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February 2019

2018 was a difficult year for global investors, as virtually all asset classes and regions around the world declined. In the US, equities had their worst year in a decade, with the S&P 500 falling by 6.2%, while small cap stocks dropped by 11%. Elsewhere, markets were even more hard hit, with global equities down by 13.8%, reflecting falls in emerging markets of 14.7%, in Japan of 12.6% and in Europe of 14.3%. Nor did other asset classes escape the carnage. In the US, corporate bonds fell by 2.1%, real estate stocks fell by 4% and, globally, commodities declined by 11.2%.

Given current uncertainties (see below) we remain conservatively positioned, with an asset allocation of 65% stocks, 20% fixed income and 15% alternatives, which includes commodities and real estate, as well as other strategies, which - in theory - should have a lower correlation with equity markets. Geographically, of the total assets, 35% are invested in US stocks, approximately 10% in Europe, 10% in Japan and 10% in emerging markets.

Looking forward, it is hard to feel overly excited about the investment environment, though there are certainly areas of opportunity. In the US, we are in the tenth year of a bull market, underpinned by a strong economic cycle. While the FED has paused its interest rate increases, and appears likely to do so for much of 2019, it is continuing to unwind its bond positions, at monthly rate of approximately $50 billion. Future corporate earnings will no longer be benefiting from the $2 trillion tax stimulus they enjoyed in 2018, which is estimated to have added 1% to GDP. Expectations for GDP growth in 2019 are for a decline of half a percent compared to 2108, reducing growth for the year to around 2.4%.

All of these factors argue for caution, as does the increasing tension with our most important trading partners, amplified by the ongoing political uncertainties in Europe. However, in my view, while the laws of cyclicality have not been repealed, unless we are heading for a substantial recession, equity markets in the US remain fairly valued.

The question then arises: what might propel them forward? Given the macro environment described above, earnings growth, which over time has the most important impact on stock prices, is expected to be modest this year, with forecasts in the 6% range -- a far cry from the 17% growth of 2018. With both P/E and price-to-book ratios in the 80th percentile of their historic range, it is difficult to see where the momentum for upward movement in US equity prices is likely to come from. Further, tech, which has contributed close to half of the growth in corporate margins over the last ten years, is struggling, and is unlikely to be the substantial catalyst it has been in the past.

An additional concern is the political uncertainty the US, and much of the rest of the world, is facing. Not only has this contributed to the volatility of markets, which have been negatively impacted by US government shutdowns and growing tensions with China, but, more importantly, it has injected a substantial level of uncertainty into our business community. According to the Goldman Sachs Uncertainty Index, which seeks to estimate the level of corporate uncertainty in the US, current levels are 3 times the median of the past 20 years. Markets are by nature cyclical, and over time this one has treated us better than most. Regardless, at the end of the day, stock prices are based on corporate profitability and earnings, which in the short term are largely driven by consumer spending, but in the longer term are a function of productive corporate investment, which requires a certain degree of stability.

All of this makes defensive, dividend-paying stocks look appealing. Value, which is trading at multi year lows against growth, has had only limited participation in the recent rally. Sectors including energy and health care, as well as other defensive options like utilities and Master Limited Partnerships, should benefit from the relatively static yield environment we find ourselves in. In addition, if we enter into a recessionary environment in 2020 (as many are predicting), these sectors will have less sensitivity and lower correlations to a slowing economic environment.

On the fixed income side, rates in the US are likely to remain flattish over the next several quarters. FED concerns about keeping rates high enough to be able to reduce them in the event of a 2020 recession have receded, and it appears that interest rates have plateaued for the time being.

However, crowding out by the burgeoning public sector debt is a growing issue. With the US deficit approaching a record $22 trillion, equivalent to 110% of GDP, the ability of the private sector to raise capital may eventually be threatened. But, with private sector debt at reasonable levels, and inflation remaining quiescent, that moment does not appear imminent. Consequently, dollar bonds are likely to stay around current levels. Coupled with a flattening yield curve, fixed income securities are not overly attractive in terms of their yield structure but should provide a consistent source of revenue. Their primary source of value added will continue to be the negative correlation with stock prices and providing an anchor to windward, if, and when, stock prices fall.

