A Lot Of Balls In The Air…

Let’s start with some observations to “set the table.”
Let’s first focus on facts and then we’ll get to opinion:

1) Q1 earnings for S&P 500 companies rose 24.4% year over year (YOY), 8% ahead of Wall Street expectations
2) Q1 revenues for S&P 500 companies rose 8% YOY, 1.3% ahead of analysts’ expectations
3) Capital expenditures increased 21% YOY in the first period of 2018
4) The U.S. unemployment rate fell to 3.9%
5) U.S. retail sales were +5.9% in May YOY
6) The Personal Consumption Expenditure (PCE) Index, the Fed’s favorite inflation index, came in at +2% for March, hitting the Fed’s long-established target
7) The 10-year US Treasury yield rose above 3% – first time in a long time
8) The Fed raised the Fed Funds rate by 25 basis points to a range of 1.75% – 2% and signaled that there might be two more rate increases in 2018
9) President Trump met with the G7 in Canada
10) Kim Jong Un, leader of North Korea, and President Trump met in Singapore
11) China’s GDP grew 6.8% in Q1
12) China’s leader Xi announced new measures to open the Chinese economy, allowing more foreign participation in financial services and ownership in auto joint ventures
13) UK GDP rose 1.2% in Q1
14) Eurozone GDP grew just 0.4% in Q1
15) The European Central Bank (ECB) will reduce its massive bond buying beginning in September of 2018 and perhaps halt it by year-end – but interest rates will be kept flat through the summer of 2019
16) President Trump withdrew the U.S. from the Iran nuclear deal, while all other parties remained committed to it
17) Trade tariffs were implemented by the U.S. against Canada, the Eurozone, China and Mexico.

Several points above “paint” a US economic picture which appears quite robust. We are about to enter “earnings season” for the second quarter and analysts expect corporate income to grow approximately 20%. For all of 2018, the pundits look forward to S&P 500 company earnings expanding some 23%. Higher capital expenditures would suggest CEO optimism; higher retail sales, consumer optimism; higher interest rates, Fed optimism. Other parts of the world (China, the Eurozone and the UK) are growing – some faster than the U.S., others not so fast. There also is the potential for global risk reduction, as a result of the meeting in Singapore between President Trump and Kim Jong Un, the first ever between these two heads of state. Perhaps peace will break out on the Korean peninsula, perhaps not. But it is a start to a conversation. Finally, there are several points above which would suggest political tension. The unilateral pullout of the US from the Iran “deal” while other signatories stayed the course, the activation of the first of a potential series of trade tariffs against allies and competitors alike and, by all reports, the none too friendly G7 meeting in Canada – all would suggest that there is a good bit of “pushing and shoving” and discontent amongst supposed friends. There indeed are a lot of balls in the air! Investors have enjoyed the “economic points” but are a bit anxious about the unpleasant “political points”. We would continue to urge investors to focus on the “economic” rather than the “political”. The economic reflects what is going on corporately and individually. So long as the economics stay strong, then the markets should be reflective of those conditions. The political could affect economics. But politics is whimsical and politicians capricious. Until the politics really begin to affect the economics, it is best not to project that result, lest one be caught out.

Above is a chart which well demonstrates that every year since 1980 there has been a “down draft” and the average of those setbacks has been 13.8%. But even with those retrenchments, the S&P 500 ended the year positively 76% of the time and the average increase was 16.7% – pretty goods odds, we would suggest.

BELIEVING IN DEMOCRACY, OR NOT……
We are fast approaching America’s birthday and a recent survey conducted in 2018 by a German polling firm, Dalia Research, caught our eye. The survey interviewed 125,000 people in 50 countries around the world – some rated “free” by the U.S. organization Freedom House and others “not so”. When asked “do you feel that your government is acting in your best interest?” 64 percent of respondents living in democracies said “rarely” or “never”. In non-democracies 41 percent said the same. People in Saudi Arabia, Egypt, Turkey and China, all countries considered “not free’ by Freedom House, most rarely gave that response. Of the 10 nations that had the highest percentage of responders saying their voices were rarely or never heard, nine are democracies, according to Dalia.
We find these comments sobering and reflective of the detachment so many people feel with regard to politics, politicians and policies. However, this is not the first or the only time in America’s history that there has been disquiet among so many. One only has to go back to the late 1960’s and the early 1970’s to revisit the assassinations of Bobby Kennedy and Martin Luther King Jr., the race riots, the aftermath of the Vietnam War, and Watergate to remember that the U.S. has been “through the wringer” before, survived the turmoil and went on to thrive. America’s Founding Fathers devised a governance system with many checks and balances to distribute power among three distinct branches of government, with each branch having its own rhythm of governance so that power would never devolve to just one. When downcast, one should think about the genius of our political forbears and have faith that the American democratic experiment is still strong. It has been tested numerous times by many people and has never been found wanting.

