THE WINTER LETTER
Nature does not hurry, yet everything is accomplished.”
– Lao Tzu
Economic Perspective
Economic participants wrestle with what to make of the recent corporate tax cuts. Will they be squandered on stock buybacks and dividend increases or invested in capital goods? Have the cuts contributed to the exuberant stock market?
Twin curves, the yield curve and the Phillips curve, offer contradictory forecasts, on future economic prospects. An inverted yield curve, with short term interest rates exceeding long term rates, often foreshadows recession. Currently, the yield curve is flattening (possibly toward that inversion) with short term interest rates, driven higher by the Federal Reserve, approaching long term interest rate levels.
The Phillips Curve, made popular by neo-Keynesian economists in the 1960s, and only intermittently reliable since, illustrates a hypothetical trade-off between inflation and the unemployment rate. It postulates that in times of low unemployment wages, and by extension, inflation will rise. Conversely, inflation will be low during bouts of high unemployment. The current condition of low unemployment and low inflation challenges that thesis. And looks set to unravel.
The US factory utilization rate hit 85.5% at year end 2017, its highest level since 2005. Commodity prices are starting to feel the effects, yet oil remains over 40% below its 2011 peak. Durable goods orders advanced strongly in four of the last five months. The fourth quarter GDP number of 2.6% with its substantial drawdown of inventories left room for a better first quarter result. Secretary of Treasury Mnuchin talking down the US dollar has favorable trade implications but unfavorable inflation consequences.
Market Thoughts
The stock market, in 2017, rode the tailwind of global economic expansion. Most of the good news is already in the market. And the VIX, an index of volatility or riskiness of stocks is rising again after years of near comatose behavior. US Treasury 10 year yields recently pierced their cyclical high (set in 2014) suggesting that higher inflation and higher interest rates loom ahead.
In the long run, financial markets exist to facilitate the efficient allocation of capital. Short term they give market participants premature ulcers. The year opened with a rise in global stock prices. As January goes so goes the year; but history suggests that we may have witnessed the year’s entire net advance in US stock prices in this first month. Moreover, we will not be spared further intermittent volatility.
Geopolitical risks cloud the outlook. Populist demagoguing and anti-globalist sentiment stalks Europe. Austrian and Eastern European governments harbor anti-immigrant hardliners. Turkey’s President Erdogan invades Syria under the pretext of fighting Kurdish “terrorists”.
In an effort to navigate the treacherous market waters we emphasize sectors like: more resilient large cap names (Illinois Tool Works, Parker-Hannifin); the out-of-favor pharmaceuticals and biotech (Eli Lilly, Merck, Pfizer, Gilead, Celgene); entertainment (Liberty Media, Disney, Comcast); technology (Ansys, Microsoft and Google), dividend plays like Prologis and ONEOK Inc.; and specialty manufacturing (Hexcel, Reliance Steel, and Wabtec).
Stephen K. Bache, CFA
Sources: Bloomberg Businessweek, The Economist, New York Times, The Wall Street Journal; Dennis C. Rasmussen, The Infidel and the Professor: David Hume, Adam Smith and the Friendship that Shaped Modern Thought
