Investment Outlook and Recap4 Q 2 0 1 9

Conflicting Signals

The third quarter equity markets were noted for earnings declines,investor volatility and contrarian market signals. Corporate earningsbegan the quarter in negative territory, a trend that will likely carry-through the Q3 reports, as the latest estimates reflect an annualizeddrop of 4.15 percent for the S&P company earnings report card. Thismight also help explain the more risk-off investor trend so far this year,moving approximately $210 billion out of the equity markets and in turnmoving $350 billion into an already richly valued fixed income market.What has underpinned the equity markets to date has been thecorporate buy-backs which over the past 5 years have totaled in theneighborhood of $4 trillion dollars.

Valuations

Fundamental valuations (over market cycles) do matter in theinvestment markets but unfortunately over shorter periods valuationscan be masked by changing monetary policies (easing and tightening),volatile economic data and investor behavior (search for yield, safety,emotions, etc.). In today’s market environment there is still a case to bemade for an equity portfolio allocation given the diversification ofstrategies, more affordable management expenses, an expectedrecovery of earnings growth the latter part of 2019 and into 2020(assuming some settling of ongoing global trade concerns).Price/earnings multiples have certainly risen over the past 12 monthsbut with current ratios of 16-17X earnings, valuations aren’t consideredstretched. And while S&P corporate earnings are expected to trendnegative this third quarter, estimates are contemplating a positivereversal into next year, providing another round of equity valuationsupport. In terms of investor cash-flows (S&P 500 dividend yield), earlierthis quarter the dividend yield topped that of the 10-year treasury,signaling what has proven to be a positive sign for the equity markets.

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Later Stage Markets Volatility

There are a number of equity tailwinds that should continue to benefitinvestors even in what we believe to be a later stage bull-marketenvironment, including:

Improving growth in consumer spending and confidence.

High levels of employment.

Historically low interest rates providing additional boosts forconsumer and business spending.

Still attractive mortgage environment both for purchase andrefinance.

Continuing stock buybacks that will help support share price.

Dividend payouts that provide an attractive source of income.

This latter stage market will likely continue to see an increased level ofvolatility (upside and downside) which will probably come in shortbursts. Factors that will contribute to these reversals might include:

Domestic Politics and Geopolitical uncertainty.

Algorithmic and High Frequency Trading is a fact of investment life.These strategies have little to do with fundamental market orcompany level analysis. More momentum and technical based.

Aforementioned sources of short term volatility can provide longterm investors with opportunities to invest at attractive levels, (ThinkWarren Buffet).

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Source: Morgan Stanley

Drivers of Future Equity Returns Will Include:

Powerful trend of the democratization of Artificial Intelligence, MachineLearning and Big Data is providing business, from the global behemothsto Main Street, a revolutionary tool set. Revenue growth and costefficiencies are tangible outcomes that support economic sustainabilityand future prosperity.

Inventory and supply chain management

Marketing intelligence

Product development

Communications

Although index and beta strategies will have their place going forward,the “Rising Tide lifts All Boats” days of passive investors will likely giveway to Skill Based Managers that can apply active judgment whiledeploying both fundamental and quantitative analysis.

Successful Managers will deliver Alpha cost effectively.

Capturing Risk Premium with superior downside capture should berewarded.

Investors will likely put a premium on investing with Firms that havea legacy of corporate governance and stewardship.

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Fed Policies, Statements and Impact

Federal Reserve policy management was quite evident this pastquarter, as two rate cuts were enacted, with the hint of one or twomore cuts over the balance of 2019. FOMC Chair Powell has adopteda market friendly tone, signaling that the Fed will begin buyingTreasuries for the next six months at an initial pace of $60 billion permonth. The goal is to leverage reserves up a bit more during thissomewhat turbulent market.

Despite the two recent rate cuts, money growth (M2) has averaged atepid six percent growth rate until recent slowing to four percent.This pace of growth is proving to be more of a headwind to nominaleconomic growth here at home (and apparently overseas as well),which when coupled with the strong dollar performance andconstrained wage growth has helped cap most inflationary concerns.

Low yields, flight to quality and global uncertainty contributed tobond yield anomalies that many feared were beginning to soundrecessionary warning bells. This yield curve “inversion”, whereshorter-term maturity yields exceeded longer-term yields, occurswhen investors buy longer-term Treasuries which in turn bids upprices and pushes yields lower. Conventionally, this is a pessimisticsignal as investors are signaling harder economic times ahead and arelooking for safe havens for their capital. While these inversions dohave a solid track-record in predicting impending recessions, thistime may indeed be different. Participants today include our owndomestic investors (and savers) as well as a global market weigheddown with negative yielding bonds. There is a flight to higher yieldtoday from these global participants looking for income streamsgreater than zero (or negative).

