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 3.2% during the third quarter of 2017, a slight increase from the 3.1% AGR during the second quarter of 2017. GDP may be locking into an elevated range. As we discuss below, continued performance at these levels could suggest our economy is entering a new economic stage, transitioning from a mature economic environment to a moderately expansionary one. Personal consumption expenditures (PCE) are a measure of how well Goods (Durables and Non-Durables) and Services in our economy are performing. PCE has performed well post-recession. Gross private domestic investment (GPDI) has also done nicely since the end of the recession, though the metric has been peppered with near-term negative results. In our last commentary, we asserted that PCE and GPDI performing well at the same time for an extended period might push the US economy into new positive territory. For the past two quarters, PCE and GDPI have done just that, and GDP has held above 3%.
At the December 13, 2017 Federal Reserve Open Market Committee (Committee) meeting, the Committee released the following statement, in part: “Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability… the Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12-month basis is expected to remain somewhat below 2 percent in the near-term but 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.”
Most of our internal indicators suggest a recession in the near-term is unlikely, though inflation, and the Federal Reserve’s (Fed) reaction to it, are a continuing concern. 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 a combination of production and consumption would be expected to continue pushing the economy forward, yields would potentially rise, and GDP could continue see moderate-to-robust growth.
Monetary Policy: The Federal Reserve Open Market Committee’s December 2017 statement included the following: “The Committee continues to expect that, with gradual adjustments in the stance of monetary policy, economic activity will expand at a moderate pace and labor market conditions will remain strong. Inflation on a 12-month basis is expected to remain somewhat below 2% in the near-term but to stabilize around the Committee's 2% objective over the medium-term. Near-term risks to the economic outlook appear roughly balanced, but the Committee is monitoring inflation developments closely… The stance of monetary policy remains accommodative, thereby supporting strong labor market conditions and a sustained return to 2% inflation… The Committee will carefully monitor actual and expected inflation developments relative to its symmetric inflation goal.” The Fed continues to assert that monetary policy remains accommodative in their policy statements; it is worth pointing out, though, that most money supply (MS) measures peaked in terms of year-on-year percent change (y-o-y) in the latter part of 2011. The y-o-y MS has been declining steadily, though it has yet to drop into a range that would concern us in terms of its impact on economic growth or signal a coming economic stage shift into a mature economic or recessionary environment in the near-term. The Fed’s moves have been extremely moderate, which is why our view on monetary policy is still neutral for stocks.
Interest Rates: The yield curve, as measured by the 10-year T-Note (10y TN) minus the 1-year T-Bill (1y TB), has been declining; as of the end of December 2017 it is at its lowest level since the beginning of 2007. A yield curve spread of 0.64 does not mean a lot on its own, but other factors such as how far the spread has fallen in the context of the overarching economy, interest rate trends across the board, and movements in CPI, paint a mildly concerning picture. In general, the declining yield-spread has been caused by long-term interest rates running flat over the intermediate-term while short-term interest rates have risen steadily. Regarding long-term corporate bonds, the quality spread is declining as lower-rated bonds are falling in yield slightly faster than higher-rated bonds. A quality spread in this position is generally positive for both the economy and the stock market.
Equity Valuations: As of December 29, 2017, the S&P 500 index sits at 2,673. Our proprietary valuation work uses both fundamental and technical analysis, and provides justification for the S&P 500 at roughly 2,600. 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 ValuationTM 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 2,350 to 2,880. To us, fair-value means the stock market should perform within the parameter of its historic mean. As equities continue their assent, we are watching corporate earnings growth closely, as changes in earnings data has the potential to change valuation levels quickly.
Inflation: One of the reasons we expressed an expectation of restraint from the Fed in our interest rates discussion is our view of inflation, which we think 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 it tends to lift most associated prices; this tends to help wages grow, triggering an inflationary cycle. Over the past few months, the Consumer Price Index (CPI) has reached and surpassed the Feds initial target of 2%, reaching 2.7% in February 2017. On the supply-side, one of the production metrics we focus on is capacity utilization. When capacity 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.
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. 1/17 © Saratoga Capital Management, LLC; All Rights Reserved. Saratoga Capital Management, LLC is not affiliated with Northern Lights Distributors, LLC, member FINRA/SIPC. 6068-NLD-1/19/2018