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PGAM 3Q2018 Investor Letter
October 9, 2018

The divergence in performance of global equity markets persisted in the third quarter of 2018. As was the case in the second quarter, the U.S. equity market forged ahead in response to evidence of a strong economy and growth in corporate earnings. These positives continued to outweigh concerns over U.S. trade policy and the gradual shift of the Federal Reserve to a less accommodative monetary policy. On the other hand, emerging markets were adversely affected by the perception that protectionist trade policies by the U.S. would have a greater impact on the Chinese economy than the U.S. and the negative impact of a stronger U.S. dollar. Developed markets outside the U.S. exhibited modest gains reflecting evidence of positive, albeit modest economic growth in Europe and Japan. Following is a summary of performance of various equity market indices, which show a continued outperformance of the U.S. equity market over all time periods exhibited in the chart:

Recently there has been a change for the better in U.S. trade policies, reflecting a trend toward resolving problems with major allies and focusing upon China. On September 30, a deal was announced on trade between the U.S. and Canada which follows the achievement of an accord with Mexico reached in late August. The structure of NAFTA is retained with the agreement providing for more auto content being produced in North America, and the percentage of auto parts made in the U.S. rising from 62.5% to 75% and more cars having to be produced with higher cost labor. Canada loosened its restrictions on dairy products imported from the U.S. A separate trade deal was reached with South Korea and there is movement on trade negotiations with Europe on autos as well as Japan.

These developments leave the focus on U.S.-China trade relations where the problems seem increasingly intractable. These problems include threats to intellectual property and cyberthreats exemplified in a recent report that Chinese hackers implanted tiny chips in server circuit boards of 30 companies, including Amazon and Apple. Since the U.S. is running a $375 billion annualized trade deficit with China, the U.S. can more adversely impact the Chinese economy if it carries through in its threat to place 25% tariffs on all Chinese exports than vice versa. Other potential measures which China could take, including a devaluing of its currency or sale of U.S. Treasury securities would also hurt China. However, the Trump administration approach to U.S. -China trade does not take the history of Chinese relations with the West into account. China has not forgotten its perceived humiliation at the hands of the Western powers going back to the Opium Wars of the 19th century and this perception makes it extremely difficult for China to back down and accommodate legitimate U.S. grievances on trade.  Given this reality, the U.S. Chinese trade dispute is likely to be protracted with a negative impact on both economies including slower economic growth and higher inflation for the U.S.  It is estimated that tariffs on all goods would cost the U.S. GDP 0.3 percentage points compared to 0.9 percentage points for China before “second derivate” effects.

 

Outside of trade, the U.S. economy should continue to grow strongly at least through 2019 as consumer confidence remains high and the increase in short term interest rates by the Federal Reserve has been benign to date.  Inflation in the U.S. is beginning to pick up, particularly for wages due to a tight labor market. Anecdotal evidence of wage increases is provided by Amazon’s announcement on October 2 that it was raising the minimum wage paid to all U.S. workers to $15 an hour even as it ended bonuses and stock awards for hourly workers.  At some point short-term interest rates could reach a level which begins to impact the U.S. economy—the Federal Reserve estimates the so-called “neutral rate” for Federal Funds at 3.0% compared to the current rate of 2.00-2.25%. The risk that monetary policy becomes overly restrictive is unlikely to emerge for an extended period, however we are monitoring a few areas of concern where higher rates could have an adverse impact – including corporate debt (as share of GDP), which has risen back to new highs (red bars signal recessions):

Source: Bloomberg, MKM Partners

Outside of the U.S., the outlook for Japan has improved following the election of Abe to a new three-year term for the governorship of the Liberal Democratic Party and his continuation as prime minister. His success insures that pro-growth economic policies will continue in Japan. European economic growth appears to be gradually accelerating despite the uncertainty over BREXIT. China is likely to continue to pursue policies to offset slowing economic growth exacerbated by the trade dispute with the U.S. so that overall emerging market economic growth should not decelerate further. On balance prospects for global economic growth remain favorable, enhancing potential for higher share prices.

