At first glance, market results during the third quarter pleasantly surprised us but given the strong economic data, the moves appear justified. That said, our 2018 expectations for equity returns have been exceeded and we still have three months to go. Bonds, while slightly negative for the year, have held up well considering the path of the Federal Funds rate. Interest rates have moved higher and appear to continue that trajectory. Of course, concerns persist on many levels which we will discuss below.


In our last letter we indicated that second quarter GDP was estimated to be in a range of 2.8% to 4.0%. The actual reading came in above estimates at 4.2%. Current projections for economic growth in the third quarter are in a range of 2.5% to 4.4%, with recent revisions moving higher. Unemployment remains below 4%, a level below the long-run “natural” rate. So far in 2018 over 1.6 million (non-farm) jobs have been created, with an additional 184,000 expected to be announced in the September reading. Resulting consumer confidence levels have been very high, coming in at 138.4 for September which is the highest measurement since the third quarter of 2000. Considering these data points, it is fairly straight forward as to why the equity markets have been so strong.

Risks to this persistently robust economic growth may lie with the Federal Reserve and any adverse impacts from “trade wars.” Over the last three years, the Federal Reserve has increased the overnight rate to a range of 2.0% to 2.25% from 0% to 0.25%. It has also signaled that rates may be heading to 3.0% over the next 18 months if the economy continues its current trajectory. The Fed’s goal is to maintain full employment with stable prices. The strength of the economy, and its impact on wages and input costs, could push inflation above the Fed’s 2.0% target. The last reading on the Consumer Price Index (excluding food and energy) was 2.2% and the Core Personal Consumption Expenditures Index was right on target at 2.0%. The charts below show four of the variables that impact inflation. You can see the cost of materials, the cost of money (as represented by the 10-Year Treasury yield), and the Capacity Utilization Rate have all been rising. The fourth, the cost of labor (wages), is turning up and in September reached a robust 2.9%. If these trends continue, higher inflation rates could jeopardize the recent economic strength.

The Fed has raised interest rates before each of the last 5 recessions. This time it appears the Fed is taking a slower path to tightening monetary policy but only time will tell. The bottom line is that their restrictive stance has yet to show up in economic metrics.

Regarding trade policy, we have reached an agreement on a “new” NAFTA. We’ll keep the details brief (the deal covers 34 chapters of fine print) but it covers $1.2 Trillion in trade between the three nations and it will have positive impact on many industries in the U.S., namely autos, pharma, and agriculture. We view this as a positive and likely served as a message to China that we intend to shepherd in a deal that is “fairer” to the U.S. If an agreement with China is not reached, eventually economic expansion could be curtailed and both participants lose.


The S&P 500 posted a strong third quarter, returning 7.7%. Year-to-date, the S&P 500 is now up 10.6%, and recently hit an all-time high, along with the Dow Jones & Nasdaq indices. However, not all asset classes are reacting as favorably as domestic stocks. Through mid-September, the chart below shows that this year is on track to deliver the lowest share of positive returns across 17 major asset classes since 2008.

U.S. equities have been the standout performer this year, and our economic section outlines many of the reasons why. Consumer confidence readings are strong, GDP growth appears to be accelerating, and expectations for corporate earnings growth in 2018 are just over 20%.

Looking at the sector-level performance for the third quarter, all eleven economic sectors in the S&P 500 posted positive results. The Healthcare sector (up 14.5%) was the best performing sector during Q3. Fund flows into Healthcare stocks (right) picked up during the quarter, due to relatively attractive valuations combined with the defensive characteristics of this sector. The Technology (up 8.8%) & Consumer Discretionary (up 8.2%) sectors outperformed during the quarter, and remain the two best performing sectors year-to-date (both up 20.6%). These two sectors are more growth-oriented and investors continue to favor growth, with Growth stocks outperforming Value stocks by a 13% spread YTD.

According to a recent industry survey (left), investors are most fearful of a trade war impacting U.S. equity markets. The Materials sector (down 2.7% YTD), which includes agriculture, has been directly impacted by tariff discussions. The Consumer Staples sector (down 3.3% YTD) is indirectly hit by rising input costs, and continues to be squeezed by changing consumer preferences, such as fresh versus packaged foods. These two are the only sectors in negative territory year-to-date.

One additional sector related note. The former “Telecommunications” sector will now become the “Communications” sector going forward. This is a pretty significant change as several large companies (primarily media & social media related) will be moving from the Technology and Consumer Discretionary sectors into the new Communications sector (chart below). The old Telecommunications sector weight was ~2% of the S&P 500. The new Communications sector weight will be ~10% of the S&P 500. Sector weights in Technology and Consumer Discretionary will both shrink accordingly. We will be evaluating the sector changes and may make some shifts in portfolios, but do not expect any drastic changes.

According to FactSet Research, the 12-month forward P/E Ratio for the S&P 500 is 16.8x, which is just above the 5-year average and well off the Jan-18 peak (of 18.4x). As mentioned above, consensus earnings expectations call for 20% earnings growth in 2018, with an additional 10% growth in 2019. The backdrop for equities remains constructive, but we would like to see more participation out of other asset classes, along with a resolution to trade concerns.


Similar to the second quarter, the taxable U.S. bond market was basically flat in the third quarter, returning 0.17%, as measured by the Barclays Intermediate Government/Credit Index. The tax free municipal market was a little weaker with a negative return of 0.14% as measured by the S&P Municipal Index. The bond market is responding to the monetary policy of the Federal Reserve and increased inflation expectations as a result of above trend growth of the economy. The yield curve has flattened, meaning there is very little yield pick up to own a 10-year Treasury vs. a 2-year Treasury.
The chart to the right shows the spread as you extend out on the yield curve. As of the end of the quarter investors could increase yields by only 0.23 percentage points by extending out eight years. That is introducing a fairly substantial amount of interest rate sensitivity while only marginally increasing the yield level. Economists and investors are watching this closely as a flat/inverted curve increases the probability of a recession (note the gray bars indicate historical recessions). In this environment we are typically investing in the 1 to 5-year range so we can reserve the opportunity to reinvest at (presumably) higher rates in the future.

While bonds have been down this year, yields in the 5-year sector are well above 3% for government agency bonds. These are levels we have not seen in many years. Investment-grade tax-free municipal bonds in the 5-year sector yield around 2.25%, or near 4.25% taxable equivalent yield for those investors in the maximum tax brackets. We are working to keep the portfolios invested while managing the duration risk. Our strategy of using individual bonds with a set maturity date will continue to show its value as rates are managed higher.


More and more, it feels like the political and media climates have gone mad. One feeds the other until we are in a frenzied state. We are sure many of you share this sentiment regardless of your political leanings. It is always helpful to step back from the “madding crowd” and remember the tremendous social and economic progress we have witnessed even in our own lifetimes. We remain as fixed as ever to our investment disciplines which have guided our firm so well. We thank you for your continued business.