SARATOGA CAPITAL MANAGEMENT, LLC ECONOMIC OVERVIEW – As measured by the Real Gross Domestic Product (GDP), the value of the production of goods and services in the United States (US) advanced by an annualized growth rate (AGR) of 2.9% during the fourth quarter of 2017. This was a slight decline from the 3.2% AGR during the third quarter of 2017. Personal Consumption Expenditures (PCE) have continued to perform well, up almost 4% during the fourth quarter. The durable goods portion of PCE is leading the way, with double-digit growth during the quarter; the service sector portion of the PCE has maintained a more modest, but nevertheless healthy, growth rate. Gross private domestic investment advanced by more than 4.6% in the quarter. Most major sectors within GDP are doing well. Many economic statistics we track, both in terms of consumption (demand) and production (supply), are currently showing positive trends, suggesting we may be transitioning towards a sustainable expansionary stage of economic activity. Moderate expansionary environments generally mean that both production and consumption are pushing the economy forward, yields are rising, and GDP is seeing moderate-to-robust growth. A shift from a soft growth economy towards a moderately expansionary environment could trigger an allocation shift in our asset allocation models. At the March 21, 2018 Federal Reserve Open Market Committee (the Committee) meeting, the Committee released the following statement, in part: “Information received since the Federal Open Market Committee met in January indicates that the labor market has continued to strengthen, and that economic activity has been rising at a moderate rate. Job gains have been strong in recent months, and the unemployment rate has stayed low… The Committee expects that, with further gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace in the medium term and labor market conditions will remain strong. Inflation on a 12-month basis is expected to move up in coming months and to stabilize around the Committee's 2 percent objective over the medium term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely.”
Monetary Policy: In their March 21, 2018 FOMC policy statement, the Federal Reserve (Fed) noted that it had increased the target range for the federal funds rate (FF) to 1.5% - 1.75%. The Fed started their most recent round of FF increases in December 2015 from a floor of 0% - 0.25%, and has raised the rate six times since, though they continue to maintain that monetary policy remains accommodative. Most money supply (MS) measures produced by the Fed peaked from a year-on-year percent change (y-o-y%) perspective in the latter part of 2011. M2, a broad measure of the money supply principally held by “households,” reached a cycle high of about 10.25% y-o-y in January 2012. As of February 2018, M2 is up only 4.04% y-o-y. The monetary base (MB) is a fundamental tool for the Fed to achieve its primary objectives. The MB peaked over 100% y-o-y in the middle of 2009 and its most recent reading was 2.9% y-o-y in February 2018. The MB’s long-term average y-o-y growth rate is roughly 8.9%, while M2’s long-term average runs near 6.9%. When MB and M2 are below their long-term averages, stock market conditions tend to show increased volatility and negative trends. The Fed has noted its intentions to develop a policy that is ready to fight inflationary pressures. While they continue to call their overall policy accommodative, we believe that the combined FF and money supply action the Fed has taken, though moderate, is now negatively impacting both stocks and bonds.
Interest Rates: While most of the interest rate array is now increasing in a stable upward trend, short-term interest rates have been rising more rapidly than long-term rates, which is driving a declining yield curve spread. The monthly yield curve spread, as measured by the 10-year T-Note (10y TN) minus the 1-year T-Bill (1y TB), has been in a downward trend for some time, bottoming at 0.70 in December 2017, its lowest level since the beginning of 2007. During the first quarter, the spread jumped around a bit, moving up to 0.90 in February, before declining back down to 0.78 in March. Much has been made recently of the possibility for an inverted yield curve and historical correlations between inversion and recession, so the spread’s downward trend has worried many equity investors and economists alike. However, we don’t believe the current spread level tells us much on its own. Other factors are needed to provide context: the size of the spread decline from its high, additional interest rate trends, and CPI should also be considered. This dynamic has our attention, and in this context, we do not believe interest rates are negatively impacting stocks or forecasting a recession in the near-term. Regarding long-term corporate bonds, the quality spread has flattened. The quality spread has historically been a good predictor of confidence in the bond markets; a flat spread at its current level is still in good form for corporate bonds.
Equity Valuations: As of March 29, 2018, the S&P 500 index sits at 2,640. Our proprietary valuation work uses both fundamental and technical analysis and provides justification for the S&P 500 at roughly 2,421. We believe the market is in fair-value territory. In order to create a band or range of equity market outcomes, we use a valuation tool which we refer to as our Proper PE Valuation™ tool. Among other things, this analysis provides us with a set of ranges above and below which we consider the S&P 500 overvalued or undervalued, respectively. Currently, our analysis suggests that an appropriate S&P 500 fair-value range is roughly 2,300 to 2,700. To us, fair-value means the stock market should perform within the parameter of its historic mean. The current level and direction of many economic statistics we enter into our valuation algorithm indicate that we are likely to stay in fair value range for the near-term. We are watching corporate earnings growth closely, as changes in earnings data has the potential to change valuation levels quickly.
Inflation: We believe inflation should remain at a moderate rate of growth over the intermediate term. Historically, the employment private service providing sector’s (EPSP) weekly earnings 12-month percent change and its direction have correlated well with CPI. CPI has been trending up from the middle of 2015, and it has come close to the EPSP level, which has likewise been trending positively since May 2015. Another sector that has a long-term effect on inflation is the manufacturing sector. When there is strong pricing pressure from the manufacturing sector, associated prices are inclined to increase; this tends to help wages grow, triggering an inflationary cycle. One of the key production metrics we focus on is capacity utilization. When capital utilization is near its high pricing pressure builds as production becomes limited by factories nearing full capacity. While this dynamic is not yet fully in play, the Producer Price Index (PPI) has recently reversed trend, telling us that costs are beginning to put upward pressure on inflation. Over the past few months, the Consumer Price Index (CPI) has reached and surpassed the Fed’s target of 2%, and has remained above 2% since September 2017. Growth in wages is building steam, putting more money in worker’s pockets. If these trends continue the Fed could be put in a difficult position. As we see a steady trend above 2% along with a strong wage metric the Fed will likely be pushed further into reducing its balance sheet.
1The S&P 500 is an unmanaged, capitalization-weighted index. It is not possible to invest directly in the S&P 500.
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