We
held our fourth quarter investment strategy meeting on September 27. I titled
this commentary “Goldilocks” because right now we have a set of conditions in
the financial markets that are positive for stocks….not too hot, not to cold,
but just about right: stable economic growth, growing corporate profits,
expectations for continued low inflation, and still highly accommodative global
monetary policy. By implication, we believe this set of factors is supportive
of higher stock prices in the near term. That said, there are some concerns in
the overall picture such as above average valuations and geopolitical factors
(e.g. North Korea); but at the moment, we do not view these as serious enough
to offset the generally positive conditions for stocks.
One
factor on which we spent some time was the possibility of a policy mistake by
the Federal Reserve. The Fed has gotten itself into a difficult position having
reduced interest rates to a well below normal level; however, it did not
anticipate that inflation would remain as low as it has. This raises a question
of gauging how fast the Fed should raise rates: raising them either too fast or
too slowly both raise some problems for the economy and financial markets. We believe
the Fed is aware of these problems and we believe it will most likely pursue a gradualistic
policy that should not destabilize the financial markets. We expect the Fed to
raise the Fed funds rate in December and again in the spring of 2018.
We discussed the situation in North Korea and the broader issue of “black swan” events. The problem with geopolitical “black swan” events is that, by definition, they cannot be predicted and therefore hedging for a specific “black swan” event is virtually impossible. We did not take any hedging actions specifically related to North Korea but we did set a trigger which would require that in the event North Korea takes military action against another sovereign nation, we would reduce invested capital to its lowest allocation in our models. We also set a trigger in the event inflation goes higher than we expect: it is a “combination” trigger that would cause us to reduce investment exposure in the event that 1) inflation measured by “core” CPI rises above 3% and 2) the yield on the 10-year U.S. Treasury bond goes above 3%.
We discussed the situation in North Korea and the broader issue of “black swan” events. The problem with geopolitical “black swan” events is that, by definition, they cannot be predicted and therefore hedging for a specific “black swan” event is virtually impossible. We did not take any hedging actions specifically related to North Korea but we did set a trigger which would require that in the event North Korea takes military action against another sovereign nation, we would reduce invested capital to its lowest allocation in our models. We also set a trigger in the event inflation goes higher than we expect: it is a “combination” trigger that would cause us to reduce investment exposure in the event that 1) inflation measured by “core” CPI rises above 3% and 2) the yield on the 10-year U.S. Treasury bond goes above 3%.
With
respect to changes in our investment holdings, we continue to maintain a tilt
towards value stocks because we believe 1) valuations are high for “growth”
stocks and 2) value stocks tend to be do better in a rising interest rate
environment. We also maintain an overweight position in international equities
in part because of their lower valuations relative to U.S. stocks, particularly
Europe. Tilting our holdings toward value stocks also acts as a way of hedging
against potential market volatility as “value” stocks tend to be lower
volatility in nature due to their perceived stronger cash flows and higher
dividend payouts.
In
line with our tilt towards value stocks, we added positions in the health care and
financial sectors. Health care remains a very positive secular growth story and
financials should benefit from rising interest rates. Within fixed income, we
continue to underweight long bonds and overweight short maturities in order to
keep durations on the shorter end. In the long bond area, we added a position
in preferred stocks as a way of increasing income in this sector.
Bob
Toomey, CFA/CFP
Vice
President, Research
