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PGAM 2Q17 Investor Letter

The rally in global equity prices continued through the second quarter of 2017.  Accommodative monetary policy and resultant ample liquidity was the primary force behind the continuing advance in share prices.  Improving economic conditions, particularly outside the U.S. also were a catalyst behind higher equity prices.  International equity markets outperformed the U.S. for the second consecutive quarter.

Despite dialogue to the contrary, central bank monetary policy remains accommodative.  The Federal Reserve is the furthest along in raising interest rates, but the current 1% Federal Funds level is not sufficiently high to be a headwind for economic growth.  In the statement which accompanied the latest rise in short term rates on June 14th, the Federal Open Market Committee outlined a plan for slowly reversing the quantitative easing of recent years but the meeting notes which were released on July 5 indicated that there was disagreement over when to start the unwinding.  As indicated in the notes, “Several preferred to announce a start to the process within a couple of months.  Some others emphasized that deferring the decision until later in the year would permit additional time to assess the outlook for economic activity and inflation.” Mario Draghi, President of the European Central Bank discussed the eventual tightening of monetary policy by the European Central Bank but emphasized that any such action was a long way off.    At a minimum, short term rates need to move above the underlying rate of inflation before monetary policy will begin to tighten and the central banks seem a long way away from reaching that level, even in the U.S.

The political background also remains supportive for global equities.  In the U.S., the governing Republican party is under pressure to deliver on their campaign promises or face the consequences in the 2018 midterm elections.  A reduction in regulations is ongoing.  While the future of healthcare legislation is uncertain, some form of tax reform, particularly in the corporate sector still seems likely, along with spending on infrastructure.  These initiatives would be positive for U.S. equities.  In Europe, the election of Macron in France as President with an accompanying legislative majority should pave the way for long needed economic reforms, starting with labor markets.  In the U.K., the failure of the Conservatives under Prime Minister Teresa May to attain a majority in the recent snap election increases the chances for a so-called “weak” British exit from the European Union.  This outcome could entail Britain’s remaining in the single market and customs union.

Another positive catalyst for share prices is the rise in corporate activism, particularly in Europe. Recent examples are Koninklijke Philips, Nestle and AkzoNobel.  According to a recent New York Times article, there is $121 billion in activist funds available for such investment on behalf of private investors, pension funds, and sovereign wealth funds. European companies, long ignoring shareholders will increasingly face the need to create value, either through return of capital, corporate restructuring, and cost cutting. This trend will combine with attractive valuations and improving earnings growth to enhance the appeal of equities in general and European stocks.

Energy prices have remained an underlying concern for global markets.  As measured by the spot price for West Texas Intermediate oil, the price declined from $56 per barrel at the beginning of 2017 to $46 at the end of the quarter. The OPEC agreement to cut production and drain global inventories was partially undone by the rebound in U.S. production, increases in output in Libya and Nigeria, and surprising resilient offshore production.  Regarding global markets, we do not believe lower oil prices are a leading indicator for stocks:

Also, we do not foresee a substantial further decline in crude oil prices.   In the U.S. we have seen the beginnings of a plateau in oil production in recent weeks and the Baker Hughes rig count for the week of June 30th showed the first decline in US oil rigs since January.  Within OPEC, the announcement of a new crown prince in Saudi Arabia, 31-year-old Prince Mohammed bin Salman, will reinforce efforts to restructure the Saudi economy to reduce dependence on crude oil.  With less of an interest in maintaining market share and an increased emphasis on the level of crude oil prices, a further cut in Saudi oil production is likely to be implemented if necessary to prevent a significant further decline in oil prices.  Oil also serves as a hedge against geopolitical unrest as we evaluate tensions in North Korea and Qatar.

With this outlook in mind, we are retaining our weighting in Energy shares with a focus on companies that have healthy balance sheets and can generate positive free cash flow in a lower oil price environment.  We retain a focus on the Financials sector with an improving regulatory environment and the likelihood of a rise in longer term interest rates.  We also expect sectors capable of maintaining above average rates of earnings growth to perform well, justifying significant commitments to Technology and Health Care, which also trade below their 20-yr average P/E multiples.  We remain more cautious on the Consumer sectors, especially those exposed to U.S. auto and retail spending, as U.S. household debt has risen to all-time highs due to growth of auto loan and student loan balances:

Fixed Income:
U.S. Treasury yields fluctuated during the second quarter, declining much of the time before rebounding late in the quarter.  By the end of June, 2 year Treasuries yielded 1.4% compared to 1.2% as of March 31.  The yield on 10 year Treasuries ended June at 2.3% compared to 2.4% and the end of March.  The yield on 10 year German bonds was 0.5% at the end of June vs. 0.2% on March 31, while the yield on 10 year Japanese bonds was unchanged at 0.1`% during the three months ended June 30.

After the increase in short term rates in June, The Federal Open Market Committee is likely to pause before increasing rates again, most likely waiting until December.  We continue to believe that the trend is higher for longer term rates as a tight labor market will inevitably lead to an acceleration in wages. In view of this expectation, we continue to focus on maintaining shorter than average durations in our taxable and tax-exempt portfolios to have liquidity with which to take advantage of higher rates.

Princeton Global Asset Management LLC

Important Disclosures:
This report is for informational purposes only, and contains data based on information Princeton Global Asset Management (PGAM) believed to be accurate.  However, PGAM cannot assure the accuracy of the data. Past performance is not a guarantee of future results. Portfolio holdings and characteristics are subject to change. The information in this report should not be considered a recommendation to purchase or sell any particular security. It should not be assumed that any of these securities transactions or holdings that may be cited were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of securities cited.

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