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Investment Letter

3rd Quarter 2016

The calendar has turned to October and daylight hours are getting shorter, but the unveiling of Mother Nature’s majestic fall display has been delayed thanks to the lingering summer of 2016.  As we wait for the seasonal transition to arrive, the warm temperatures were not the only sizzling headlines of late.  Police brutality issues sparked civil unrest; major flooding occurred in Louisiana; the U.S. Presidential election debates started; Hurricane Matthew headed for the east coast; the domestic economic expansion continued; and the secular bull market that began in March of 2009 advanced past 90 months.

 

Equities enjoyed a successful period of performance during the 3rd Quarter 2016.  The Dow Jones Industrial Average (DJIA) set record closing highs on nine different occasions during July and August (highest record close on 8/15/16 at 18,636.05) before relenting some of the summer gain and ending the quarter at 18,308.15 points.  The DJIA 3rd Quarter total return was +2.78% and +7.21% year-to-date.  The summer spike in asset prices also benefited the S&P 500 and Russell 2000 indices.  The large company stock index (S&P 500) increased to set a new record close on 8/15/16 (2,190.15).  The S&P 500 Index ended the quarter at 2,168.27 points with a +3.85% quarter total return and +7.84% year-to-date total return.  The small company stock index (Russell 2000) was the big winner for the quarter.  While the index came very close to setting a new record close during the latest three month period, it had an outstanding total return of +9.05% for the quarter and +11.46% year-to-date. 

 

The table below recaps the 3rd Quarter and year-to-date performance of other major indices:

 

Asset Class

Index

3rdQtr. 2016 Total Return

2016 Total Return

Cash

BofA/ML Three-Month U.S. Treasury

0.10%

0.24%

U.S. Bonds

Barclays Intermediate-Term Treasury

-0.26%

3.39%

U.S. Large Co. Stocks

S&P 500

3.85%

7.84%

U.S. Small Co. Stocks

Russell 2000

9.05%

11.46%

International Stocks

MSCI EAFE (net div.)

6.43%

1.73%

Real Estate

DJ Select Real Estate Securities

-1.24%

9.45%

                           Source: Morningstar

 

The aging economic expansion keeps marching forward at a slow but steady pace.  According to the U.S. Department of Commerce, the second quarter revised estimate for Gross Domestic Product (GDP) increased at an annual rate of 1.4%.  The increase in GDP reflected positive contributions from personal consumption expenditures, exports, and nonresidential fixed investment.[1]

 

The economy added 156,000 jobs in September (fewer than forecasted), and the unemployment rate rose slightly from 4.9% to 5.0% due to an increase in the amount of people entering the work force.  As a result, the labor-force participation rate (the number of people either employed or actively looking for work) ticked up to 62.9%, but remained near a 40-year low.

 

Other major economic points for the 3rd Quarter:

 

  • Consumer spending (the largest component of GDP) remained supportive.
  • Consumer confidence increased in September.
  • Consumer balance sheets remained attractive.
  • Activity in the manufacturing sector expanded.
  • Inflation remained low but increased slightly in August.
  • Oil prices varied slightly during the quarter but remained in an acceptable range.  The West Texas Intermediate spot price on 9/30/2016 was $47.72/barrel.
  • Housing activity disappointed as sales of new homes and starts declined.
  • The strong dollar, poor performance of the energy sector, and slowing global growth remained headwinds for corporate profits as 2nd Quarter results weakened.

 

Data from the most recent Federal Open Market Committee meeting confirmed the economy is still on solid ground.  The committee stated, “Labor market conditions strengthened in recent months and that real gross domestic product was increasing at a faster pace in the third quarter than in the first half of the year.  Consumer price inflation continued to run below the Committee's longer-run objective of 2 percent, restrained in part by earlier decreases in energy prices and in prices of non-energy imports.”[2]  The committee agreed that the case for increasing the federal funds rate had strengthened, but ultimately decided to delay a rate hike at their September meeting and maintain the federal funds rate at ¼ to ½ percent.  A rate increase before the end of the year will be contingent on economic data, but only two meetings remain in the Fed’s 2016 schedule.  The November meeting is close to the presidential election, and the Fed will most likely defer a rate hike decision until after the election results.  Therefore, we expect an increase in the federal funds rate at the December 13-14 meeting.  While the Fed remains cautious, several members of the committee emphasized delaying policy adjustments too long could ultimately force a faster tightening schedule, thus posing more risk to the current economic expansion.