Equity Strategy

Our sector strategy remains consistent to previous quarters.  Economically sensitive areas, including Energy (see chart below), Industrials, and Financials remain attractive.  The classification of Technology has changed with the shifting of internet stocks such as Alphabet (GOOGL) to Communications Services, and our combined weighting in the two sectors remains significant.  With short term rates expected to continue to rise, we remain underweight in higher yielding sectors or “bond proxies” including Telecommunications, Utilities, and REIT’s. At this duration of the equity market cycle and the increasing risk of a choppy market, our investment committee has assembled a list of “Durable Growth Defensive” stocks that we believe should perform well regardless of market conditions. We are also highly scrutinizing or avoiding companies with leveraged balance sheets.

Crude oil prices have risen to multi-year highs, but the relative performance of energy stocks has lagged considerably (show in % gain over trailing 12 months). We see opportunity in oil producers:

Source: Bloomberg. Brent Oil Price % change in orange, Energy Select Sector SPDR ETF % change in white

In our Global Equity Strategy, we are overweight the U.S. to the All World benchmark which has benefitted year-to-date performance, but we recognize the divergence in performance between the U.S. and international equity markets and are looking for attractive buying opportunities outside the U.S.  Japan appears particularly interesting as a focus of new buying – the Japanese stock market, as measured by the Nikkei Stock Average is close to a 27-year high while 40% of companies in the broad Topix index trade below their tangible book value.  The continuation of pro-growth policies under PM Abe should lead to a significant revaluation of Japanese equities in the months and years ahead. We have also been looking for fundamentally attractive companies that are mispriced in emerging markets due to the recent macroeconomic turmoil.

In our Dividend Growth strategy, we continue to focus on companies which stand to benefit from strong U.S. economic growth and have low vulnerability to the expected gradual acceleration of inflation. We have further increased the commitment to Energy and mid-cap Consumer and Industrial companies which we believe offer strong prospects for price appreciation and long-term dividend growth. We have also selectively added to the Consumer Staples sector, which we believe offers stable growth and exposure to emerging market consumer trends. Year to date, the Dividend Growth strategy has underperformed the S&P 500 while outperforming high dividend stock indices. The strategy’s “value” skew has been a headwind in 2018 vs. the S&P, but we continue to stick to our disciplined approach of investing in a portfolio of stocks with goals of 10%+ dividend growth and a dividend yield 1% higher than the S&P 500.

We have an agnostic view of styles as we build diversified portfolios, but we do monitor extremes. The last 18 months of Value stock underperformance vs. Growth stocks has similarities to the dot-com bubble. Value industries (i.e. Banks, Energy, Pharmaceuticals) look attractive and contain many dividend growers:

Source: Bloomberg

Fixed Income Strategy

U.S. Interest rates continued to rise in the third quarter, following in line with the continued gradual increase in short term rates by the Federal Reserve. The most recent increase was from 1.75-2.00% to 2.00-2.25% in September. The increase in rates continued the gradual narrowing in the differential between short- and long-term rates. Yields on two-year Treasuries increased from 2.52% to 2.82% in the third quarter, while the yield on five-year Treasuries rose from 2.55% to 2.74% and on ten-year Treasuries from 2.86% to 3.06%. Yields on foreign bonds also increased during the third quarter, with ten-year German bond yields rising from 30 to 46 basis points and ten-year Japanese bond yields increasing from 4 to 13 basis points.

As indicated previously, we expect the Federal Reserve to continue to raise short term interest rates in 25 basis point increments through 2019.  The stated goal is to achieve a so-called “neutral” rate sometime in 2019.  The Federal Reserve seems to consider the 3% level as the neutral rate, that is, a rate which is neither accommodative or restrictive.  Whether the Federal Reserve will go beyond neutral in increasing rates is uncertain at this time, but the policy being followed should lead to higher intermediate and long-term rates through the foreseeable future.  However, we remain of the opinion that the Federal Reserve wishes to avoid having short term rates exceeding intermediate and longer-term rates as such an inversion in the yield curve would increase the risk of an economic slowdown in the U.S.  Given this outlook we continue to pursue a strategy of maintaining shorter-than-average durations in our taxable and tax-exempt portfolios, with shorter-duration Treasury obligations becoming increasingly attractive for taxable accounts.

 

Sincerely,

 

Princeton Global Asset Management LLC

 

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 important Disclosures:

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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