Category Archives: Client Letters

Q3 2018 Letter

October 2018

In the early 1980’s 30-year U.S. Treasuries were yielding more than 15%, inflation was running north of 13%, and the economy was sputtering at best with back-to-back recessions in 1980 and ’81. Sentiment was dour. Stocks were cheap, trading at less than 10 times normalized earnings or 40% below their long-term average multiple. Newly appointed Fed Chairman Paul Volker nearly doubled the federal funds rate from 11.2% in 1979 to 20% by the middle of 1981. He is widely credited for subduing inflation and laying the groundwork for what would later become known as the great moderation. It was impossible to know at the time, but looking back, the early 80s would turn out to be an important inflection point. For the next 35 years, long-term interest rates would grind inexorably lower, not in a straight line of course, but continuously marking a series of lower highs and lower lows. By 2016 the yield on 30-year treasuries hit an all-time low of 2.1% and the fed funds rate was barely above zero. This 35-year trend of falling interest rates has been a key component of this era of market history. It has been very supportive of risk assets.

The path of long-term interest rates is something we and others have been watching very closely. For the last year and a half, 30-year treasury yields have been bouncing around in a sideways trading range just under 3%. That is until just recently. Earlier this month yields broke above 3.25% for the first time in four years. This looks like a significant development that could be signaling a major shift. It is impossible to know in real time, of course, but looking back, this may be an important inflection point. If the path of long-term interest rates is now up rather than down or sideways, it could have profound implications for risk assets going forward.

In many ways today’s environment is the opposite of what we saw in the early 1980s. Interest rates, growth, and inflation have all been stubbornly low. Economic news has been mostly positive. Sentiment is upbeat. Credit is plentiful. By some measures, stocks have enjoyed the longest bull market expansion in history. Households’ equity investments as a percent of total assets is now higher than it has ever been except during a short period leading up to the peak of the technology bubble in 2000. Many have argued this is all reasonable considering low inflation and low interest rates. But if the trend of inflation and interest rates has shifted, the argument may no longer hold sway.

Q3 Letter 18

Concerns over inflation and interest rates are growing based on several factors. First, a tight labor market puts upward pressure on wages and downward pressure on corporate profit margins. The unemployment rate recently fell to 3.7%, the lowest rate since 1969. Job growth has now been positive for 96 straight months, further extending the longest continuous jobs expansion in history. Amazon recently announced it would raise its entry level wage to $15 an hour and lobby for a similar increase to the federal minimum wage, currently $7.25 an hour. The announcement follows Walmart’s earlier move to raise its entry level wage to $11 an hour.  Average hourly earnings are growing at 2.8% and it would not be surprising to see wage growth accelerate from here, potentially raising inflation expectations and encouraging the Fed to quicken the pace of rate hikes.

Trade tariffs are another area of concern. Tariffs are ultimately a tax increase on domestic consumers and tend to put upward pressure on prices and downward pressure on corporate profit margins. There remains a considerable amount of uncertainty around the future path of U.S. trade policy and its effect on future growth and inflation.

One final area of concern involves the expanding federal budget deficit. Nearly 10 years into the economic expansion the U.S. is engaging in a level of deficit spending that is normally associated with counteracting a recession or high unemployment. The current deficit is approx. 3.7% of GDP vs. a long-term average of 2.9% going back to 1970. The Congressional Budget Office expects this number to grow to 4.9% in the next couple of years and potentially much higher if a recession arrives. More bonds must be issued to finance this additional deficit spending, increasing the supply of treasuries available in the market. At the same time, the Federal Reserve is contracting its balance sheet at a rate of $50 billion per month which reduces the demand for treasuries. It would not be surprising for this increased supply and reduced demand to put upward pressure on interest rates. There could be a self-reinforcing component to this phenomenon as increased rates lead to higher interest expense on the debt, which then leads to additional deficit spending to cover the higher interest expense, and so on.

What does all this mean for investors? If this is indeed a durable shift in trend for inflation and interest rates, then the next ten-year period is not likely to resemble the last ten-year period in many key respects. The returns on risk assets are likely to be somewhat lower than their long-term averages. Volatility is likely to be somewhat higher than it has been recently. Bonds may not offer the same diversification benefit as they have in the recent past, especially long-term bonds.  Active management may be more attractive relative to passive exposure than it has been in recent years.

No matter how events unfold we will maintain our focus on long-term strategic thinking, careful cash flow planning, being vigilant about taxes, fees, and expenses, and identifying opportunities in the less efficient and less correlated private markets. These are the areas where we can add value no matter what the direction of interest rates turns out to be.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.  We are grateful for the opportunity to work with you and your family.

Nicholas Hoffman & Co. 

