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PGAM 1Q17 Investor Letter

Global stock markets extended their fourth quarter 2016 rally through the first quarter of 2017.  Evidence of an improving global economy and some reduction in political uncertainty provided the catalysts for higher share prices.  While the U.S. continued to lead global equity markets in the fourth quarter, this pattern showed the beginnings of a reversal in the first quarter of this year, with both developed and emerging equity markets outperforming the U.S.

Several surveys of the U.S. economy in recent weeks are supportive of a stronger rate of growth in coming months. These include the Business Roundtable measure of CEO optimism, consumer confidence levels as reflected in a survey by Bloomberg and the Conference Board, and small business optimism emanating from the National Federation of Independent Business. The outlook for U.S. corporate earnings is also favorable with the consensus for a 9% year-on-year increase for the first quarter of 2017.

Uncertainty remains over the future for initiatives proposed by the Trump Administration and the Republican majorities in both houses of Congress.  Concern has been reinforced following the withdrawal from Congress of a bill which would have repealed and replaced important aspects of the Affordable Care Act. However, we remain optimistic over prospects for several other key parts of the Trump and Republican agenda, namely, tax reform in the corporate sector, regulatory reform, and a large infrastructure spending program. Timing of passage remains uncertain and a risk to near-term stock market performance, but Republican controlled houses of Congress are motivated. Failure to enact legislation in these areas would have a major negative impact on prospects in the 2018 elections.

Also positive is evidence that the Trump Administration is softening its stance on trade, lessening the probability of a destructive trade war.  The two executive orders signed on March 31 merely order a 90-day study of abusive trade practices and a directive aimed at increasing the collection of duties from countries that American officials believe are selling products in the U.S. below their cost of production. President Trump also appears to be backing away from a threat to walk away from NAFTA, now focusing on efforts to improve the agreement through renegotiation. A more measured approach to global trade would remove a major negative from the global economic outlook.

While prospects for the U.S. remain favorable on balance, we are becoming more optimistic over the outlook for non-U.S. equities and we are focusing on opportunities to add European equities in our investment strategies. Politics plays an important part in our favorable outlook. Election results in the Netherlands on March 20 reflected the success of the centrist Prime Minister Rutte in turning back the far-right populist party.  Next up are the French elections on April 23 and May 7, where the odds favor the centrist Macron over the right wing LePen. In German elections scheduled for September 24. The choice will be between the parties of Angela Merkel and Martin Schulz, both centrist. If election results in these countries proceed as expected, the risk to the Euro and European Union are greatly diminished while the exit of the UK from the EU should not impact the unity of the rest of the EU.

Economic prospects for Europe also appear to be improving. Per UBS, earnings per share growth for European companies should be the best in 6 years supported by commodity price stabilization, normalizing inflation, and recovery in emerging market product demand.  At the same time, the below graph shows that European equities have underperformed the U.S. by 60% since 2007:

While this underperformance reflects a lag for European earnings vs. the U.S. over the same period, European equity valuations also trade at a wide discount to U.S. equities. The combination of attractive valuations and improving earnings growth creates attractive opportunities in European equities. At the end of this letter, we have also included a “quilt chart” of asset class returns (apologies for the eye exam!) which shows that non-U.S. equities have undergone a prolonged period of underperformance—the last year that international equities outperformed all categories of U.S. equities being 2006.  A shift in relative performance seems overdue, and we believe that fundamentals will be supportive of international equity outperformance for 2017 as a whole, as has taken place in the first quarter.

Overall, our equity strategy remains similar to that expressed in our previous letter with the focus in increasing representation in European equities. Given the potential for improving global economic growth we remain overweight in sectors which benefit from a more favorable economic environment and higher probability initiatives of the Trump administration. Currently, these include Financials and Technology. Energy also remains attractive as the recent increase in U.S. oil inventories should reverse due to the supply response from OPEC and international producers while demand benefits from improved global economic prospects.

As always, we will communicate future changes in strategy on a timely basis.

Fixed Income:
Yields on U.S. Treasuries continued to rise during the first quarter of 2017 through mid-March, extending the uptrend which commenced in the middle of last year.  Following the increase in short term rates initiated by the Federal Reserve Open Market Committee in March, yields retraced much if not all the increases since the end of 2016, ending the quarter virtually unchanged for the first quarter of 2017.  The yield on two year Treasuries ended March at 1.3% vs. 1.2% at year-end after rising to 1.4% in mid-March.  The yield on the ten-year Treasury ended the quarter at 2.4%, unchanged from year end and below the mid-March level of 2.6%.  Yields on 10 year German and Japanese bonds remained in positive territory, at 0.2% for German obligations and 0.1% for Japanese bonds as of March 31, 2017.

We expect the Federal Reserve Open Market Committee to increase short term rates at least several more times this year in recognition of gradually rising wages and overall inflation as well as evidence of improving economic conditions in the U.S.  These increases should result in a resumption of the uptrend in intermediate and longer term U.S.  rates which commenced in mid-2016.  In view of this outlook, our strategy remains focused on maintaining shorter-than-average maturities in our taxable and tax-exempt portfolios. When making new purchases, we continue to focus on corporate obligations with attractive reward/risk characteristics.


Princeton Global Asset Management LLC

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