Client Letter 2018 Q2

Q1-2018 Market Results

For the first time in nine consecutive quarters, the equity markets were down almost across the board in the first quarter of 2018. The S&P 500 was down -0.76% and global ex-U.S. stocks were down -1.33%. Only the emerging markets were positive for stocks last quarter, up +1.28%. Bonds were also down, with the Barclays index down -1.46%. Short-term treasuries were up slightly at +0.34%, probably a result of being viewed as a safe-haven destination. Not a terrible quarter by any means, but a significant reversal of the positive trend seen for over the last two years.

Portfolio Thoughts

The U.S. stock market took a breather in the first quarter from its strong, positive trend of the last two years. After all of the three U.S. markets (S&P 500, Dow Jones & NASDAQ) hit all-time highs on January 26, 2018,

the market began a sell-off in early February. No major global event initiated this selloff, and it seems clear to me that the market fundamentals did not change in less than a week. My sense, is that the selling began, for whatever reason, and market emotions took over. I frequently hear questions asking how much further the markets can go, and when we should expect a correction. To me, these questions lead me to think investors are looking for any reason to believe a correction is upon us and reacting accordingly. The sell-off continued over the next five days, with the markets bottoming down just over 10% by Feb. 8. That amount, -10%, is the minimum needed to be considered a market “correction.” Now, that’s not to say that this correction was unwarranted. I would argue that the market increase in the month of January was extremely unusual, and unsustainable. The S&P 500 was up +5.62% in January. The idea that the markets adjusted for that unusually strong month’s return seems reasonable. The big question is, where do we go from here? Not an easy question. Within a week of the market bottom, nearly half of the losses had been recovered. I commented to several people that I was not convinced the correction was over, and I’m still not. By the end of March, markets were back down close to the low-point of February 8, indicating to me that the markets are still looking for balance. The high level of volatility, seen clearly with strong, positive days followed by equally strong, negative days illustrates the market struggle. U.S. and global economic fundamentals look positive, but the markets aren’t satisfied that price matches value. I expect we may find some balance, with market pricing somewhere between where we are now and the highs from January 26, but I have no idea how long it will take to get there.

From a portfolio view, I made lots of changes during Q1 and now into Q2. My momentum indicators still point towards global, non-US stocks, so I plan to further overweight emerging markets. I’ll reduce exposure to US Large Value. For bonds, I’ve brought in a new multi-sector bond and added exposure to emerging market debt. I’ve reduced exposure to Core US bonds. I’ve also adjusted alternative investments by pulling out of global real estate in favor of an equity long/short position. This position will help protect more aggressive portfolios in the event of a continued market correction.

Q1-2018 Notes

I feel reasonably confident that some of the extended gains seen in January were in-part driven by the new tax law and the expectation of improved corporate profits. While I believe corporations will gain from the reduced tax burden, those new profits have not yet been realized. For me, it’s too early to rely on them. Markets may have come to this same conclusion as part of the February correction.
Adding to the market concerns, we have the Federal Reserve (Fed) continuing to increase short-term interest rates and threatening more increases to come. Markets expect interest rates to continue to move higher, which I agree is likely. Markets also seem to fear the coming of an inflationary spiral, which I don’t agree with. I just don’t see how, with global interest rates still near historic lows, we will get rapid inflation. Inflation fears likely played a role in the February correction, and are likely also playing into the bond weakness we saw during Q1. The bond market is struggling with the same inflationary concerns with which the stock markets are struggling.

Global economics are currently strong, but the volatility we’ve seen since February is concerning. I continue to believe we won’t be seeing a slowdown or recession in 2018. But I do see signs of economic adjustment as we progress into 2019. I’m not suggesting anything like the Global Financial Crisis (GFC) from 2008. I expect something much less severe that might provide not only an economic reset, but also the re-establishment of a traditional economic cycle. In my opinion, the economic cycle has been nonexistent since the GFC. I’ll be watching these developments closely.

I don’t have a lot of space left to talk about global events, so I’ll wrap-up this letter with a few thoughts on the potential U.S./North Korean summit. To start, the idea of a U.S. summit with North Korea is appealing. At some point, it seems direct negotiations need to take place to move from the current stalemate. It is entirely unclear what North Korean leader Kim Jong-un’s intentions are for the potential summit. Is he truly trying to find an acceptable compromise, or is this merely a showcase for delay purposes? North Korean history suggests the latter, combined with gathering as many generosities as the North can get from both the U.S. and South Korea. The North Korean bait-and-switch tactics are so wellknown, it seems hard to believe they might try them again, but stranger things have happened. Interestingly, in a recent covert meeting between Kim Jong-un and Chinese president Xi Jinping, the Chinese leader painted the younger, less experienced North Korean leader into a corner. Kim’s options for a bait-and-switch are more limited when China holds a strong position, which they made clear was exactly the case. President Xi didn’t do this solely because of the piece of chocolate cake he shared with president Donald Trump. China wants a more stable Korean peninsula, preferably without nuclear weapons. And China wants its nearby neighbors to be very clear about who’s in charge. But, pursuing those goals, while simultaneously gaining leverage in U.S. trade negotiations for helping manipulate North Korea, is a very pragmatic strategy. China and the U.S. are more adversaries than allies, but even adversaries can find common ground on which to work for mutual benefit.

As always, I will watch and research the global economy and make investment choices to the best of my ability for each and every client portfolio. If you have questions about your portfolio, my views expressed in this letter, or anything else financial, please do not hesitate to call.

Best Regards,

Jim

Barron Financial Group, LLP is a fee-only Registered Investment Advisor regulated by the Connecticut Department of Banking.

This newsletter is for general information only and should not be considered investment advice.  Investors should consult with a trained investment professional to discuss their particular situation.