Client Investment Letter January 2018

“I doubt if you can have a truly wild party without liquor.”– Carl Sandburg

2017 was a year of celebration for financial markets. The S&P rose every single month of the year for the first time in history. Asset prices globally, from old world properties to newfangled cryptocurrencies, soared, and generally the riskier the asset, the better its performance. Global GDP growth even picked up after years of sluggishness. Mergers and acquisitions (M&A) were omnipresent.  In short, the party in the global financial markets, fueled by the liquor of years of loose central bank policies such as low rates and quantitative easing, raged on in 2017. Indeed, even Congress got in on the act in the United States and passed tax reform right at year end which ensured that the financial egg nog was extra potent over the holidays, as corporations anticipated a coming windfall. Never mind the creeping indebtedness the tax plan produces or the long historical track record that shows how hard growth is to come by when debt levels exceed GDP, as is the case currently.

The question that lingers is what happens as the revelry dies down? Indeed, the Federal Reserve, having raised rates three times in 2017 – five times now this cycle – and reduced quantitative easing modestly since October seems to have said “last call.” In 2018, it expects to hike rates three more times according to policy-makers’ projections. In addition, the Federal Reserve is rapidly doing away with quantitative easing. Instead of buying billions of dollars of Treasuries and mortgages each month, the Fed will let its existing holdings mature and therefore shrink its bloated balance sheet, embarking, for the first time, on the long road of quantitative tightening. The Fed first telegraphed this change in June of 2017 and began the program slowly in October of 2017 with a reduction of $10 billion in holdings per month. By the end of 2018, the Fed expects to be letting $50 billion per month run off its balance sheet. Will the absence of such a large purchaser impact the markets? It is hard to imagine it won’t. In addition, this great unwind will be spearheaded by a new and less experienced group of policymakers, with only three Fed members involved in the balance sheet expansion beginning in 2008 still around.

Your companies enjoyed the celebration last year. M&A was a theme throughout the portfolio as Monsanto and 21st Century Fox received acquisition bids or are in the process of completing them.  Gilead acquired a long-awaited new leg of growth in oncology by purchasing Kite Pharmaceuticals. And Qualcomm not only is in the process of trying to close its acquisition of NXP Semiconductors, but it is also the target of a hostile takeover bid by rival Broadcom. Even those companies who weren’t playing the M&A game enjoyed healthy results and appreciation. Apple rallied into the launch of its tenth anniversary iPhone X, closing the year up 46%. Google parent Alphabet put up impressive results all year and appreciated nearly 33%. Other notable winners were Dell Technologies Class V, Inovalon, Las Vegas Sands, Xylem, ABB, Bristol-Meyers, and Accenture, all of which gained more than 25% for the year.

One notable drag on performance last year was the energy infrastructure and services space. The pipeline companies, Enterprise Product Partners and Kinder Morgan, continued to generate great cash flow in 2017, despite volatile commodity prices. We expect the same will be true in 2018 and beyond, and so we are happy to continue to own them and collect dividends that we expect to grow over time. Schlumberger’s services business is improving from low levels and we expect it to continue to do so.

Our growing cash position is finally earning a little bit of interest (12 month Treasuries yield 1.75% now). We expect continued improvement in short-term rates during 2018 and feel confident that having dry powder is critical for both risk management and opportunistic purposes. If the party ends abruptly, as it sometimes does, having cash on hand to pick up discarded gems will be useful.

We don’t see any tell-tale signs of recession in the offing. Unemployment is low, but wage growth hasn’t picked up like you would expect in an economy that is overheating. While an overly aggressive Fed tightening cycle could induce a recession, we don’t think it’s the most likely outcome, at least not yet. One of the main worries for us is high valuations more than economic fundamentals. A significant correction in asset prices driven by increased risk aversion in the markets would be healthy.  Right now there is almost no fear at all in the markets, as indicated by the CBOE Volatility Index (VIX), which hovered near its all-time lows for most of the second half of the year, as well as many other sentiment indicators. A change in this market posture driven by geopolitical events would not surprise us at all, but we’re mindful that given the large amount of money directly or indirectly short volatility, such a move could quickly escalate. In addition, we continue to stew over the implications of crowding in passive ETF vehicles and note that there are more indexes today than there are individual stocks.

We continue to carefully research potential investment opportunities.  However, we refuse to deploy your capital unless there is an appropriate margin of safety, and lately we aren’t finding such a cushion available in the prices of most companies. The world may have lost Tom Petty in 2017, but when it comes to great investment opportunities, he had it right: “…the waiting is the hardest part.” We have plenty of liquidity, though, to quickly act when the opportunity arises.

Thank you for the continued trust you place in us and may your 2018 be happy and healthy.

Penn Davis McFarland, Inc.
January 2018