THE CUSTOMER IS ALWAYS RIGHT, ESPECIALLY A BIG ONE….
As a rule, a trade war is never good. We are not here going to delve into every facet of the “war of words” and possible trade war that is being broadly discussed. Rather we are going to simply analyze the Chinese trade imbalance. Generally speaking, the U.S. exports (sells) approximately $130 billion of goods to China and imports (buys) approximately $500 billion of goods. In “round terms” there is a deficit of approximately $370 billion. Both the U.S. and China are threatening tariffs on one another’s products if a trade war begins. So, what would the Chinese tax? Well, what do the Chinese import from the U.S.?

The above chart, sourced from the Congressional Research Service, outlines the major categories. Aerospace products (think Boeing) are a huge import as are motor vehicles (think GM and Ford). Boeing products could get taxed (they are not as of this writing) but that would leave only one other supplier to China, Airbus, as the aerospace business is essentially a duopoly. By raising prices (via tariffs) on Boeing product the Chinese government creates a “price umbrella” for Airbus to also raise prices to Chinese airlines – not sure about how good that strategy is. Ford and GM have built cars for years in China. They also import vehicles and parts. Forcing GM and Ford to raise auto prices in China might hurt the companies and their employees. One thing China does not want to do is create unemployment in China. Semiconductors are a significant import for China because they go into a lot of products that China exports to the world. We would think that again China would be reticent to tax semiconductor imports. Look at the recent example of the U.S. banning sales of semiconductors to ZTE, a major Chinese telecom company. That action shut down ZTE. So, what is essentially left for the Chinese to tax are commodities: oilseeds, grains and energy. The problem here is that American commodities are like others from elsewhere – an American soybean is like a Brazilian soybean. If U.S. farmers lose part of the Chinese market to Brazil, some Brazilian soybean customers, no longer supplied by Brazil, will become US soybean customers. Commodities are fungible. There may be some market disruption, but customers will be replaced, as long as demand is strong. So simply, we do not think the Chinese are in a strong negotiating position with trade tariffs as their primary weapon against the U.S. Some analysts have suggested that the Chinese might use “interference” as another tool against American companies operating in China. In other words, use bureaucracy to slow down needed regulatory approvals or conduct needless surprise company audits – i.e. make it more expensive and less profitable for U.S. companies to do business in the Middle Kingdom. However, this idea has been denied by the Chinese government. According to the South China Morning Post this past Thursday, President Xi Jinping declared China open for business to a gathering of top American business executives including David Solomon (President of Goldman Sachs) David Abney (Chairman of UPS) and Albert Bourla (COO of Pfizer Inc.). Again, hurting foreign investment in China would probably create unemployment – a taboo. We said before that we think deals will be done and we continue to believe so.

PREDICTIONS FOR 2018

1) Inflation will rise above 2%, using the Fed’s favorite measure. –  Still believe, not quite there yet

2) U.S. GDP >+3% & international GDP growth will accelerate. – Still believe – some think Q2 U.S. GDP >+4%; international doing OK, but some worries over trade tariffs

3) U.S. unemployment will decline to 3.6% & ex-U.S. unemployment will decline. –  Still believe

4) U.S. corporate profits +12% with higher profit growth ex-U.S. – Yes – Q1, +24%, Q2, +20%

5) The dollar will drift lower. – Trade worries have sparked some dollar strength

6) The U.S. bond curve will get “flatter” but not “invert.” – Yes

7) Investment spending will rise again. – Yes – Q1 capital expenditures +21%

8) Republicans will take a “political beating” in the midterms. – Still believe

9) Consumer confidence in the U.S. & abroad will stay strong. – Yes – still strong

10) Equity markets will do well, while bond markets will stagnate. – Bonds have stagnated, but so have stocks due to “political worries”


A FINAL THOUGHT

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.

We recommend that you compare our statement with the statement that you receive from your custodian.

A list of our Proxy voting procedures is available upon request.

A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinmgt.com/disclosure/

A GHOST FROM THE PAST …

It was several years ago that investors worried aloud about a “meltdown” of the Eurozone. Greece was the “whipping boy” of Europe with Portugal, Spain and Italy as clubmates. The strong from northern Europe (think Germany and the Netherlands) lectured almost daily their Mediterranean cousins about their spending habits and lack of productivity. The Eurozone came close to dissolution except for the actions of the European Central Bank (ECB) and its forceful leader Mario Draghi who declared that the ECB would do anything and everything in support of the Euro – which was enough for markets. The Eurozone survived to fight another day.