Meanwhile, economic growth in Europe continues to falter, with consensus forecasts for GDP growth rates in 2019 in the 1% range. However, the gap with the US may narrow, as last year’s fiscal stimulus in the US begins to wane, while the European economies remain underpinned by low interest rates and a potential boost from the European Central Bank. Much as in the US, stocks in Europe have rebounded smartly off their December lows, having recovered over half of the fourth quarter losses so far this year. While stocks are by no means cheap, there are some interesting pockets of opportunity, particularly in banks, some of which have been clobbered for no apparent reason and are trading at fractions of their book value.

As in the US, political uncertainty in the form of Brexit, the unsettled situation in Italy and the rising tide of right wing populism all remain a concern. Europe is also subject to additional risk because of its much greater dependency on trade. Exports in the US account for about 12% of GDP, while in Europe the average is closer to 30%. Consequently, European economies and companies are more sensitive to trade disruptions and the negative impact of tariffs. Given these challenges, we remain underweight in Europe, with the exception of bank and energy stocks, both of which continue to look cheap.

Japan paints a somewhat similar picture, though the risks there are more a function of regional issues --in particular how events may unfold in Korea and China. For the time being, despite the market-oriented reforms introduced by the Abe government, corporate earnings remain lackluster. Because of this, prices have languished, with the Tokyo market trading at a 13% discount to its historic price to earning ratio. One bright spot is in the area of share buy backs, where Japanese companies have begun to emulate the US. Several of our holdings, Sony and Softbank, have benefited from this trend, and recently announced substantial buy back programs. Japan also serves a useful function as a diversifier, since it tends to have a lower correlation with the US than does Europe. As a result, despite headwinds, we are roughly market weighted in Japan.

Over the past several years, emerging markets have performed in typical mercurial fashion, having been strongly up in 2017, before plunging for most of 2018 and, recently, rallying. China continues to be the most significant player, with its economy having a spillover effect throughout the region. To the extent that demand in China falls, countries like Korea and Taiwan, in particular, will suffer. While markets have been stronger in recent months on expectations of a trade deal with the US, that outcome should not be viewed as a foregone conclusion. Having a centrally planned economy has many disadvantages, but it has enabled the Chinese to stimulate the economy in response to the Trumpian tariffs, thereby maintaining steady GDP and capital markets growth rates. India continues to be one of the fastest growing major economies in the world and may be one of the few beneficiaries of rising US-China tensions, as its trade with both continues to increase. At the moment, the stock market is not cheap, but recent changes in the leadership of the central bank, coupled with an upcoming election cycle, may presage a period of reduced interest rates, which would be equity friendly. Corporate earnings growth rates also remain robust.

Overall, emerging markets look to be good value, with higher growth rates and cheaper stock prices than developed markets. While export oriented developing economies may struggle because of sluggish economic growth in the developed countries, worldwide central bank easing, especially in the US, is providing them with a countervailing boost. Though not for the faint of heart, we continue to believe emerging markets are a good long-term play, and have positioned our portfolios accordingly. Lastly, as noted above, the performance of the alternatives portion of our portfolio was a disappointment in 2018, especially in the tumultuous fourth quarter. Gold, commodities, real estate and TIPS all had negative returns in 2018, which was a unique year in the sense that almost every asset class was down. However, for a long-term investor, one year’s results should not invalidate the hypothesis. We believe that, over time, the diversifying benefits of these strategies will once again make themselves felt. Given where we are in the economic cycle, ongoing volatility and the vulnerabilities of equity markets globally, maintaining a substantial alternatives position is sensible.

I hope the above provides some clarity on our market outlook and asset allocation.