Q2 2017 – “Outlook for the Remainder of 2017″ (Part 2)

July 14, 2017

A factor that continues to concern policymakers is the lack of inflation. The Fed’s preferred inflation gauge briefly surpassed the Central Bank’s 2% target in February but posted a greater than expected drop since then, having risen just 1.4% on the year ending in May.

A low level of inflation is a concern to the Fed because it calls into question whether the Central Bank will be able to keep raising rates to what it considers normal levels without damaging the economy. As we have previously mentioned over the years, we see limited upward pressure for inflation, with technology widespread in all facets of consumers’ lives.

For example, excluding a major disruption in the Middle East, energy prices should remain low as US oil and gas producers continue to increase production and export oil and gas throughout the world by using technology to lower their production costs.

Additionally, competition within the US grocery industry is set to increase with the entrance of Lidl, one of the world’s largest retailers based in Germany, and grocery discounter Aldi’s plans to invest nearly $5 billion over the next five years expanding its own footprint. This was before Amazon announced it was acquiring the upscale grocery chain Whole Foods in June.

The competition for consumers’ wallet share is getting fierce with no signs of slowing and, because of this, food prices, similar to a lot of consumer goods the past several years, will likely see downward pressure. Multiple Fed policymakers believe that the recent downticks in inflation are “temporary,” but time will tell.

If somehow inflation is able to tick upward towards the 2% Fed goal, then we would expect to see another quarter-point increase in the Federal Funds Rate before year-end. If inflation continues to lag, it is likely that multiple policymakers on the fed committee will be reluctant to increase rates given how data dependent the Fed has been over the past decade.

From a market risk perspective, we remain concerned about the influence that passive investments, such as ETFs and index funds, could have on stock prices in a volatile market. Barron’s recently mentioned a point that the dramatic increase of passive investments have put a large amount of stock ownership that isn’t tied to the fundamental performance of the company, nor its valuation. For instance, Vanguard Group owns 5% or more of 491 companies in the S&P 500, up from 116 in 2010.

While ETFs are known for lower fees than actively-managed mutual funds, there are times when the underlying securities price-per-share within the ETF and the price of the ETF security are trading at a disparity, which hides the true costs to the shareholder.

A recently published study in the Financial Analysts Journal looked at approximately 1,800 ETFs from 2007 to 2014 and found that the harder the underlying securities in the ETF are to trade, the bigger the gap between actual securities price versus the ETF gets. With the increased passive ownership limiting the float available for the stock to trade, the number of underlying securities that could have potential difficulty in trading has increased. The author of the study concluded that an ETF portfolio could be costing investors 1% or 2% without the shareholder knowing it.

A flash crash on August 24, 2015 halted trading in almost 20% of US listed ETFs, and we believe that foretells the problem that the passive strategies will have in times of great market volatility.

With the markets continuing their strong move from the first quarter into the second, we could see the market take a “breather” during the summer months, but we would recommend being opportunistic on any pullback in the market, particularly on good companies selling at attractive valuations.

From an income-generation perspective, we continue to seek good quality, high-yield bonds with short duration to minimize negative impact to raising interest rates. We also continue to seek dividend paying stocks that should have strong fundamentals to their underlying businesses to potentially allow the dividend to grow.

If comprehensive tax reform or an infrastructure spending bill materializes in the Fall, we believe the market will have a strong finish into the end of the year.