Back to Quarterly Letters

Back to Quarterly Letters || Previous Letter || Next Letter

Quarterly Letter to Clients

April, 2018

Indices at quarter-end (March 31, 2018):

Dow Jones Industrials: 24,103.11 1Q'18 -2.49% YTD -2.49%

Standard & Poor's 500: 2,640.87 1Q'18 -1.22% YTD -1.22%

To recap the quarter just past: January was whoo-hoo, February was oops, and March was ouch. When all was said and done, the DJ finished the quarter down about two and one-half percent.

Several actions, both proposed and already passed, have dramatically influenced our stock and bond markets. The tax cuts, especially the large cuts for corporations, initially drove stocks higher on the premise of more money at the bottom line. The rise in interest rates drove the price of bonds down. But it is the threat of a trade war that seems to have really spooked the markets. With the announcement of the tariff proposals, volatility returned to the markets in force.

In very simplified terms, here is how things are supposed to work: when times are tough, the government should take measures to stimulate the economy. Those measures are several, including spending money on anything that governments spend money on; lowering taxes; lowering interest rates; putting more currency into circulation. The national debt should go up. Following the crisis of 2007-8, this is what we did, and it worked.

When times are good, we should reverse that. We should slow down spending, raise taxes, raise interest rates and draw currency out of circulation. The national debt should be paid down (at least a little). The objective is to keep the business of the nation at a simmer, not to let it boil over, and not to let it get cold. The Goldilocks economy we used to call it.

This is theory, and it is logical and reasonable in my opinion.

But now we have diverged from logic and have begun stimulating an already-robust economy. The stimulus is in the form of tax cuts and increased Federal spending on military and infrastructure. And it is not just us; it seems the entire developed world has joined this party.

Offsetting the stimuli is the upward push in interest rates, a trend that is accelerating; and the shrinking of the Fed’s balance sheet, meaning that currency is being pulled from circulation.

But the stimulating factors (so far) greatly outweigh the dampening actions. Skipping the question of why we would stimulate a vigorous economy, we are left with the question of what might result from doing so. One answer is inflation, a lessening of the value of our nation’s currency; another is a sharp rise in the national debt level. These two items are linked, and both have begun to make their presence known.

The rather quick rise in rates has driven down the price of bonds, and is one thing that has given some pause to our over-oxygenated stock market. It is my opinion that rates have been too low for too long, but no one at the Fed has yet asked me for my opinion. So I am not unhappy to see rates finally pushing higher, even though it dings my bond holdings.

To date I remain unconvinced that the tools of raising rates and withdrawing currency will be enough to dampen the excess stimulation. But the proposed trade tariffs just might be. This action is likely to more than cancel out the modest tax cut for individual taxpayers by increasing costs for finished goods. There are further ramifications in various sectors of the economy as our “economic enemies” (read China) institute retaliatory measures.

I’m not arguing against re-negotiating our trade agreements, there are a lot of potential positives. Getting there, though, will not be pretty.

While business is too strong to suggest an imminent slowdown, prices seem, to me at least, to be too high in both stocks and bonds. So if it seems that I am cautious about the markets in general, you are right. Caution seems to be warranted, in stocks certainly, but especially in the bond market. While I am avoiding making investments in bonds, I continue to look for high-quality stocks selling at reasonable prices. Even though I may suffer should the market decline, I believe that we will prosper over the longer term, and it is the long term that is the best metric of success.

Jim Pappas