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Fixed Income Markets Outlooks and Considerations

This year the Treasury market is delivering one of its best periods forreturns, as intermediate and longer maturity yields have declined totheir lowest levels in several years, the result of income starvedinvestors. The Barclay’s US Treasury Index returned 7.71 percentthrough the first three-quarters of 2019, while the long-end of thecurve (25 to 30-years) generated returns over 20 percent. Inflation-protected bonds trailed the nominal Treasury sector rally, given theglobal concerns for weakened growth and declining global tradewhich have helped dampen inflation expectations.

The Barclay’s US High Yield Index returned 1.33 percent and 11.41percent over the third quarter and year-to-date periods, respectively.Unlike the Investment Grade category, the High Yield market did seea sizeable performance differential based on credit risk. The higherquality end of the risk curve (BB) delivered sizable outperformance,closer to 10 percent for the period, while triple-C rated securitieswere flat as some of the deep cyclical industries (i.e. energy)delivered negative returns over the year to date.

Rate Outlook

The third quarter was remarkable in terms of rate activity and globalpolicy reversals, as easing monetary policies seemed to becoordinated globally in their timing. There was a concerted effort byinvestors to pick-up yields against the back drop of what was a peakof +/- $17 trillion in negative yielding overseas debt. In thisenvironment, and for the foreseeable future, we expect to seecentral bank policy to continue easing globally, for low rates toremain low, putting an effective ceiling on any significant inflationarypressures.

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Employment Still Adding Momentum

Labor market growth is slowing but not stalling. While nonfarmpayroll growth for September posted 136,000 new jobs additions,the three-month trend was a respectable monthly average of157,000 new positions. State and local municipalities also added jobsat a three-month rate matching 2016 highs. The most recent Augustdata also points to the 18th straight month were there were moreavailable positions than people looking. This might help explain thedrop in the unemployment rate to 3.5 percent, a 50 year low, whilealso helping answer why we dismiss any near-term recessionaryfears.

Housing Framework

Low mortgage rates and solid job markets are continuing to supportthe housing markets today. Recent data suggests strength indemand, starts, permits and sentiment. Underlying strength is aidedby what were three-month lows in mortgage rates last month,exacerbating one of the larger declines in existing home inventory inthe past 13 months. Single family starts (an eight-month high),permits and homes under construction were up this past month forthe fourth consecutive time despite a reversal in multi-family starts.

One forgotten metric tied into the housing revival is the multiplierimpact to other segments of the economy. There are spill-overimpacts to consumer confidence and durable good purchases whichalso highlight the broader strength in the domestic economy. Therecent Fed monetary easing should probably continue to providestimulus to the housing interests courtesy of still cheap interest rates,a still muted inflation level and the job strength already mentioned.All positives also staving off near-term recessionary worries.

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Consumer Perspectives

Consumers appear to still be engaged these days despite increasingpolitical headline risks. The latest poll from the Michigan ConsumerSentiment Index just hit a three-month high with respondentslooking at potentially positive changes their future householdincome, spending and general outlook in the current economicconditions.

In terms of spending to date, consumers have yet to live up toexpectations as the most recent data points suggests that estimatesfor this past quarter were weaker than expected. Real consumption(through August) was up a nominal 0.1 percent on a month/monthbasis, representing the slowest pace in six months. The news wassomewhat bifurcated however as service sector consumption was offslightly for the month while spending in the durable goods marketswas the highest in three months. One bright spot was thatdisposable income (+0.4 percent) was the sharpest one monthincrease since February. Over the past three months, wages were upan annualized +5.7 percent. Given the continuing job gains andtightening labor markets, wage gains may become a more significantvariable driving consumption.

Interestingly, consumer prices have remained relatively muted overthe past few months, this despite recently enacted trade tariffs.Headline prices were essentially unchanged in September with coreprices increases up an annualized +2.4 percent. While there wereslight increases in medical care and airline fares, used car pricesdepreciated a bit as did fuel prices. Thus far, there have been no realvisible signs of the 10 percent tariffs that were imposed on importsfrom China at the beginning of September. Assuming there is realprogress in trade talks, this may be a sidelined price issue.

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Manufacturing Signals

Certainly mixed data in recent manufacturing reports over the pastfew month, some of which can be attributed to uncertainties in tradepolicies. Most recent data indicated that the ISM manufacturingindex fell to a decade low in September (49.1 to 47.8). There were anumber of components adding to the index fall, including a decline inthe production index and a drop in inventories (manufacturingslowdown). There was also a significant drop in the headline exportdata to a decade low which would have been exacerbated by globaleconomic slowdowns. There were a few positives though with anominal uptick in the new orders index (47.2 to 47.3) along with aslight uptick in construction.

In terms of actual manufacturing output levels, there was a -0.5percent decline in September, a good portion of which was courtesyof a -4.2 percent decline in auto output (GM strike). Absent whatshould be a temporary drop-off in auto production, there were stillproduction blips in the machinery and electrical manufacturingindustries along with a drop off in mining output, the latter off -1.3percent primarily attributed to a drop in drilling activities over thepast 12-months (-13 percent). Data that is likely be factored intoboth the most recent two-rate cuts and possibly one or two more bythe Fed. Assuming the GM strike is truly short-lived, traderesolutions are negotiated and the FOMC continues easing, thismanufacturing downturn may prove to be short-lived. At least onthe domestic front.

