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Thomas R. Kiley
Chief Executive Officer
Great Lakes Advisors

U.S. equities fared much better than most international markets in the third quarter. Trade tensions and the threat of U.S. tariffs pushed both emerging market equities and currencies lower; emerging markets lost about 1%, and are now off almost 10% for the full year. The Turkish market declined more than 21% in the quarter, and has been cut nearly in half in 2018 as the country continues to be plagued by both debt and currency problems. Greece has declined by almost 20% in the first nine months of the year, Brazil is off 17%, and Germany, Italy, and Spain are each down almost 10%. Lastly, the Chinese equity market has declined more than 7%, while its currency (the yuan) has lost 2.5% in value. The U.S. dollar has strengthened by more than 5% thus far against a basket of global currencies, making U.S. exports more expensive to much of the rest of the world. It is now clear that the synchronous global economic recovery has been interrupted, with the U.S. economy (at least for now) outpacing the rest of the world.

The broader U.S. equity market, represented by the S&P 500, hit an all-time high in September, and rose 7.7% for the quarter, putting its year-to-date gain at 10.6%. The Russell 1000 Value Index gained 5.7% in the quarter ending September 30, erasing its small first-half loss, and now stands 3.9% higher than year-end 2017. The small cap Russell 2000 Index gained 3.6% in the quarter ending September 30, extending its first half gains, and now stands 11.5% higher than year-end 2017.

Oil prices fell 12% to a low of $65/barrel in August, but bounced back to finish the quarter virtually unchanged at $73.25/bbl. The yield on the 10-year U.S. Treasury Note rose by 20 basis points to 3.05% at the end of the quarter, reflecting continued strong economic growth in the U.S., as well as consistent messaging from the Federal Reserve. As widely expected, the FOMC raised the Federal Funds rate to a target range of 2% to 2.25% on September 26, drawing criticism from the President in the process. Markets continue to price in one more 25 basis point increase in December, with the outlook for 2019 calling for one to three additional hikes.

We live in “extraordinary times.” So concluded Federal Reserve Chairman Jay Powell on October 2, addressing the 60th annual meeting of the National Association for Business Economics.

“I am glad to be able to stand here and say that the economy is strong, unemployment is near 50-year lows, and inflation is roughly at our 2 percent objective. The baseline outlook of forecasters inside and outside the Fed is for more of the same. This historically rare pairing of steady, low inflation and very low unemployment is testament to the fact that we remain in extraordinary times1.”

The value of the S&P 500 Stock Index has more than quadrupled since March, 2009, generating an 18.8% annual compound return for those investors brave enough to remain invested (or reinvest) at the end of the 2008-2009 financial crisis; its small cap counterpart, the Russell 2000, has compounded at almost 20%. Extraordinary times indeed.

Mr. Powell went on to say that the Fed’s “ongoing policy of gradual interest rate normalization reflects our efforts to balance the inevitable risks that come with extraordinary times…” (emphasis added). As stewards of our client’s capital, we constantly focus on protecting our portfolios from downside exposure. As such, there are two risks we have identified that merit discussion.

The first is trade tariffs. We are of the camp (as are a vast majority of economists2) that global free trade, while certainly disruptive and difficult at times, has made the world on balance a wealthier place. The Trump Administration’s position on global trade is at odds with conventional U.S. trade policy of the last several decades and threatens to disrupt the benefits of free and fair trade enjoyed by most countries and their citizens. While the administration’s recent agreements with Mexico and Canada, and on-again, off-again discussions with other trading partners, may lead some to conclude this disruption will be temporary, extended discord between the U.S., China, and our other trade partners could have a significant negative effect on the U.S. and global economies.

Recently, JPMorgan concluded that “there is no clear sign of mitigating confrontation between China and the U.S. in the near term,” and now expects we will see a “full-blown trade war” in 2019, resulting in U.S. tariffs of 25% on more than $500 billion of imports from China.3 Should JPMorgan’s forecast come to fruition, we are likely to see further weakening of the Chinese (and other emerging market) currency, a stronger U.S. dollar, and continuing downward pressure on global equity and credit markets as economic growth slows around the world in response to the imposition of these taxes. The longer-lasting impacts of such pressures are not factored into many investor’s corporate earnings expectations, in our opinion.

Our second concern is growing U.S. budget deficits, and the more than $1 trillion in U.S. Treasury annual debt issuance required to finance them. Recent tax cuts, while providing at least a small boost to U.S. economic growth, have led to White House forecasts of budget deficits exceeding $1 trillion starting next year and into the foreseeable future. The Congressional Budget Office estimates that in five years the United States may pay more in interest payments on its debt than it spends on military programs.

We will not fill this space with a litany of reasons why excessive government deficits might harm longer-term economic growth. Suffice to say that we believe we should be reducing debt, not growing it, during a period of “extraordinarily” good economic fortune. We are bewildered that the Trump Administration is using loose fiscal policy to stimulate the economy at the same time as the Federal Reserve is tightening monetary policy. We think it more prudent that the Treasury reduce government debt during times of prosperity, replenishing borrowing capacity for a time in the future when it might once again be needed to help restore economic prosperity. We may be witnessing a rise in longer term interest rates (the 10-year Treasury note yield hit 3.24% on October 5) in part because fixed-income investors are growing concerned with the huge slate of government borrowing coming in 2019.

Equity markets appear benign today, and most U.S. equity indices are at or near all-time highs. Investors are bullish on growth, and (as Mr. Powell noted) are embedding similar expectations in asset prices in the current environment. We would hope our style of investing—placing value on high returns on invested capital, prudent capital structures, abundant free cash flow, and goal congruence with management—would weather any economic dislocation relatively well. We find this approach to be both wise and attractive.



This commentary is provided courtesy of our affiliate, Great Lakes Advisors. This manager commentary represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. This information should not be relied upon by the reader as research or investment advice. No mention of particular securities should be construed as a recommendation or considered an offer to sell or a solicitation to buy any securities.