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Guest Commentary: Portfolio review and strategy Q4 2017
November 22, 2017

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U.S. stock markets continued their course higher throughout most of the third quarter despite a modest increase in day-to-day volatility. Tensions with North Korea remain a concern, although market participants seem to be taking the war of words largely in stride. To the extent this continues, we feel it is important to remind our clients and readers that we do not reposition portfolios around geo-political brinksmanship and discord. These issues have a tendency of making everyone nervous in the short term, while having no long-term impact on the trajectory of the economy or the earnings growth of large U.S. corporations.

To some extent, the same can be said for political dissonance. It seems clear that most legislative items proposed by the new administration to enhance economic growth are proving more difficult to pass and implement than many expected. Corporate tax reform remains the most important item on the agenda as far as investors are concerned. A lower tax rate would impact asset prices immediately. As more money falls to the bottom line, the intrinsic value of companies is enhanced across the board. Nonetheless, we expect the growth prospects and dividend profiles of the companies our clients own to remain constructive with or without legislative accomplishments.

On Sept. 20, the Federal Reserve Board announced they would be reducing the size of their balance sheet by letting their treasury and mortgage-backed bonds mature over the next few years. This will amount to approximately $10 billion of maturities per month, which is certainly meaningful, but not so aggressive considering the Fed's portfolio of bonds is currently worth $4.2 trillion.

Similar to raising the Federal Funds rate, shrinking the balance sheet is another form of monetary "tightening" intended to raise interest rates and dampen inflation. We see this as a positive sign that the Fed continues to take steps toward normalizing monetary policy. We have also been pleased to see minimal volatility around recent Fed decisions, a sign the market is accepting the decisions and adjusting accordingly.

We will continue to watch the shape of the yield curve. An inverted (negative sloping) yield curve generally portends poorly for economic activity, and we have seen a flattening in the curve more recently. We certainly believe higher interest rates are forthcoming, but change is not always smooth and we expect some volatility as the paradigm shifts.

Considering our expectation for higher rates, we have largely avoided traditional fixed-income (bond) investments unless clients can accept lower returns to avoid volatility. Very simply, as interest rates rise, bond prices fall. All else being equal, we continue to believe that high-quality stocks pose a better risk-adjusted value. We will wait to add bonds to client portfolios in a meaningful way until interest rates rise, which may take several years. In the meantime, income needs continue to be met by using high-quality income stocks (utilities), preferred stock, REITs, and master limited partnerships (MLPs).

International stocks have performed very well throughout 2017. While we have limited our direct exposure to emerging markets due to outsized risks, we do own several individual companies headquartered abroad and have been allocating more dollars to developed markets such as Europe. As the economic landscape improves across Europe and other developed regions, we will continue to evaluate the opportunities.

Ian N. Breusch, CFA

Chief Investment Office

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