That day may have arrived. It is not Greece this time which is the “bad boy”. Interestingly, Greece survived its program of economic reform and is about to emerge from the “penalty box” with a rejuvenated economy, at least for now. Rather, it is Italy, which recently elected populist candidates from two parties, that seems a bit of a “jumble”. Now while Italy never quite hit the economic shoals as hard as Greece in the last recession, it was a badly wounded economy which has since not fully recovered its old swagger. Unemployment is still five percentage points above its rate in 2007. Worker productivity is still hamstrung by archaic labor rules. Living standards are no higher than they were two decades ago. Emigration by Italians has more than doubled recently as Italians see no opportunity in their homeland.

In frustration, Italians have given no party in their parliament enough of a majority to rule. Rather, they have left their politicians with the task of forming a coalition and the two leading parties trying to form this political joint venture are both populist. Policies they advocate seem ruinous for Italy’s economy. One party wants to cut taxes to 15% for individuals, which would obviously cut government revenues. The other wants to have a guaranteed monthly income paid by the government to its citizens, thus ballooning government expenses. Infrastructure expenditures would be increased. Both parties are skeptical about the value of the Euro (€). Both parties want to scrap sanctions against Russia. This is all being talked about when Italian national debt is 130% of GDP – talk about highly levered!

Why is this of any consequence? Italy is the third largest economy in the Eurozone. Some would say it is too big to “bail out”. So, if for political reasons investors began to lose faith in Italian paper, the Italian “problem” could become a big problem. Spillover effects on other Eurozone economies could derail progress being made in other “weaker” countries like Spain, Portugal and Greece. Investors would probably scamper to German Bunds, driving down yields there but raising them elsewhere where there is a perception of higher risk. Further, Italy’s troubles would be much more of a risk to the Euro (€) than Greece’s problems ever were, because Italy is so much larger an economy.

Campaigning is not governing. Politicians say all sorts of things to get elected and then once in office, facing reality, govern in a different way. We hope this will be the course for the Italians. If not, if the populists stay true to their slogans, then the Eurozone and the Euro could face their demise and this would be unsettling to markets around the world.
Author’s Note: Since this commentary was written on May 28,2018 the President of Italy vetoed the Populists’ party candidate for Economy Minister and as a consequence: the attempt by the Populists to form a government has collapsed, the Italian President has appointed a technocrat as Prime Minister, new elections will probably be called for the fall, Italian bonds have fallen in price and the Euro (€) is weaker.

The Chinese Challenge …

Before settling into the main topic of this writing, let’s spend some time reviewing the economic and markets state of the world. The Federal Reserve (aka – the Fed) recently met for the first time under the leadership of Jay Powell. Succinctly, the Fed updated its economic projections – forecasting stronger growth, lower unemployment and modestly higher inflation, resulting in a .25% higher Fed Funds rate. GDP growth for 2018 is now expected to be +2.7% vs. +2.5%. Unemployment is forecasted to drop to the mid-3% range and core inflation is anticipated to be +1.9%. This is all “pretty strong stuff”, but not so strong as to warrant a faster or higher increase in interest rates than is expected by the markets. This is important. Further, below the reader will find a “Recession Dashboard” recently published by Credit Suisse which clearly demonstrates their positive economic outlook for the US.

Elsewhere in the world, India expects GDP growth exceeding 7% this year, while China looks forward to approximately +6.5%. Germany will grow close to 2.5% and the Eurozone around 2%. Inflation around the world has a bit more “pop” to it, but is still below a level where central banks will get concerned that they are “behind the curve”. The US is leading the move amongst central bankers to become “less accommodative” monetary policy-wise. But no one is close to having a “tight” monetary policy. Money is still cheap and will remain so for some time.

US company earnings are anticipated to increase some 25% in 2018. This includes the beneficial effects of the recently passed corporate tax reduction act. Overseas earnings are expected to be similarly robust. However, with market P/E ratios lower abroad than in America, numerous international exchanges are thought to be of better value than the US. We would concur. We are not saying that the US market is wildly overvalued. We do not believe that, especially after going nowhere in Q1. First quarter earnings “season” is about to start. We think it should be a good one, which will further demonstrate value in the markets. If good earnings do not spark a move up in stock prices, then at least the earnings will provide further support for equity prices, both here and abroad.

Interest rates in the US are up and will continue to increase. The Fed is leading that “charge”. Bond prices concomitantly are down and will continue to be so. It is “the way of the world”. We would only have shorter duration bonds in a portfolio in this environment.

