stronger economy. In 2017, the market was handicapping the odds of a tax package passing. It appears in 2018 the market will be obsessed with the fall out of tax reform on the economy, thus expect many more surprises!
To make an assessment of governmental policies, we can take a step back to 2009 at which time Washington decided to try to stimulate the economy with an 8 trillion-dollar redistribution policy. We know that ended up being the slowest recovery on record, an 8 trillion-dollar faux pas. At the same time, Keynesian economists tried to convince us to get used to the “new normal” of subpar growth.
The current administration has taken a different direction and is betting that the tax reform package and rewards to businesses will boost the economy. Estimates vary depending on assumptions about how much economic growth the law will spur. From a Supply-Side economics point of view, we are confident that the new law will spur economic growth. We have the essential elements in place; regulatory burdens are severely reduced, business confidence is high, the Fed is still accommodative, and tax incentives are aligned to encourage more business investment. The key thing here is to focus on the incentives created by the tax reform. So, what can we expect? We will find out in the future, but for now one thing we can do is look at recent economic data that has been coming in, to give us some insight as to what is currently going on.
In late December, the Conference Board Leading Economic Index (LEI) for the U.S. increased 0.4 percent in November following a 1.2 percent increase in October and a 0.1 percent increase in September. According to Ataman Ozyildirim, Director of Business Cycles and Growth Research “The U.S. LEI rose again in November suggesting that solid economic growth will continue into the first half of 2018.”
In the first week of January we received the report that ISM Manufacturing Index rose to 59.7 (over 50 signals expansion) in December beating estimates signaling continued growth. The 59.7 number was just slightly behind the September number (59.8) which was the highest reading for the year and the fastest pace of expansion going back to 2011. As pointed out by economist Brian Wesbury, this was not a yearend event, the ISM manufacturing index averaged the highest readings for a calendar year going all the way back to 2004. As a matter of fact, after the release of this strong number the Atlanta Fed revised its Q4 2017 GDP forecast to a growth rate of 3.2 % (up from 2.8% December 22).
Business leaders appear encouraged by the tax reform package, as noted by comments from Frederick Smith – Founder, Executive Chairman & CEO of Fedex “We’re encouraged by the Tax Cuts and Jobs Act legislation advancing in Congress at this very moment. This legislation offers pro-growth, pro-business tax reform solutions that will power the economy, increase business investment, expand job opportunities, and enhance incomes and improve U.S. competitiveness.”
Equally small business optimism cannot be overlooked as released in December; The National Federation of Independent Business (NFIB) Small Business optimism index for November read 107.5 the second highest in its 44-year history of the NFIB (highest was 108.0 in July 1983).
According to NFIB Chief Economist Bill Dunkelberg “the NFIB indicators clearly anticipate further upticks in economic growth, perhaps pushing up toward four percent GDP growth for the fourth quarter. This is a dramatically different picture than owners presented during the weak 2009-16 recovery.”
What about companies and stocks themselves? According to Factset: The highest Profit Margin (10.9%) Projected in 10 Years for 2018. Based on aggregate revenue and earnings estimates for the index, the projected net profit margin for the S&P 500 for CY 2018 is 10.9%. If 10.9% is the actual net profit margin for the year, it will mark the highest annual profit margin for the S&P 500 since FactSet began tracking aggregate earnings and revenue data for the S&P 500 in 2008. Nine of the 11 sectors are expected to see profit margins increase on a year-over-year basis in CY 2018.
The above is just a short sample; we can go on and on as most data from housing, employment, truck tonnage, chemical activity barometer, and manufacturing continues to grow. Therefore, does this mean a continued rise in the stock market? We never know for sure, but for now indications are that stocks will continue to do well. At times we will get corrections and pullbacks, but at the same time we will be getting new data either from companies and the economy in general which will guide us as to what lies further ahead. But for now, we stay invested.
RCM Managed Asset Portfolio
By Christopher Chiu, CFA
During the past quarter, markets continued to make incremental highs. Even with the risk of a conflict with North Korea, volatility in the U.S equity markets remains historically low. This may be an indication that the equity market’s true focus at the present time continues to be economic and corporate earnings growth.
(1) Tax policy. The US Congress and the Trump administration were able to major pass tax reform legislation. The law, when enacted, lowers the corporate rate to 21%, which is expected to increase capital investment, capital inflows, and economic expansion.
