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PGAM 3Q17 Investor Letter

Global equity markets extended their 2017 rally through the third quarter. The factors that led to higher share prices earlier in the year continued through the end of September. These included synchronized global economic growth, accommodative monetary policy and low interest rates, and strong growth in corporate earnings. Below is a summary of global stock market performance on a total return basis over various time periods. The results for the three, five, and ten-year periods are annualized. The U.S. remains the best performing stock market over longer durations, but leadership has recently shifted to International markets:

The OECD says global expansion is synchronized and stronger:

In the U.S., the specifics of a proposal to reform the corporate and investment tax systems and the naming of a new Chair for the Federal Reserve Board will have important investment implications going forward. The tax proposal outlined during the week of September 25th is merely an outline with the details to be worked out by Congress. Given the need for the Republican controlled Senate and House of Representatives to achieve some legislative success prior to the 2018 midterm elections, the probability is good that some form of tax legislation will be enacted. As Warren Buffett recently stated, “Any politician who can’t pass a tax cut is probably in the wrong line of business”.

The biggest potential for economic impact is on the corporate side. A reduction in the corporate tax rate below the current 35% level will enhance the profitability of US companies with high domestic percentages of revenues and high corporate tax rates including Banks, Energy, Insurance, and Retailing. Providing an incentive for companies to bring back cash stranded abroad should be shareholder friendly, although the direct economic impact will depend on the proportion of funds spent on direct investment. Allowing companies to expense capital investment would have a more direct impact on the economy as such a provision should have a positive impact on capital investment.

Stocks with high tax rates set to benefit the most from tax reform performed well in September, but remain well below their post-election relative performance highs:

On the individual side, the impact on the U.S. economy is less clear. Lower marginal rates on the upper income earners could be offset by a limiting of deductions such those on state and local income taxes or a decreased cap on the overall level of deductions. The current proposal calls for a raising of the lowest rate from 10% to 12% which might not be completely offset by the proposal to double the standard deduction. Consumer confidence is already well above long-term averages and consumer spending is unlikely to be materially impacted by individual tax reform.

The naming of a new Chair of the Federal Reserve Board, which might result in the reappointment of the current Chair, Janet Yellen could have major implications for monetary policy going forward. The current Chair has expressed her intention to undertake a gradual increase in short term interest rates and a slow unwinding of the quantitative easing which commenced several years ago. A major shift in Fed leadership to a more “hawkish” Chair (e.g. Kevin Warsh) and tighter monetary policy could cause a slower rate of growth in the U.S. economy and lead to pressure on stock valuations. We will monitor the developments in monetary policy closely.

The recent election in Germany and the upcoming election in Japan on October 22nd also could have investment implications. The position of the German Chancellor, Angela Merkel, has been weakened by the election which reduced the number of representatives in the German parliament for her party. While Germany will remain the leader of the European Union, its ability to influence policy and encourage a move toward increased integration could be reduced, resulting in slower economic growth than would otherwise be the case. Similarly, in Japan a weakening of the position of Prime Minister Abe could have an adverse impact on business confidence, currently at a ten-year high and weaken the ability of the government to pursue stimulatory measures resulting in stronger economic growth and improved corporate earnings.

We continue to view the global economic background in a favorable light. However, after 1) strong year-to-date stock market returns with 2) historically low volatility in the 3) 100th month of the U.S. business expansion while the 4) U.S. unemployment rate is below 4.5%, our greatest concern is there are too few indicators for investors to be bearish. We believe portfolio risk management and stock selection will become more important over the next several years than broad equity exposure. We are focused on:

  • Reasonably priced secular winners and compounders within the Technology and Healthcare sectors where stock price appreciation should follow earnings growth.
  • Opportunistic cyclicals that are temporarily out of favor and will benefit from catalysts such as tax reform or shifts to more shareholder friendly actions. These include Energy, Financial & Industrial companies.
  • International companies where despite year-to-date outperformance, valuations are relatively attractive and regional business expansion is less mature than the U.S.

Fixed Income:
Yields in the U. S. ended the third quarter little changed from levels which prevailed on June 30. The yield on 2-year Treasuries was 1.5% as of September 30 versus 1.4% at the end of June. 10-year Treasury yields were 2.3% both at the end of September and June 30. Outside the U.S., the yield on 10-year German bonds were at 0.4% at the ends of September and June while 10-year Japanese bonds yielded less than 0.1% as of both June 30 and September 30.

As indicated previously, the Federal Reserve will be moving toward a less accommodative monetary policy over the next several years. The pace of the tightening will depend on whether the current Chair is reappointed or a new Chair is named. It is likely that a change would result in a faster pace of withdrawing accommodation that would be the case under Yellen. Regardless, the trend in interest rates is likely to be higher, leading us to maintain shorter than average durations in our taxable and tax-exempt portfolios.

Princeton Global Asset Management LLC

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