THE MIDDLE KINGDOM……..
China is a force with which to be reckoned – politically, economically, militarily and scientifically. It is the scientific and economic challenges that we wish to discuss briefly here. As an example, let us examine Chinese scholarship in AI (artificial intelligence). According to Michael Wooldridge, Professor of Computer Science at University of Oxford, AI used to be solely within the purview of US academia and business. Remember IBM’s Deep Blue which defeated Russian chess Grandmaster Garry Kasperov. Think today of Watson, also an IBM system. Stanford University, Silicon Valley and DARPA (an agency for US government research expenditures) all have played vital roles in exploring, funding and experimenting with AI. In scientific papers, US academics were for years the predominant authors. In 1980, the first Association for the Advancement of AI conference was held and dominated by US researchers. There was not a paper presented by the Chinese and only some European presence. In 1998, America still dominated the proceedings – but the Europeans made themselves felt and one paper was delivered by the Hong Kong Chinese, a year after Hong Kong reverted to mainland Chinese control. Then in 2018, China’s researchers submitted 1,242 papers as compared to 934 submitted by US scientists. Of the papers accepted, China was only three behind the US. Some readers might consider this a crude “yardstick”. Nevertheless, as a measure, the US is no longer dominant in AI – it is now competitive and competitive with China. Why did we select AI as an example of a changing landscape in scientific competition? Because a growing number think that AI will be as important to the world’s future as was the harnessing of electricity for civilization. AI is an important intellectual pursuit with worldwide consequences and the Chinese are “in the race”.

So now let us look beyond China’s competitive “bona fides” to the current distant drum beat of a trade war with the US. America is China’s largest customer and China is America’s third largest customer. US companies have spent decades establishing supply chains which integrate Chinese manufacturers from low tech shoe soles to high tech computer chips into manufacturing processes. To say that we are embedded with one another would be an understatement. Just announced are two tariff positions – first from the US and a response from China. America, after a 60 day consultation period, if no satisfactory progress has been made in negotiations, will impose a 25% tariff on approximately $50 billion of selected goods. The additional $12.5B charge would equal a price increase of 2.9% on all of China’s US exports. The additional tariff equates to only 0.1% of China’s GDP and affected exports account for only 2.2% of total Chinese exports. So the direct impact of these taxes would seem to be limited. China, in reaction to just the aluminum and steel tariffs, will institute a tax of 15% on approximately $1B of various US products and then could place a 25% tariff on a further $2 billion of American goods. Again, the direct impact of the new Chinese charges on American goods will be very limited. Even the indirect costs of these policies (if enacted) should be quite manageable. In any case, markets around the world did not react well. International trade is the “lifeblood” of the world’s economic system. Messing with it is always a scary idea and we think that it is “the scary idea” that has unnerved investors. Extrapolating a bad idea, which is of no particular consequence today (and we would argue is our present condition) to a future with escalating formidable “trade” battlements is a “step too far” at this juncture. That could be our future – but we don’t think so right now.

The US and China are important to one another. This is obvious. Terms of trade will be renegotiated. This has started. A deal will get done – because this is necessary.

PREDICTIONS FOR 2018

1) Inflation will rise above 2%, using the Fed’s favorite measure. – Still believe, not quite there yet

2) US GDP >+3% & international GDP growth will accelerate. –  Still believe – tax cuts of late 2017 not reflected yet in numbers

3) US unemployment will decline to 3.6% & ex-US unemployment will decline. – Employers are hiring, but new workers coming off underemployment rolls

4) US corporate profits +12% with higher profit growth ex-US. – Q1 earnings reports are about to flow, so we’ll find out

5) The dollar will drift lower. – Yes

6) The US bond curve will get “flatter” but not “invert.” – Yes

7) Investment spending will rise again. – Still believe

8) Republicans will take a “political beating” in the midterms. – With several upsets (Alabama, Pennsylvania) in “Red” states, looking more the case

9) Consumer confidence in the US & abroad will stay strong. – Yes – very strong

10) Equity markets will do well, while bond markets will stagnate. – Bonds have stagnated, while stocks “rocketed” early in New Year & have given up gains


A FINAL THOUGHT

     

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.

The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.

We recommend that you compare our statement with the statement that you receive from your custodian. A list of our Proxy voting procedures is available upon request. A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinim.com/disclosure/


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FEELIN’ GOOD…

While equity and fixed income investors have experienced a bit of “whiplash” during the month of February, consumers have continued to feel “pretty good”, if not very good. In fact, the U.S. Consumer Confidence Index for February came in at 130.8 – its highest level since November 2000. Similar results in other economies have also been registered. As the U.S. economy, as is true of most of the world’s major economies, is largely driven by consumption, having a “happy” consumer should bode well for future economic growth.