(2) Global and domestic growth. On the global front, growth continues in Western Europe and parts of the emerging world. There is a bit of divergence in central bank policies as the US Fed continues tightening while the ECB has not yet fully committed to doing so.
Domestically, while unemployment rates are at their lowest levels in years, wage growth remains limited perhaps reflecting the amount of slack that still exists not only in the labor market but the US economy overall.
Gov’t, High Credit Corporates
Rates have risen from levels at this time last year with the Fed cautiously attempting to normalize rates. Foremost, on the minds of its members is why inflation remains persistently low despite low unemployment levels. There is the expectation that the Fed will continue to raise incrementally throughout the coming year. Bond prices consequently have begun to show some price volatility at the start of the year.
The high yield market continues to proceed in a sideways fashion. While credit conditions are still good, there is a limit to the upside to high yield. Sustained valuations have been partly due to the influx of capital into the market as investors still look for yield in a rising but low rate environment.
With defaults currently well below 4% and with a new administration advocating pro-growth policies, it seems that the credit cycle may be extended for an undetermined period. Investments in the high yield market represent riskier investments among the risk spectrum. We expect this sector to be among the most vulnerable to any increased risk and volatility; but, it will also be among the fastest to recover in any recovery of credit markets.
Recent developments in Large Caps and The Strategic Knight
Equity markets followed on gains from the year, spurred by the implementation of pro-growth policies. As stated previously, we anticipate that lower oil prices will have a positive effect on stocks.
In the Strategic Knight portfolios, we remain heavily invested in the tech sector. We think companies such as Amazon and Facebook have an overwhelming competitive advantage in their respective spaces. We do not see these size advantages, which have been enabled by the Internet, changing in the foreseeable future. The one risk that has become greater is future regulatory risk. While the legislative process is a slow moving one, various thought leaders continue to express concerns about the size and influence of large cap tech on competitive markets. Without new competition, it’s hard to see how this negative press diminishes in the new year.
The performance of semiconductors was a real standout during the last quarter, driven by the increasing application of AI in company data centers. We decided to open a position in Nvidia and Arista Network. Nvidia is a maker of GPUs (graphics processing unit) which are prevalent in servers that utilize repetitive computing processes when working with large amounts of data. Arista Networks designs and manufactures the gear that routs information intelligently from servers to end users. Both should benefit from the growth of datacenters, data analysis, and data management.
Small and Mid-Caps
Lately, small caps have performed quite well as the dollar has rebounded from some weakness earlier in the year; smalls and mids are expected to benefit from tax reform. In the Strategic Knight portfolio, we increased our allotment of small and mid-size caps.
In the mutual fund portfolio, we continue to maintain an equal weight exposure to small and mid-caps. Unlike large caps, which have a large portion of their sales to international markets, small and mid-caps sell almost exclusively to domestic markets. We view that in the long term, as rates begin to rise, there is ample cause for the dollar to strengthen. Drawbacks to investments in smalls and mids include the higher levels of debt to capital when compared to historical norms. This implies higher levels of risk that need to be weaned down over time.
Our Position in Lamb Weston
This quarter we thought we would highlight one of the stocks in our managed portfolios.
Lamb Weston is one of our holdings in the Global Equity Income Portfolio (GEIP). Split off from Conagra in 2016 as a standalone company, Lamb Weston has become one of the better performers in the portfolio.
This despite, or perhaps, because of the fact that its sole product is potatoes and specifically the French-fried potatoes consumed at fast food restaurants. It should not be taken for granted that when an economy does well there is much that does well also, including restaurant suppliers. Potatoes have done well as restaurants have continued to perform in a growing economy. Lamb Weston is the primary supplier of frozen French fries to McDonalds.
But it’s not a simple process. Any attempts at scale farming have to try to harness the variability that comes from natural growth. There is a great deal of thought and engineering that goes into the process of planting, cultivating, harvesting, sizing, cleaning, and finally cutting potatoes down into fairly regular pieces in order to fry them. I include a few videos, one from Lamb Weston that shows this process and another by QV Foods in England that better shows how potato crops are seeded, cultivated, and harvested.
What comes out of the videos is how highly mechanized and engineered the whole growing process is in order to remove as much randomness as possible.
The general information provided in this publication is not intended to be nor should it be treated as tax, legal, investment, accounting, or other professional advice. Before making any decision or taking any action, you should consult a qualified professional advisor who has been provided with all pertinent facts relevant to your particular situation.