Performance Discussion and Strategy
The S&P 500 continued to rise and is now up 11% since the election. Meanwhile, the bond market stabilized in the quarter following a rough fourth quarter. After the strong tailwinds our style received in the second half of 2016, a more nuanced environment in the quarter was not unexpected. Oil prices dropped 6 percent in the quarter causing energy to be the weakest sector in our index. Given our overweight this was a drag on performance. Our energy stock selection was a non factor.
Bond proxies slightly outperformed in the quarter after their underperformance late last year. This dramatically underweighted group still sells at a relative p/e premium over non bond proxies that is 36% above the long term relationship and is extremely expensive in our view. On the positive side, our stock selection in technology was strong.
Outlook
Economic developments have played out largely as expected during the quarter. The outlook has improved as a result of the strong post election rise in small business optimism (highest since 2004). The ISM Purchasing Manager index rose, particularly the new order component, a leading indicator, which bodes well for the second half of the year. Regional Federal Reserve surveys show the highest level of capital spending intentions in 10 years.
Reductions in regulations have begun. The Mercatus Institute believes the cost of regulation is 80 basis points of GDP growth per year. Even if they are overestimating this number, reduced regulations should meaningfully enhance growth. Consumer confidence is also rising, reaching the highest level since 2000. Discouraged workers are reentering the workforce. In particular, income gains by low end workers are accelerating increasing the overall workforce’s average hourly earnings index to 2.7%, up from a low of 1.5%. Potential reductions in corporate and/or individual tax rates would further accelerate economic growth.
We are still in the benign portion of the short rate cycle as the Fed is currently only normalizing rates as core PCE inflation approaches the 2% target. The peak of the forward Fed Funds curve, if correct, at 200 basis points, would imply roughly zero real rates and no inverted curve. It would take a realization of the Fed’s future dot plots at 300 basis points in 2019 to get a restrictive monetary policy in the medium term. Given the massive intervention in Japanese and ECB bond markets, the forward curve may not be as useful as in the past. Whether the bond market or the Fed, as currently composed, is correct will have implications for the duration of the recovery since it usually takes an inverted curve and high real rates to cause a recession.
All of these developments are particularly good for our banks. Rising short rates will boost Net Interest Margins. Lower tax rates, if not fully passed through to customers, will bolster earnings. Banks have been among the hardest hit by the explosion in regulations. Any reductions in costs will help.
While we have reduced our energy exposure, we believe recent worries about shale growth beyond 2017 are somewhat exaggerated. Production decline rates are cyclically low currently due to very little first year production following 2016’s depressed level of drilling. First year production has hyperbolic decline rates. As drilling accelerates, overall decline rates will also rise, thus increasing the “treadmill” for production. Also 2017 production growth is being accelerated by a one-time reduction in drilled but uncompleted wells. U. S. shale represents 5% of overall global production (U.S. overall is 10% total). The other 95% is largely either in a flat to declining forward growth profile, or in unstable locations subject to geopolitical disruptions.