With a happy consumer powering the economy, has the Fed done anything yet with monetary policy which might cause a recession? In the following chart there are two curves – the Blue curve looks at the real cost of money (i.e., is money expensive as evidenced by high inflation-adjusted interest rates?) and the Red curve looks at the bond market’s anticipation of a recession (reflected in the slope of the Treasury curve, where if the slope is negative, bond market investors believe a recession is implied and vice versa). As the reader will note, the Blue curve has just touched zero after being negative for quite a few years. So, money is cheap! Further, while the Red line has gone down, signaling a less positive Treasury slope – the slope is still positive. So, no recession is in sight, according to bond market investors.

Volatility is back and we would expect more over the remainder of 2018. Nobody doesn’t enjoy “upside” volatility. It is the “downside” volatility that unnerves – but it is a fact of an investor’s life. Asset prices go both ways. However, we still believe that stock prices, here and abroad, are underpinned by solid fundamentals reflecting synchronous world economic growth. Bond prices, on the other hand, will be pressured by increasing short term rates from the Fed.

Aging Out???

If the stock market does not wonder about an investor’s age, should an investor wonder about the stock market’s age? We would argue no. But that has not stopped many pundits from opining about the age of the current “bull” run in most any equity market around the world, concluding that there must be a fall in stock prices “just because.” We think that silly, as markets do not typically collapse with economies as strong as they are currently around the globe. Could there be a short-term correction of 5%? Assuredly one could come “out of the mist” with no particular rationale as to why. However, such a correction would probably be bought quickly by all who missed the market before and want to get in – keeping any such “correction” short and shallow.

Specifically, let’s look at a spike in interest rates as a potential catalyst for an equity market setback. In the chart below, one will see that if the 10 year Treasury yields increased 40 – 60 basis points (BPS) in a span of 20 days, US stocks might well fall 5%. As the reader will also note, the stock market can withstand even higher interest rates without a fall, if those rate increases are spread out over a longer period of time.

So, while a “spike” in interest rates is a possible worry, are monetary conditions “easy” or “tight”? In fact, conditions are “easy” and have been getting easier as seen in Chart 2.

Finally, is there still value in the US market as represented by the S&P 500? Following, please find some interesting work done by UBS, the very large Swiss bank.

Looking at the left side of the chart, the reader will note that relatively low interest rates and tax rates add 6 – 7 multiple points to equity P/E ratios. In other words, in a low interest rate and low tax rate environment, stock prices should be higher than they otherwise would be. On the far right of the chart, note that the stock market is still cheap to UBS’ Fitted P/E.

Again, we say that “bull” markets do not die of old age, especially when economies are strong. Certainly, there could be a “correction” – but one we believe would be short lived.

UP, UP AND AWAY MY BEAUTIFUL BALLOONS………

 

 

 

We have written in the past about a world which is experiencing a spate of synchronized economic growth, which we expect to continue at least through 2018, barring any “Black Swan” event. This has provided a helpful backdrop for corporate sales, earnings and cash flows which have allowed management teams to increase dividends and equity buybacks and have encouraged investors to bid up stock prices around the globe. It has “felt good” to be an investor. But is that good feeling about to change?

To seek an answer, let’s look again at a relationship we mentioned in our Q3 letter in the US bond market – the biggest, most liquid market in the world and the obvious alternative for most investors for their investment capital.

Above, the reader will note two yield curves – one dating from December 31, 2013 and a more recent one dated September 30, 2017. Please note the shape of the respective curves, with the more recent curve being “flatter” than the 12/31/13 curve. In other words, there is less yield difference between the short and long maturities in 2017 than there was in 2013, which is anomalous as investors usually demand substantially more return (i.e. higher yield) for taking more risk as they extend maturities. This “flattening” of the yield curve is usually a signal to bond market “players” that the economy is about to deteriorate, especially when the curve “inverts” – i.e. when short rates are higher than long rates. It has been a pretty effective predictor. So we should pay attention to this sign. However, the bond curve is not yet inverted and typically a recession materializes about one year after a curve inversion.

So, if we still have some time before the next recession (which are never good for stock market performance), can equity prices go up with increasing interest rates?

We have used the above chart before and present it again because it clearly shows that increasing interest rates are not necessarily bad for equity prices as long as those interest rates are below 5%, as measured by the 10 year Treasury bond, which is currently at 2.35%.

To recap so far, we think that the world economy is doing well and we do not think that we are on the “cusp” of a recession. Moreover, we believe that stock prices can go up despite increasing interest rates and that we are still quite distant from when bonds will be competitive with stocks – i.e. reach a 5% yield on the 10 year Treasury. So where should one invest?

