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PGAM Second Quarter 2019 Investor Letter

July 11, 2019

Global equity markets climbed a “wall of worries” and cautious investor sentiment during the second quarter to extend 2019’s gains. Signals that monetary policy in the U.S. and Europe would become increasingly accommodative were the prime catalyst for higher shares prices in developed markets. Stock prices also benefitted from expectations that a further significant escalation of global trade tensions appearsless likely. The following is a summary of global equity markets over various time periods which shows a persistent pattern of outperformance of the U.S. equity market:

Evidence of a slowing of global economic growth increased during the second quarter. The slowdown in growth was reflected in weakness in measures of global manufacturing. The trade tensions between the U.S. and China and Europe are creating uncertainty in the longer-term outlook which has caused a reluctance for corporations to increase spending on capital investment. Manufacturing purchasing managers indexes (PMI) weakened across the globe in June:

In the two largest economies, consumer spending is also under pressure. This trend is evident in weakness in declining auto sales and weakening demand for housing in both the U.S. and China. On the positive side, the employment picture in the U.S. remains strong. Including the 224K increase in nonfarm payrolls in June, above the six-month average gain is 172K.

The positive implications of this weakening are reflected in trade and monetary policy. On the monetary policy front, the Federal Reserve is reinforcing the reversal in policy which began earlier this year. Rather than continuing to increase short-term interest rates, the Federal Reserve is emitting strong signals that the next move in short- term rates will be down in response to expectations that inflation remains well below the 2% stated target and global economic growth is in a slowing trend. Recent developments in Europe are also positive. The outgoing European Central Bank President Mario Draghi indicated a willingness to pursue increasingly aggressive monetary stimulus, even with short-term ECB rates in negative territory. His successor as ECB President will be Christine LaGarde, currently head of the International Monetary Fund. She is likely to continue the Draghi regime of increasingly accommodative monetary policy and to encourage the European governments, and Germany in particular, to utilize fiscal tools to stimulate increased economic growth.

On the trade front, at the G20 meeting in late June, the U.S. and China agreed to further talks on improving trade relations between the two largest economies and to not escalate protectionist measures, such as the imposition of 25% tariffs on Chinese exports to the U.S., at least for the time being. The disputes between the U.S. and China are likely to persist, but the easing of tensions should relieve pressure on the global economic outlook.

Equity Strategy

Overall the trend toward increasingly accommodative monetary policy in the U.S. and Europe should support economic growth and bode well for global share prices. In the post-war period, Fed monetary easing has led to higher stock prices. Financial conditions and global economic indicators have also had a strong relationship:

Evidence of cautious investor sentiment also provides a favorable background for equity markets. According to the Bank of America Merrill Lynch June Global Fund Manager Survey, investor confidence was at its most bearish level since the Global Financial Crisis of 2008-2009, which historically is a solid contrarian indicator for positive future stock returns.

The easing of trade tensions is a positive, but the direction of discussions are fluid and the final outcome remains uncertain. We view a breakdown in the trade negations as the greatest risk to the uptrend of the global equity markets. Further setbacks could freeze business spending and disrupt supply chains causing corporate earnings to fall – the Semiconductor industry experienced this form of disruption following the Trump administration’s ban of sales to the Chinese hardware manufacturer Huawei. Second quarter 2019 earnings are forecasted to decline year- over-year on difficult compares but are anticipated to recovery later in 2019 and 2020. The outcome of the trade negations will be an important factor in the achievability of future earnings growth:

Our overall strategy remains focused on maintaining a balance between durable growth and attractively valued economically-sensitive sectors. Our recent purchases have focused on companies we forecast will deliver solid earnings growth in various macroeconomic environments or “all-weather” stocks, including additions in the Healthcare sector. One of our favorite procyclical sectors remains Financials, where select companies have structurally improved their business models and are delivering earnings growth despite the headwind of a flat yield curve. We continue to avoid stocks that offer high current dividend yields at the expense of future growth and balance sheet health. We also see very frothy valuations of high momentum stocks and we are avoiding chasing this style of stocks.

In our Global Equity Strategy, the developing global background should lead to an improving performance for Emerging Markets. A lowering of short-term interest rates in the U.S. should lead to a weaker U.S. dollar and stronger emerging market currencies. We continue to see attractive long-term price appreciation potential of Emerging Market equities and a positive outcome of trade negotiations would be the catalyst for EM’s relative outperformance. Among the developed global equity markets, Japan is becoming increasingly attractive due to improving corporate governance. This trend is reflected in a friendlier attitude toward shareholders through an increased willingness to undertake share repurchase programs.

In our Dividend Growth Strategy, we have continued the process of selectively replacing our exposure to economically sensitive holdings and increasing our exposure to companies we perceive as quality long-term growers (both earnings and dividends) trading at reasonable valuations. Industries with the largest representation include Software and Technology Services, diversified Healthcare, and Consumer Entertainment. Relative performance of the strategy has been solid over the past several months and a low global interest rate environment should increase the attractiveness of companies paying healthy dividends with above market growth.

In our managed Exchange Traded Fund portfolios, our equity exposure remains tilted towards Value, Quality, and Mid-Cap fund styles. We maintain healthy exposure to Emerging Markets, which we favor over International developed markets and we favor Equity Income funds for value exposure. Within fixed income, we have reduced our High-yield bond exposure as interest rates and credit spreads have narrowed and favor Preferred Stock funds for fixed income exposure. Tracking error, liquidity, and low expense ratios remain key considerations in fund selection.

Fixed Income Strategy

Outside of the short term, U.S. interest rates continued to decline in the second quarter of 2019. U.S. fixed income securities continued to attract strong demand reflecting a yield advantage over foreign fixed income markets. For example, 10-year German bonds had a negative yield of 33 basis points by the end of the second quarter. The purchase of U.S. obligations also reflected a cautious stance among investors seeking a safe haven. By June 30, yields on 2-year U.S. Treasury obligations had declined to 1.75% from 2.26% on March 31. 5-year yields were 1.77% versus 2.23% on March 31, while 10-year notes yielded 2.01% on June 30 versus 2.41% on March 31.

With the Federal Reserve moving toward a more accommodative stance, several reductions in short-term rates now seem likely between now and the end of 2019. The rate cuts should lead to a more optimistic assessment of economic prospects going forward as well as an expectation that inflation should at least equal, if not exceed the oft-stated 2% target. This environment would provide a catalyst for yields in the 2-year and longer maturity range to move back toward levels seen earlier this year. In view of this outlook, we are staying with our strategy of maintaining shorter than average durations in our taxable and tax-exempt fixed income accounts.

We are always available to discuss any investment or financial matters. Our highest priority is to ensure you have the proper portfolio asset allocation that enables you to stay invested during our long-term journey.

 

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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