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Recession Worries

There have been a number of headline stories over the past several monthsespousing fear of a pending recession. A multitude of reasons have beenoffered, with the most common being the aging of this decade-long andcounting bull-market. Bull-markets typically do not run out of steam fromold age, but these are the factors that investors have focused on:

Tightening monetary policy: Very unlikely given the current easingstance here at home and overseas. The Fed has already eased twice thisquarter and is signaling possibly more ahead.

Collapsing housing markets: Not very likely here in the U.S given lowmortgage rates, increasing new home buyers and shrinking inventorylevels.

Collapsing job markets: Another non-issue here at home, or in a numberof the developed markets. Record low (50-year) unemployment ratesand moderate wage growth are a perfect combination for sustainability.

Escalating inflation worries: Inflation has been absent for several yearsnow, but we’re assuming it’s not gone forever. It’s not an issue now, asevidenced by easing FOMC efforts, moderate wage increases and risingconsumer consumption growth rates.

Asset bubbles: The stock markets are more expensive today than tenyears ago but multiples aren’t overly stretched and earnings estimatesare expected to move up through next year. There are no meaningfulbubbles in real estate or other financial assets, except perhaps in therecent IPO market. In terms of overall growth in debt, current interest-rate servicing costs remain low and affordable for both corporations andhouseholds. No signs of overly irrational exuberance.

Financial instability: Companies are in good shape overall, with soundbalance sheets and a stronger banking system. Meanwhile families haveincreased savings, are seeing greater employment opportunity and animproving income stream.

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Global manufacturing PMI new orders and export orders moved further into contraction territory

Source: Bloomberg

Trade Casualties Continue

Two of the more at-risk countries in Europe today are Germany and theUnited Kingdom. Economic news on the German front is primarilyfocused on ongoing trade issues which have recently pushed the ZEWbusiness service index into negative territory. The UK has likewiseposted somewhat lackluster economic growth for slightly differentreasons, primarily related to its on-again/off-again breakaway from theEuropean Union. The three-year (plus or minus) exit has worn onbusiness and consumer confidence as well as housing prices, the labormarkets and more recently wage growth. If there’s a positive, recentParliamentary tactics may be successful in finalizing the Brexit pull-awayby this year’s end.

In terms of driving forces behind slowing growth in the non-US markets,there are a number of factors involved including the tear that the dollarhas been on over the past year-plus and the impact a strong dollar hason trade finance and the export markets (cheaper for the US to buyforeign goods than foreigners to buy ours); increasing tensions betweenglobal trading partners has not only slowed trade but alsoexpansion/Cap-ex expenditures; and the high leverage that a number ofthe emerging markets have inherited, which has led these countries,including China, to reduce investment and consumption.

This past September’s manufacturing data reaffirmed the slowing globalgrowth momentum. The primary driver of the shrinkage was theManufacturing sector, as noted in falling PMI reports, though the Serviceindustries seem to be holding up well. The IMF recently downgradedexpectations for Global GDP (3.2 percent) primarily related to the tradedisruptions, with the countries most impacted including China, Germanyand Taiwan. Expectations are for GDP growth and trade fears todissipate early next year, with trade normalizing over the ensuing twelvemonths. Will require quite a bit of cross-border political resolution.

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commentaries about the current state of the global economy. Theirrecent GDP report of an annualized 6 percent growth rate this pastquarter represents their slowest level of growth since the 1990’s.There were a few positives in the report (relative to the magnitude ofother country growth rates) including 5.8 percent growth rates formanufacturing and 7.8 percent growth in retail sales. To put thisgrowth rate into perspective, China’s growth rate is likely moresustainable than years prior when the country was aggressivelybuilding, buying and developing. There is an ongoing stimulusprogram underway from Beijing that will likely help boost growth athome and in their overseas markets.

As China’s economy slows, it has been reducing its spending overseaswhich has helped push its trade surplus higher, to the consternationof the Administration here at home. This cut-back is likewise havingan impact on their other peripheral trade partners which includeGermany, Hong Kong, Japan, Vietnam, India and South Korea.Companies (and countries) that once did business in China are nowfacing a new reality in the slower growth economy.

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This commentary is furnished for informational purposes only and is not investment advice, a solicitation, an offerto buy or sell, or a recommendation of any security to any person. Managers’ opinions, beliefs and/or thoughtsare as of the date given and are subject to change without notice. The information presented in this commentarywas obtained from sources and data considered to be reliable, but its accuracy and completeness is notguaranteed. It should not be used as a primary basis for making investment decisions. Consider your ownfinancial circumstances and goals carefully before investing. Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions.Forward-looking statements are not indicators or guarantees of future performance and involve certain risks anduncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversificationstrategies do not ensure a profit and cannot protect against losses in a declining market. All indices areunmanaged and investors cannot invest directly into an index. You should not assume that an investment in thesecurities or investment strategies identified was or will be profitable.

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