Overseas markets, especially the so-called Emerging Markets (think China, India, etc.) would seem attractive to us. Recently, these foreign bourses have come out of a “deep slumber”, outperforming the US so far in 2017. For years post the “financial meltdown” the only stock market in the world worthy of investor consideration seemed to be the American market. Perhaps it was nothing more than fear which kept investors at bay. Whatever the rationale, as can be seen by the above chart, the World (as represented by the All Country World Index ex-US) has trailed the performance of the US stock market by a significant amount and trades at a demonstrable forward P/E discount to the S&P 500.

Further, global stock market correlations have returned to normal, which means that by investing overseas, a US investor is getting real portfolio diversification, thereby reducing investment risk (see below).

So it would seem to make some sense that an American investor should have/enlarge international equity exposure to find value and decrease risk through increased diversification.

In spite of a year with “outsized” political noise, markets around the world rallied strongly in the face of real skepticism. Economies around the globe grew. Investors just about everywhere prospered! Stock prices are higher than they were – but that does not mean that they are about to go down. We need to be aware. Equity prices are no longer in the “bargain basement” bin – but there are still places in the world ex-US where value can be found and we think investors should own those markets.

A THOUGHT OR TWO ON BITCOIN AS TO WHETHER IT IS A CURRENCY OR NOT…..
We have been asked by people about our perspective on various cryptocurrencies, with Bitcoin being the most famous. Speculators are no doubt giddy about the meteoric price rise that Bitcoin has had over the past several months. But that “ride” has not been smooth or only in one direction. There have been days of collapse. Bitcoin is too volatile to be a reliable store of value. Typically, a currency is based on the real economic productivity of a nation. With a cryptocurrency, there is “no there/there”. There are no industries, no resources, no laws or regulations to back up this so called “medium of exchange” – only euphoric trust. But this trust is periodically undermined when “hackers” have breached repositories and stolen currency.

Further, the transacting of Bitcoin (as an example) consumes brobdingnag amounts of electricity (according to one recent estimate about as much as all of Denmark) in order to solve complicated mathematical equations which record transactions. This mechanism keeps the cryptocurrency scarce, but also means that huge server farms are tasked with wasteful calculations. Interestingly, some of the largest server farms used to “mine bitcoin” are located in China and the electric power generated there is fueled by dirty coal. We find it ironic that the youthful community which favors Bitcoin are also those who are supposedly environmentally conscious. Hmmmmm!

There is also a rather notorious crowd of drug dealers and capital regulation “evaders” who are heavy users of cryptocurrency to avoid authoritative “peering eyes”. This is why China has cracked down on exchanges. In fact the author can attest to Bitcoin being a “currency” of choice amongst criminals, as Bitcoin was demanded as payment during a recent attempt at extortion.

Related to the above, cryptocurrencies are going to run into immovable central governments who consider the issuance and operation of a national currency their inalienable right. Controlling a country’s currency is one of the most important ways for a government to control a country. Stripping a sovereign state of that power will not be easy.

In short, we are not at all sure that there is any future for Bitcoin or its “relatives” as a currency. Underlying these cryptocurrencies, however, is an interesting technology called blockchain which is being experimented with by various companies. This will be the focus of our attention.


PREDICTIONS – SO HOW DID WE DO IN 2017????
1) S&P 500 corporate earnings +10% – 15% 

Yes – Throughout the year companies did better than expected

2) Inflation to range from 2.5% – 3%

No – Inflation did not “inflate” – A puzzlement

3) Business investment up due to cuts in corporate tax rates & overseas profits repatriation Yes – Delayed from earlier in the year, but with a tax bill passage it should continue into next year

4) Government spending up due to infrastructure investment

No – Infrastructure spending is supposed to be next, but we have doubts

5) Personal consumption up due to tax cuts & wage gains

Yes – Consumers are in a good mood

6) Real GDP growth +3%

No – Growth is more robust, but not quite 3% over a 12 month period

7) The Federal Reserve will raise the Fed Funds rate by 0.75%

Yes – As per plan

8) Bond prices will drop, yields rise (10 year Treasury yield 3.5% – 4.25%)

No – Pension demand has been strong for bonds

9) The Treasury will issue bonds with 40+ year maturities to take advantage of still historically low interest rates

No – Treasury gave up due to lack of market interest for a very long bond

10) Equity prices will rise on higher earnings & lower bond prices

Yes


PREDICTIONS FOR 2018

1) Inflation will rise above 2%, using the Fed’s favorite measure

2) U.S. GDP >+3% and international GDP growth will accelerate

3) U.S. unemployment will decline to 3.6% and ex-U.S. unemployment will decline

4) U.S. corporate profits +12% with higher profit growth ex-U.S.

5) The dollar will drift lower

6) The U.S. bond curve will get “flatter” but not “invert”

7) Investment spending will rise again

8) Republicans will take a “political beating” in the midterms

9) Consumer confidence in the U.S. and abroad will stay strong

10) Equity markets will do well, while bond markets will stagnate


A FINAL THOUGHT


[1] A play on lyrics written by The Fifth Dimension, which obviously dates the author.