 

Success in international economies varied.  In Europe, the BREXIT decision by the U.K. dominated economic news.  Fortunately, fears that the Eurozone economic recovery would come to a halt were over dramatized (at least in the short-term), and recent economic data showed Europe’s economy, including the U.K., appeared resilient in the wake of the BREXIT decision. The BREXIT negotiations will be an arduous ordeal, and the long-term outcome is uncertain for the U.K. and Eurozone countries.  Britain’s new Prime Minister Theresa May is determined to get the ball rolling and is expected to begin official negotiations in early 2017by invoking Article 50 of the Lisbon Treaty.  This should set the stage for the U.K. to leave the European Union in two years.

 

China (the world’s second largest economy) had another solid quarter of growth.  The latest growth results (6.7%) were in line with government projections but far from the torrid pace the country enjoyed for decades.  China’s economic transformation from an infrastructure and trade-fueled economy to one driven by domestic consumption attributed to slower growth over recent years, but the reform was a necessity for long-term economic sustainability.  Going forward, fears of a real estate bubble, decline in private business investment, and increasing corporate debt levels will be growing concerns. 

 

Elsewhere in Asia, Japan’s economy remained weak as recent data showed 0.2% growth for the second quarter.  The Bank of Japan’s attempts to jump start the economy with stimulus measures have not met expectations, and it appears government officials will keep adjusting fiscal and monetary policies until they find they right mix to spur economic growth.

 

As a collective, emerging market economies have improved somewhat but remained a mixed bag.  Economic improvement continued to be country specific depending on external developments, global trade exposure, and commodity driven economies.

 

Once again, our outlook for the domestic economy remains optimistic.  We believe the current pace of growth is sustainable, and improvement in corporate profits, housing, and manufacturing could lead to an acceleration of growth into 2017.  Additionally, a strong labor market should persist, oil prices seem to be range bound and more stable, and inflation should remain low.  All of the above should translate into favorable financial conditions for domestic markets.  The Fed continues to be dovish regarding future rate hikes, but we believe they have positioned themselves for a rate increase later this year.  Barring a major economic or financial market shock, we anticipate a rate hikeof 25 basis points (0.25%) at the December meeting.

 

Our international economic outlook is more cautious.  Over the short to medium term, the U.K. and the rest of the Eurozone could see increased volatility due to BREXIT related negotiations.  China’s ongoing economic transformation and debt concerns have the potential to cause some instability that could spill over to other parts of Asia.  Japan’s weak economy continues to be a global economic concern, and many emerging market economies are too dependent on volatile commodity prices.  While we believe there are many opportunities abroad, investors need to recognize regional uncertainties and the increased potential for volatility. 

 

As the domestic expansion continues to mature, there are a few risks on our radar screen that concern us.  The most obvious risk for our domestic economy is the U.S. Presidential election. This memorable and unconventional election cycle is getting closer to conclusion, but the outcome is still undecided.  Financial markets don’t react well to uncertainty, so we expect elevated volatility during the next month until the election dust settles.  Regardless of the winner and the policies of the new administration, it is important to remember that our political system was designed with checks and balances.  As a country, we have weathered many storms and survived leaders of all types, and we don’t believe this election will be any different.  Additional risks we are tracking include the following: continued strength of the dollar relative to other currencies, energy prices, rising inflation, fiscal and monetary policies, BREXIT negotiations, China’s decelerating economy, and the always unpredictable geopolitical wild card. 

 

Despite all these risks, it is important to remember the following statement.  The successful long-term investor is patient, weathers market swings, and adheres to a disciplined investment process that includes a diversified asset allocation strategy based upon a tolerance for risk and need for return.  Our investment philosophy remains based on the fundamentals, and we believe that it is time---not timing---that matters most. 

 

With the end of the year rapidly approaching, it is time to complete any last minute year-end tax planning strategies.  The list below provides some items to consider:

 

  • Gift appreciated property.
  • Contribute the maximum amount to retirement plans.
  • Make charitable donations.
  • Defer income and accelerate deductions.
  • Manage investment gains and losses.
  • Bunch itemized deductions (medical and professional fees/expenses) to exceed the adjusted gross income (AGI) floor.
  • Check estimated tax payments to avoid underpayment penalties.
  • Take required minimum distributions (RMDs) by the deadline.

 

In closing, I want to thank you for the opportunity of working with you and for your continued confidence and trust. Please contact me if you have any questions or if you would like to discuss the tax planning strategies above.

   

With kindest personal regards, I am

 

Very truly yours,

 

WILLIAM HOWARD & CO. FINANCIAL ADVISORS, INC.

 


[1]Source: Bureau of Economic Analysis Gross Domestic Product: Second Quarter 2016 (Third Estimate), http://www.bea.gov/newsreleases/national/gdp/2016/gdp2q16_3rd.htm

[2]Source: Federal Reserve System, Minutes of the FOMC Meeting, 20-21 September 2016, http://www.federalreserve.gov/monetarypolicy/fomcminutes20160921.htm

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