SARATOGA CAPITAL MANAGEMENT, LLC ECONOMIC OVERVIEW –As measured by 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 2.0% during the first quarter of 2018. This was a decline from the 2.9% AGR during the fourth quarter of 2017. The largest component of GDP is Personal Consumption Expenditures (PCE), which helps us to understand how the American consumer is doing. It performed poorly during 1Q18, advancing less than 1.0% AGR. The Durable Goods segment of PCE declined by more than -2.1% AGR during the quarter, its worst performance in 27 quarters. Meanwhile, the Non-Durable Goods portion of PCE was up a multi-quarter low, advancing only 0.5% AGR. Another of GDP’s important components, Gross Private Domestic Investment (GDPI), advanced more than 7.25% AGR during the quarter, with many of GDPI’s sectors advancing to multi-quarter highs. To determine the health of our domestic economy, we look to both the consumer and to domestic investment. While recent consumer performance is disappointing, we believe the domestic economy is strong and should be sustainable. We believe that the US economy has stabilized into a moderate expansionary environment, where we would expect both production and consumption statistics to continue pushing the economy forward. At times, GDP could realize moderate-to-robust growth. At the June 13, 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 May indicates that the labor market has continued to strengthen, and that economic activity has been rising at a solid rate. Job gains have been strong, on average, in recent months, and the unemployment rate has declined. Recent data suggest that growth of household spending has picked up, while business fixed investment has continued to grow strongly... In view of realized and expected labor market conditions and inflation, the Committee decided to raise the target range for the federal funds rate to 1.75% - 2.0%. The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2.0% inflation.”
Monetary Policy: In the June 13, 2018 FOMC policy statement, the Federal Reserve (Fed) noted that it had increased the target range for the federal funds rate (FF) to 1.75% - 2.0%. The Fed continues to assert that it is maintaining an accommodative monetary policy. In the Fed’s H.4.1 balance sheet, its headline measure Total Reserve Bank Credit is down over 4.0% since February 2015; over the same period, in the Fed H.3 statistical release, Aggregate Reserves of Depository Institutions and the Monetary Base, Required Reserve Balances are up over 30%. We view this as a clear tightening of monetary policy. Most money supply (MS) measures, from a year-on-year percent change (y-o-y%) basis, peaked in the latter part of 2011. The monetary base (MB) is a core tool for the Fed to achieve its primary objectives. The MB topped up over 100% y-o-y in the middle of 2009, as the Fed was trying to stabilize an economic downturn. The MB’s most recent reading, May 2018, is down over 2.6%. The MB long-term average is roughly 8.9%, while M2 is 6.9%. When the MB and the M2 were below their long-term averages, stock market conditions are often volatile. The Fed has displayed its intentions to develop a policy that is ready to fight inflationary pressures. However, we believe the Fed’s actions, in both rate of change and duration are 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 0.58 at the end of June 30, its lowest level since the beginning of 2007. It is widely known that an inverted yield curve often portends a negative stock market, 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 help 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 just yet. Regarding long-term corporate bonds, the quality spread has widened. The quality spread has historically been a good predictor of confidence in the corporate bond market; a widening spread could mean trouble for this segment of the market, though current levels are not alarming.
Equity Valuations: As of June 29, 2018, the S&P 500 index sits at roughly 2,718. Our proprietary valuation work uses both fundamental and technical analysis, and provides justification for the S&P 500 at roughly 2,612, a solid gain from last quarter’s figure. 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 2,450 to 2,850. 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 since the middle of 2015. The EPSP level, has been trending positively since May 2015 and is trending close to the CPI level. When there is strong pricing pressure from the manufacturing sector it tends to lift most associated prices, which, in turn, tends to help wages grow, potentially triggering an inflationary cycle. The Producer Price Index (PPI) has recently been trending higher, with some components rising rapidly, suggesting to us that costs to the retail sector (cost-push inflation) are beginning to put upward pressure on inflation. Likewise, there is moderate consumer demand-side upward pressure on inflation. The growth in the wages complex is building, putting more money in workers’ pockets. If these trends continue, the Fed could end up in a difficult position. Over the past few months, the Consumer Price Index (CPI) has reached and surpassed the Fed’s initial target of 2.0%, and has remained above 2.0% since September 2017. As of May 2018, the CPI increased to 2.8% y-o-y. As we see a steady trend above 2.0%, along with strong wage metrics, the Fed will likely be pushed into reducing its balance sheet and increasing the FF more rapidly, potentially having to push higher by more than 0.25% per raise.
1The S&P 500 is an unmanaged, capitalization-weighted index. It is not possible to invest directly in the S&P 500.
Information contained herein was obtained from recognized statistical services and other sources believed to be reliable and we therefore cannot make any representation as to its completeness or accuracy. Any statements not of factual nature constitute opinions which are subject to change without notice. Past performance is no guarantee of future performance. Investors should carefully consider the investment objectives, risks, charges and expenses of the Saratoga Funds. This and other information about the Saratoga Funds is contained in the prospectus, which can be obtained by calling (800) 807-FUND and should be read carefully before investing. The Saratoga Advantage Trust’s Funds are distributed by Northern Lights Distributors, LLC. 7/18 © Saratoga Capital Management, LLC; All Rights Reserved. Saratoga Capital Management, LLC is not affiliated with Northern Lights Distributors, LLC, member FINRA/SIPC. 7272-NLD-07/24/2018