The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC.  These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. The reported numbers enclosed are derived from sources believed to be reliable.  However, we cannot guarantee their accuracy.  Past performance does not guarantee future results. We recommend that you compare our statement with the statement that you receive from your custodian. A list of our Proxy voting procedures is available upon request. 

A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinim.com/disclosure.htm

Lookin’ and Feelin’ Good…

We are now past the nine-month mark and coming around the turn for the year end finish of 2017. The cacophony emanating from Washington has almost overwhelmed the listening capacity of most investors. Thankfully, those who work for and manage companies here and abroad have been able to focus their efforts on corporate progress. Distractions are abundant – but business is “being done”.

We have noted in past writings that the Service Sector of the US economy (and we believe the Eurozone) makes up about 70% of total Gross Domestic Product (GDP). So, the Service Sector primarily determines the health of the overall economy. As can be seen above, the Service Sectors in America and in the Eurozone are quite healthy – ergo, so are the overall economies, as we live during a period of synchronized world economic growth.

Further, small business optimism is at a high level, as can be seen above. Small businesses are drivers of most US economic growth. They are the creators of many more jobs than either large companies or government. They are run by the entrepreneurs who create new industries. If small business optimism is high then people get hired, people spend money and the American economy moves forward.

These are but two “snippets of information” which encourage us. Despite the rancor expressed in certain corners of our world, business is “being done”. This heartens us to believe that there are fundamental underpinnings to “full” stock market valuations. While “Mr. Market” has traveled far, his footsteps have not been on just “thin air”.


The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.
The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.
We recommend that you compare our statement with the statement that you receive from your custodian.
A list of our Proxy voting procedures is available upon request.
A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinim.com/disclosure.htm

Top Spotting…

We would never attempt to “call a top” in markets for we think that “a fool’s errand”. But we are mindful that prices do not rise forever. There are plenty of pundits who have worried aloud about the advanced age of this equity “bull market” in the US. We have not been one of them because we believe that bull markets do not die of old age. There has to be a catalyst and usually that “tipping point” is the onset of a recession. We see no evidence of a recession for the foreseeable future in America and for that matter most of the developed and developing world because the world is in an unusual period of synchronized growth. Nevertheless, it is wise to be watchful. Here are some “sign posts” which will help to guide us going forward.

Consumer confidence is high, as is small business optimism.




















Unemployment is very low. While none of this is bad theoretically, taken to an extreme (and some might argue that we are there or close) when “animal spirits” are let loose, there could well be unintended consequences. What consequences could be significant? With employment high and confidence robust, investors fear less and demand more return, assuming more risk. They no longer want the safety of low-yielding liquid money, which was in high demand during the “Great Recession” when people were fearful.



















As can be seen in the above chart, savings deposit growth has fallen dramatically since 2009. Further, during “the dark days” when investors were not interested in risk, neither were the banks. Instead of lending money to entrepreneurs starting new businesses, banks hoarded deposits and lent them conservatively to the US government (buying Treasury bonds), building excess reserves.



















So “safe” money was in great demand as reflected by historically low yields. Investors were not interested in the returns they were getting on their cash – but were very interested in the RETURN OF THEIR CASH. That time has passed. Investors are looking for something other than safety. Deposits lose their appeal as an investment and capital is re-directed to riskier assets which potentially generate higher returns.

In addition to investor demands for higher yields on money, low unemployment could spark wage rate escalation which could in turn push inflation up in the US and the Eurozone.




Source: Bloomberg, 7/31/17









Right now, this is not a worry as seen above. But it is a potential concern.

If “junk bonds” blow up, it could be a signal that a recession is not far in the future. Higher yields on “High Yield” bonds would suggest that investors are nervous about the economy – about getting their money back – and want a greater yield to reward them for the perceived heightened risk.




Source: Bloomberg, 7/31/17









So we will watch the high yield bond market closely. If high yield paper starts to yield what it did in 2009, a stock market correction is probably in the offing.

If the yield curve flattens (i.e. yields on the 10-year Treasury and the Fed Funds rate are equal), then a recession might be close. It is anomalous for short and long bonds to yield the same. Typically, long fixed income yields more than short because an investor is taking more risk the longer the maturity of the paper. When long paper equals the yield on short bonds or worse yet, yields less than short term paper, it can mean that bond investors think a weak economy is near.




Source: Bloomberg, 7/31/17









If the dollar rallies vs. emerging market currencies, this would hurt earnings from US multinational companies. An earnings recession could cause a stock market correction.




