Global investors may be more than a little unsettled after October’s equity market sell off. U.S. equities dropped 7-10%, international markets declined even further, and bond prices sagged as interest rates rose.

It is easier to explain why something happened after it occurs. As in the past, we had identified key risks to the “forecast” earlier this year, but did not counsel our clients to make meaningful changes to their asset allocation or investment portfolios. Likewise, while I briefly discuss our near term outlook below, my belief that investors must take a long term (7-10 year) view is unchanged, and in that context we advise investors to do two things: (1) make sure your asset allocation is sensible relative to your financial needs, rebalancing if necessary; and (2) otherwise stay the course.

Equity markets are a discounting machine; they reflect global investors’ collective beliefs relating to corporate profits and cash flows, as well as future interest rates. While there are far too many short-term speculators who gamble in stocks, these two factors alone determine the value of a business, and hence its share price, for the long-term investor. The same is true of bonds—a bond is only worth the stream of expected cash flows it will generate over time, discounted at the appropriate rate of interest.

Developments in global economies over the last several months spooked investors in October. The Federal Reserve continued down its well-advertised path of raising short-term interest rates. The Fed will raise the Fed Funds rate again in December; we believe, to 2.25% - 2.50%. They are doing so to reduce the chances that economic growth, which has been quite strong, will produce excessive inflationary pressure in the U.S. economy. With the unemployment rate at 3.7%, we are beginning to see rising wages, which is good for consumers and households but can lead to rising inflation if allowed to grow too quickly for too long.

Interest rates are rising for several reasons; in our view, this is not only because of the Fed’s actions. Clearly, inflation expectations have risen in the last several months, driving longer-term interest rates higher. Just as important, tax revenues have declined with the reduction in the corporate tax rate-corporate tax receipts are more than 30% less than last year. The U.S. Treasury borrowed almost $1 trillion in the last 12 months and, according to the White House and the Congressional Budget Office, will have to do so for at least the next 5 years. Bond investors are likely growing somewhat concerned with that prospect, wondering what might happen if global fixed income investors do not have the voracious appetite for U.S. dollar denominated assets that they have exhibited for the last 10 years.

Businesses are beginning to report rising input costs, a result of growing demand, tariffs, and labor shortages in some industries. We heard many companies report higher costs for steel, aluminum, sugar, fuel and transportation in the third quarter. Many have, or will, increase final prices to consumers as a result. Corporate earnings in 2018 are quite healthy, growing at about 20% over last year as a result of solid economic growth in the U.S. and the Trump tax cut enacted last December. These earnings, if they persist, provide strong support for equity prices near current levels. However, tariff pressures, inflation fears, and concerns that consumer spending may tail off in 2019 may threaten an otherwise healthy outlook for corporate profits.

There are several important economic factors with which to be concerned. A discussion of geopolitical factors is beyond the scope of this note; suffice it to say there are many troubling issues around the world as well. Markets do not like uncertainty, and the uncertain outcome of midterm elections in the U.S. next week may weigh on short-term focused investors’ minds.

My greatest concerns for the next 12 to 18 months are (a) the potential negative impact of trade tariffs and (b) the potential disruptive impact of U.S. government borrowing. The Trump Administration’s tariffs, in my opinion, are ill conceived and potentially damaging to beneficial trade relationships built around the world over many decades. If they persist, they will result in higher costs to businesses and consumers, slower economic growth, and ultimately less robust corporate profits. Not positive for equity prices. Likewise, if the Treasury’s voracious appetite for borrowing results in higher interest rates, crowding out private borrowing and slowing growth, we may see pressure on both equity and bond prices. Higher rates resulting from solid economic growth can be absorbed without an impact on equity values; rising rates caused by chronic government deficits may not be so easily absorbed.

I am optimistic by nature, and believe our country and our economy are among the most flexible and resilient in the world. Absent aggressive, negative government interference, I believe many of our economic ills can be self-correcting over the longer term. There will be bumps along the way—October being a good example—but in time prudent and rational people understand we must balance our budgets, honor our commitments, and work intelligently within the global economy to increase the standard of living for all populations. It is in this context that we remain committed for the longer term to our investment philosophy and process, and encourage our clients to do the same.



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