Middleburg Trust Company • 3rd Quarter 2017 Review

Quarterly Review

The U.S. equities market, as represented by the S&P 500, generated a +4.5% total return in the third quarter, dividends included. The Dow Jones 30 returned +5.6% and the NASDAQ returned +6.1%. Returns year-to-date were +14.2%, +15.4% and +21.7%, for the three indices, respectively. Given that the U.S. economy has been in a recovery mode for about 8 years, the annualized returns for the past 5 years have been remarkable at +14.2% as measured by the S&P, and +17.4% using the tech heavy Nasdaq. Forgotten a few years ago when international markets lagged the U.S. markets, the MSCI Emerging Markets Index and MSCI EAFE Index have produced returns in 2017 of +28.1% and +20.5%, respectively. To include fixed income, high yield corporate bond indices have returned +7.0%, the BofA/Merrill Municipal Index +4.6%, and the Bloomberg Barclays Aggregate Bond index +3.1% thus far in 2017, including income and price appreciation.

The best performing sectors for the quarter were Technology (+8.6%), Energy (+6.9%), Telecom (+6.8%), and Financials (+5.3%). Six of eleven sectors lagged the S&P with the worst performances coming from Consumer Staples (-1.3%), Real Estate (+0.9%) and Consumer Discretion (+0.8%). On a year-to-date basis, Technology (+27.3%) and Healthcare (+20.3%) equities left the rest in the dust, outperforming the S&P by a wide margin. Earnings growth and reasonable valuations can be found in both sectors and this trend should continue, though maybe not by this margin. Mega cap stocks in the technology sector have posted astounding performance but some investors suspect this has become a “crowded trade” due to the impact of index investing through “passively” managed ETFs. “Growth” portfolios have outperformed “Value” oriented portfolios, and most portfolios underweight the largest cap companies (i.e., Apple, Alphabet, Facebook, and Microsoft) have lagged the S&P by a significant margin

Equity markets repeatedly made new highs during the quarter and again this past week, including the MSCI World Index (both developed and emerging markets.) “Synchronized global growth” is a term in use currently and many central banks remain accommodative with monetary policy, providing the conditions for markets to continue to move higher, but at a slower pace. More strategists recommend caution regarding equity market valuations and remind investors that recent returns have exceeded historical averages. That said, higher valuations by themselves do not produce significant price corrections and there are no signs of recession. Just this past week the IMF raised its forecast for the rate of worldwide economic growth and international markets could outpace growth in the U.S. as our recovery from the Great Recession has exceeded that of other developed economies.

The Federal Reserve last raised its target for overnight lending between banks, known as the “Fed funds rate”, in June, to a band of 1.00% to 1.25%. This was the 3rd hike dating to December 2016, however, market rates have not moved much since the funds rate was held at 0% to 0.25% for seven years following the financial crisis. Market expectations are for one more 25 bp adjustment this year, likely at the FOMC December meeting. While the market awaits that event, the Fed affirmed in September that it will begin this month the “balance sheet normalization program” outlined in June. The Federal Reserve Bank holds $4.5 trillion of Treasury bonds and mortgage backed securities that it acquired over a period of years through a program of “quantitative easing.” This massive purchase of securities was undertaken to add liquidity to the banking system, encourage lending, and drive rates lower. It certainly accomplished that last goal! This extraordinary monetary stimulus will now be withdrawn by allowing the portfolio to run off without reinvestment, resulting in a $10 billion monthly reduction, initially, growing to $50 billion monthly by the middle of 2018. Most observers think this is so gradual that the effect on rates will be minimal, however, it has never been done before and our central bank is not the only one that participated in this strategy to lower rates. The central banks of the EU, Japan, and China are the other major players along with a dozen smaller countries. The total of securities held by central banks worldwide is estimated at just under $25 trillion! What will happen when they exit?

At Middleburg Trust, we have been unenthusiastic investors in fixed income for several years and do not consider ourselves ardent “Fed watchers”. The point is, most managed portfolios need an allocation to bonds so we hold some preferred shares, investment grade corporates including variable rate securities, and municipals, mainly due inside ten years,. The variable rate bonds have reset to higher quarterly coupons since the end of 2015, as expected. We would like to obtain more current income than available on intermediate fixed rate bonds, without taking significant credit or duration risk. In our opinion, the long end of the yield curve has not offered a reasonable balance between risk and potential return, but admittedly, there have been decent returns generated by fixed income in years when rates lurched lower and credit spreads tightened. As for tax free municipals, we do not consider taxable equivalent yields to be attractive for most individuals except those in the highest brackets, after considering the prospect that personal income tax rates may be lowered this year or next.

One question is how much and how soon long term rates will move now that the Fed’s “punch bowl” is beginning to be withdrawn and how will this impact earnings and stock prices? Inflation is not showing signs of getting to the Fed’s 2% target, using the PCE measure that was just 1.4% at an annualized rate this past quarter. Core CPI for the last 12 months was just +1.7%. If inflation stays low and U.S. GDP growth remains in the 2%-2.5% range, can interest rates move significantly higher if sovereign yields overseas are below ours? What impact would a larger budget deficit have on rates? Will the “normalization” of rates being undertaken by the Federal Reserve dampen domestic growth and risk prompting a recession?

As we wrote last quarter, valuations for the domestic companies that comprise our portfolios are higher than a few years ago. They are higher now than three months ago and earnings growth needs to pick up to justify current price levels. The three largest sectors: Technology, Healthcare and Financials, are generating improving earnings and still offer reasonable investment opportunities. Our research sources do not see an end to the global economic expansion while rates are low. Adjustments should be made to equity portfolios where appreciation has pushed the allocation above target and to individual equity names that are fully valued relative to industry peers and current earnings expectations.  As usual, we will hold bond allocations at or below duration targets and monitor changes to the shape of the yield curve and credit spreads. The Fed has begun the long awaited process to remove excess stimulus and though they have provided much detail on how this will transpire, there could be unpredictable reactions and impact to all asset markets.


George Calvert, CIO                                October 17, 2017                                    gcalvert@middleburgtrust.com