Letter - January 2018





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Passing the Baton

It has been almost ten years since the world economy experienced the Great Recession and the financial crisis of 2007-2008. For most of that time, US GDP has grown at a sub-par rate of 2%. This was despite the monetary stimulus of historically low interest rates provided by banks world-wide. The recovery has been durable but anemic according to the record books.

Since the election of Donald Trump, markets have anticipated a passing of the baton from monetary stimulus (low and even negative interest rates) to regulatory relief and fiscal stimulus by way of tax cuts. For the first time since the recession GDP registered in 2017 growth of 3% for two consecutive quarters. This was a huge increase from 2%, amounting to a 50% increase in economic growth.

World growth is also accelerating. The IMF has raised its estimate for 2018 to 3.7%. China refuses to blow up despite its high level of debt. Growth in Europe is increasing, Brexit aside. Even Brazil, entangled in incredible corruption, is growing again. Some of that increased activity feeds back into the US economy. For now the world economy is experiencing a virtuous cycle of growth. One could say that what could go right has gone right.

Corporations, workers and investors are delighted. Business looks for increasing profits and repatriated cash which they can plow back into capital expenditures and investment. This, it is anticipated, enhances the prospect for long-term growth. The unemployment rate at 4.1% makes workers feel more secure in their jobs, hopeful for rising wages, and has started to coax back into the workforce labor that had previously given up looking for work. Investors, ecstatic at the prospect of higher corporate earnings and dividends, have bid up the price of stocks to an extent which has caught just about everyone by surprise.

It was a remarkable year, 2017, in that nothing seemed to hold the stock market back. Geopolitical hot spots and risks such as North Korea, China, Russia and the Middle East were ignored by investors. The rumble room which is Washington barely registered. Frankly, we are puzzled and remain fearful of risks. As Donald Rumsfeld would say, it seems that investors only discount the known unknowns and not the unknown unknowns.

The stock market remains, by historical measures, highly valued. We note that it can remain richly valued for an extended period. In 1996, Alan Greenspan, then Fed chairman, spoke of high stock market valuations, calling them a case of "irrational exuberance." The market rallied for an additional four years. Nonetheless, we are cautious for the sake of prudence, maintaining a target cash position of 20%. Among our holdings we remain well positioned to reap the benefit of an expanding world economy, with investments in manufacturing, steel, energy, railroads, technology and gold mining stocks (a resurgence of inflation).

To-date, the Fed has been successful in shifting away from the monetary stimulus of low interest rates as the administration and Congress adopt the fiscal stimulus of tax cuts and proposed infrastructure spending So far so good, though the road ahead continues to be challenging. Will the Fed raise interest rates too quickly, causing a slowdown in growth, maybe causing a recession? Will the economy overheat as it reaches full employment, causing a spike in inflation? Will resurgent growth prove to be a short-term phenomenon, a sugar high fed by deficit spending? Do politics ever matter to the stock market?

Markets word-wide have been rising with investors exhibiting a calm complacency. There is no sign of recession. Pundits predict the market in 2018 will look a lot like 2017. There is even talk of a "melt-up" in prices, a final burst of euphoria. Could be, but we aren't inclined to bet the ranch.


Tom Herzig



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