Q2 2018 Letter

July 2018

Markets in 2018 have brought contrast to the prior year. 2017 was a trek “up and to the right” for most financial markets. Except for some drama in the energy sector, most asset classes enjoyed relatively smooth and strong performance. Domestic large cap and small cap equities, international equities, emerging market equities, and even precious metals were all up double digits in 2017. This year, we have seen more dispersion among asset classes and the drama has been more widespread. On the positive side, the S&P 500 is up 2.6% year to date, the Russell 2000 index is up 7.7%, and the tech heavy Nasdaq index is up more than 11% for the year. On the negative side, developed international stocks are down -2.7% year to date and emerging market equities are down -6.7% on the year.

Drilling down further, we have seen several other trends and themes worth noting. High priced stocks (as measured by their price to earnings ratio) have outperformed low priced stocks by a wide margin. Stocks that pay no or low dividends have done much better than stocks that pay high dividends. And growth oriented names have substantially outperformed their value oriented counterparts. All this has taken place against a backdrop of increased volatility since late January.

There are several factors at play here. One we hear about frequently is trade policy uncertainty. Long term investors do not like uncertainty in the markets, particularly when it involves the possibility of an all-out trade war. Big multinational firms have built far-reaching supply chains that help drive down costs and increase efficiency. These global supply chains rely on the free flow of goods and services across borders and around the world. Escalating trade skirmishes threaten to disrupt these supply chains, introducing additional costs, delays, and uncertainty. It’s not good for sales growth, it’s not good for profit margins, and it’s not good for business. Trade policy uncertainty has had a greater impact on emerging markets where global supply chains often originate. All things being equal, greater clarity on trade policy would be supportive of equities in general and emerging market equities in particular.

The future path of inflation and interest rates is another source of uncertainty in markets. In the old days, it was fashionable to think that low unemployment led to tight labor markets and rising wages as companies had to compete for increasingly scarce labor. Rising wages increase costs and cut into profit margins, putting pressure on companies to raise their prices and pass along the added cost to their customers. In recent times it hasn’t worked that way. Unemployment has been as low as 3.8% recently vs. its 50-year average of 6.2% while wage growth has been stubbornly low at 2.8% vs. its 50-year average of 4.1%. The last time unemployment was lower was in 1969 during the Vietnam draft. Unemployment rates and wage growth have never been this low at the same time. What’s more, the Labor Department recently reported there were more job openings than job seekers. At some point we would expect to see upward pressure on wages and inflation. If wage growth breaks out to the upside, it would put pressure on the Fed to raise rates more aggressively to keep inflation in check. That could be a headwind for equities here and abroad. The most recent unemployment report showed more workers entering the labor pool and continued sluggish wage growth, easing concerns for now.

One of the themes contributing to 2017’s smooth and strong performance was the idea, “There Is No Alternative” to equities, or “TINA”. Cash and short-term investments were yielding next to nothing coming into 2017. The Fed was just beginning to raise rates after several years of holding rates near zero. The Fed raised rates three times in 2017 and twice more earlier this year. Expectations are for two more hikes in the remainder of this year. Due to Fed tightening, one-year Treasuries are now yielding more than 2.3%. That’s

higher than the 1.9% dividend yield on the S&P 500 with no credit risk and very little interest rate risk. Many investors are seeing an alternative to equities now that short-term rates are rising. We see evidence of this in Lipper’s weekly fund flow report. Over the past several weeks, money has been flowing out of equity funds and flowing into bond funds. This is a big reversal from recent trends. We too have been very active in helping clients maximize the return on short-term investments. It’s nice to see some yield on cash for a change.

Despite present uncertainties, the outlook for economic growth remains strong. The Atlanta Fed’s GDPNow indicator is suggesting GDP growth slightly above 4% for the second quarter. The Conference Board regularly reports on leading and coincident economic indicators. These indicators are signaling continued economic growth with little threat of recession on the immediate horizon, and small businesses are feeling confident about the future. NFIB’s Small Business Optimism Index is at the second highest reading in their 45-year history and a record number of respondents are reporting plans to increase compensation and expand operations.

Bespoke q218 pic

Source: Bespoke Investment Group

No one knows what the future holds. Markets have always moved forward in fits and starts. As Yogi Berra once said, it’s tough to make predictions, especially about the future. We will remain focused on areas where we have some control and in ways that can add value: long-term strategic thinking, careful cash flow planning, being vigilant about taxes and fees, rebalancing away from assets that have grown expensive in favor of assets that have become relatively cheap, and searching for attractive opportunities in the less efficient and less correlated private markets.

As always, we welcome your thoughts, and appreciate the confidence you have placed in our firm.  We are grateful for the opportunity to work with you and your family.

Nicholas Hoffman & Co.