Source: Bloomberg, 7/31/17









So these are the “sign posts” to help us along the way. These are not the only signals we will use – but they are important. We are certainly not complacent. We are watchful, but not fearful yet.

PREDICTIONS FOR 2017
1) S&P 500 corporate earnings +10% – 15%
Yes – So far earnings better than expected
2) Inflation to range from 2.5% – 3%
No – Recent numbers have been lower than expected, but still believe inflation will appear.
3)Business investment up due to cuts in corporate tax rates & overseas profits repatriation
Yes/No – Up 2-3% so far this year. Confidence is High. Still expecting cuts in corporate tax rates and profits repatriation
4)Government spending up due to infrastructure investment
Yes – To come later this year, perhaps.
5)Personal consumption up due to tax cuts & wage gains
Yes/No – Consumers are upbeat before tax cuts
6)Real GDP growth +3%
No – Expect improvement later in year
7)The Federal Reserve will raise the Fed Funds rate by 0.75%
Yes – Fed is “on course”
8)Bond prices will drop, yields rise (10 year Treasury yield 3.5% – 4.25%)
No – Bond demand remains strong
9)The Treasury will issue bonds with 40+ year maturities to take advantage of still historically low interest rates
Yes – Being actively researched by the Treasury
10)Equity prices will rise on the back of higher earnings & lower bond prices
Yes

A FINAL THOUGHT






















A FINAL FINAL THOUGHT…






















The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC. These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. The reported numbers enclosed are derived from sources believed to be reliable. However, we cannot guarantee their accuracy. Past performance does not guarantee future results.
We recommend that you compare our statement with the statement that you receive from your custodian.
A list of our Proxy voting procedures is available upon request.
A current copy of our ADV Part II & Privacy Policy is available upon request or at www.baldwinim.com/disclosure

Moving On Up…

As we come to the close of summer, equity investors around the world have enjoyed stock markets which have not suffered from the “sell in May and go away” syndrome which has too oft’ marred an otherwise pleasant vacation.  Exchanges have continued to march forward and portfolios have appreciated.  Why?

 

 

 

 

 

 

We think the above chart explains a lot.  For the first time in a long time, economies around the globe are growing together.  Low interest rates and fading global crises are probably responsible.  The International Monetary Fund (IMF) projects that world economic growth will be +3.5% in 2017 and 3.6% in 2018.  Such synchronized growth is rare.  Even long beleaguered Greece is slated to show progress this year.  Growth in the Eurozone was better than that in the US in the first quarter and was about the same as America in the second period of 2017.

Japan’s economy grew 4% in the June quarter.  China has kept “motoring along” well in excess of 6.5% and India’s economy has been growing faster than China’s.  As a consequence, corporate earnings and cash flow are up and better than what the “Street” was expecting.  Positive company surprises have underpinned markets – especially with interest rates as low as they still are. How long will this environment last?  Interest rates would have to rise quite a bit before bonds would represent real competition for investor capital.  The Fed funds rate is rising in the US – so this cannot be ignored, but watched. Employment around the world is going up, yet inflation is still not a worry to most central bankers.  Consumer sentiment is strong. Investor sentiment is strong.  Outside of politics, investors are ending their summer as a pretty happy crew.

HAVE A HAPPY LABOR DAY

 

What If…

Elon Musk is working hard to make people believe the future for transport lies with electricity.  He is producing a second model of his Tesla and other automobile manufacturers are announcing their entrants into the EV (electric vehicle) race – along with whispers of competition from non-traditional competitors like Apple and Google.

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The above would certainly represent a “sea change” in how the world’s population would travel.  Politicians in France, Great Britain and California are pushing their constituents away from gasoline and diesel-powered vehicles.  The curbing of pollution benefits seems obvious.  But is it feasible?  Do we have the technology today or will we have it in the near future to meet the goals?


The above chart suggests that the world will be in short supply of lithium – a key component of the lithium ion battery, the selected power source for electric vehicles.  No doubt market forces will come into play, driving up the price of lithium as shortages present themselves.  Higher pricing will spark more exploration and new reserves could be uncovered.  Or if no new lithium deposits are discovered, perhaps a new technology will displace the lithium ion technology.  Several oil company chiefs are today sounding as though “peak oil” demand will be here in a couple of decades and for that they are planning.  But despite their planning, the transition from the internal combustion engine to an electric motor will not be easy, cheap or convenient.  Our world has the internal combustion engine “embedded” into almost every facet of our lives.  Change will not be as swift as some pundits predict nor as simple as they would like.

Shifting gears, following are four charts we thought interesting.  For some time many economists have worried aloud that the US economy was not achieving “escape velocity”. They found fault with a “slow and steady as you go” mode of expansion.  However,we find that “plodding pays off”.

 

 

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC.  These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed.