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PGAM 2Q2018 Investor Letter

July 11, 2018

PGAM Second Quarter 2018 Investor Letter

During the second quarter of 2018, there was a divergence in the performance of global equity markets with the U.S. stock market renewing the outperformance which has prevailed during much of the previous decade. In the U.S., evidence of a strong economy outweighed concerns over the impact of protectionist trade policies and a less accommodative monetary policy by the Federal Reserve. Evidence of slower economic growth in Europe negatively impacted the performance of developed international stock markets. Weaker currencies for several emerging markets combined with a slowing Chinese economy to produce a decline in emerging markets during the second quarter. Following is a summary of performance for the various market indices for the second quarter of 2018 and for one, three, five, and ten years prior to June 30, 2018 – the S&P 500 has swept all time periods:

2Q 2018

YTD

1 Year

3 Year*

5 Year*

10 Year*

MSCI All-Country World Index

0.7%

-0.2%

11.3%

8.8%

10.0%

6.4%

Standard & Poor’s 500 Index (U.S.)

3.4%

2.6%

14.4%

11.9%

13.4%

10.2%

MSCI EAFE Index (Developed International)

-0.9%

-2.4%

7.4%

5.5%

7.0%

3.5%

MSCI Emerging Markets Index

-7.9%

-6.6%

8.5%

6.0%

5.4%

2.6%

*Annualized

The trend toward escalating trade tensions emanating from policies of the U.S. government continue to roil global equity markets, although overall volatility is less than the first quarter of 2018. During recent weeks, the U.S. has imposed tariffs on steel and aluminum on European and Canadian exports to the U.S. and $34 billion in tariffs on Chinese exports. There have also been threats to impose tariffs on an additional $200 billion in Chinese exports to the U.S., and tariffs of up to 25% on auto imports into the U.S. market. To date, China and Europe have announced retaliatory actions which are designed to inflict harm on areas in the U.S., that support the President and the Republican party. Examples from Europe include higher tariffs on Harley Davidson motorcycles, with the company headquartered in Wisconsin and Kentucky bourbon, while the Chinese have imposed tariffs on soybeans.

The key question is, what is the end game of the Trump Administration’s trade policies? Presumably, the goal is to induce U.S. trading partners to engage in negotiations which ultimately lead to reduced, rather than increased barriers to trade. As of this writing, the U.S. stock market seems to agree with the scenario of a favorable outcome to trade disputes, with reactions to individual announcements being short lived. U.S. equity prices seem more focused upon expectations that the U.S. economy will remain strong, reflecting the positive impact of favorable sentiment among corporations, high consumer confidence led by a tight labor market, tax reform, particularly in the corporate sector, and increasingly simulative fiscal policy reflected in a growing Federal budget deficit.

In truth, the U.S. has legitimate grievances with a number of foreign trade practices. The most key area of dispute is with China, where U.S. intellectual property is threatened, and the country has erected formidable non-tariff barriers. Other examples of restrictive trade practices are tariffs on auto imports into Europe and highly protectionist policies by Canada in favor of its dairy industry. However, we believe tariffs are not the best way to deal with these issues as they are simply a tax on consumers. U.S. trade deficits reflect the propensity of American consumers to spend rather than save. The trade deficits are balanced by a capital account surplus which provides the necessary capital inflows to fund investment in the U.S. as well as our growing Federal budget deficit. Carried to an extreme, a trade war would have a negative impact on U.S. economic growth and employment. The most important change in the global economy in recent decades is the development of global supply chains or the “second derivative” impact. A good example of this trend exists in the auto industry. U.S. car companies are heavily dependent on imported parts. Tariffs would result in a significant increase in the price of autos assembled in the U.S., which include products of non-U.S. companies such as BMW, Mercedes, and Toyota, negatively impacting demand and resulting in the loss of jobs domestically. We continue to agree with the current stock market assessment that the end-game for the trade tensions will not derail the U.S. economy’s strength.

Global growth decelerated from high levels in the 2nd quarter measured by the manufacturing Purchasing Managers’ Index (PMI), but remains healthy except a handful of emerging market countries (green is good!):

 

*Source: Wolfe Research Portfolio Strategy, Markit, Bloomberg

Outside the U.S., it appears that the slowdown in GDP growth in Europe in the first quarter was temporary and that growth, led by Germany, should be more robust in upcoming quarters. Japan continues to do well, exhibiting evidence of finally exiting the deflationary drag that has prevailed for decades.  The attempts to deleverage the Chinese economy has led to some slowing this year, but there is recent evidence that the government is attempting to offset the deleveraging to stabilize the rate of growth.  A return to synchronized economic growth globally should have a positive impact on emerging markets after recent volatility.

Equity Strategy:

Given our overall positive assessment of global economic conditions and our expectation that an all-out trade war will not develop, our investment approach in our two equity strategies has not materially changed.  In both we remain favorably disposed toward economically sensitive areas, including Financials, Energy, and Industrials while maintaining a significant weight in Technology.  We continue to expect interest rates in the intermediate and longer-term sectors to rise in response to rising short term rates, justifying a continuing underweight in high yielding sectors such as Utilities, Telecommunications & REITs. However, we remain cognizant of the lengthy duration of the current business cycle and the potential for trade and political risks to escalate.

In our Global Equity strategies, we have increased our U.S. exposure this year driven by “bottom-up” selection of stocks we perceive as reasonably valued, high-quality with sustainable growth over the next several years. U.S. stock market performance in the first half of 2018 was very narrowly driven by a handful of mega-cap Technology and eCommerce stocks. The Technology sector and Amazon & Netflix account for about 150% of the 2.6% S&P return, as seen in the Bloomberg chart below:

The magnitude of this outperformance has led traditional Value managers to purchase “growthier” stocks in their portfolios (please ask us for the 6/4/18 Wall Street Journal article), which we view as contrarian indicator for sustained Growth stock performance over Value. We will not chase growth and momentum, but we will continue to have an agnostic view of styles as we build diversified portfolios.

 

In Global Equity, we maintain the position in emerging markets (EM) which we increased previously. We underestimated the currency volatility experienced in the first half of this year and its impact on EM asset prices, but we continue to believe there is room for strong long-term relative performance driven by earnings growth and multiple expansion that better reflects the higher value technology and services mix of EM companies.  We reduced our exposure to international developed markets in late 2017 and early 2018 (especially Europe), but we are again seeing valuation opportunities that could emerge if our positive assessment of global economic growth is correct.

In our Dividend Growth strategy, we prefer stocks of companies that benefit from the healthy U.S. economic backdrop and that are immune to inflation risks. This includes our increased commitment to the Energy sector and select mid-cap Consumer and Industrial companies that show prospects for share price appreciation and 10%+ dividend growth over the next several years. The Dividend Growth strategy underperformed the S&P 500 in the first half of 2018 due to the narrow leadership of mega-cap Technology stocks explained earlier, but outperformed high dividend stock indices – we remain confident in the strategy in the current environment. High dividend yielding stocks’ performance is likely to remain challenged as interest rates are expected to rise. However, dividend growth stocks have historically performed much better during rising rate environments and have even outperformed the market over the last 30 years (see the green circle):

 

Fixed Income Strategy:

At its June meeting, the Federal Open Market Committee instituted a further 25 basis point increase in the Federal Funds rate from 1.75% to 2.00%.  As reflected in follow-up commentary, an additional two 25 basis point increases in Federal Funds are likely during the second half of 2018, with further increases in 2019 to a so-called neutral rate of 3.0%. The 25-basis point increase was reflected in an increase in intermediate and longer-term rates in the U.S., although the increase was more noticeable in the shorter end of the maturity range.  Yields on two-year Treasuries rose from 2.27% to 2.58% during the second quarter, while the yield on five-year Treasuries rose from 2.56% to 2.74% and on ten-year from 2.74% to 2.86%, Yields on ten-year German bonds increased from 0.30% to 0.49% during the second quarter, while Japanese ten-year government rates remained close to zero.

The financial press seems fixated on the reduced differential in U.S. interest rates between two-year and ten-year treasury maturities as an indicator the U.S. economy will head into a recession.  We do not agree with this assessment and believe a flatter yield curve is not predictive of recessions, and only an inverted yield curve would be predictive of a U.S. recession within the next two years. Research from the Federal Reserve Bank of San Francisco supports recessions are preceded by an inversion of the yield curve, calculated as the difference between ten-year and one-year Treasury yields:

We expect that intermediate and longer-term rates will follow additional increases in Federal Funds and that the differential will remain positive. Fed Presidents are also looking to avoid an inverted yield curve situation and will consider the risk of an inverted curve with future Federal Funds rate hikes. With this outlook we continue to pursue a strategy of maintaining shorter than average durations in our taxable and tax-exempt portfolios. In the taxable sector, especially in shorter maturities, the differential between Treasuries and corporate credit spreads has narrowed to the point where we are beginning to favor Treasuries in the establishment of new positions.

 

Sincerely,

 

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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