Third Quarter 2016 Letter
October 26, 2016, By: Andrew R. Duncan, Senior Vice President
U.S. GDP grew at an annualized pace of 1.4% in the second quarter bringing the 1st half annualized rate to 1.1%, or approximately half the average annual rate of 2.1% experienced this expansion. GDP this year has been boosted by personal consumption and held back by inventory drawdowns, though both figures are decelerating. The services and manufacturing PMIs both improved in September, a positive development which may portend further economic expansion on the margin. CPI inflation jumped from 1.1% year-over-year in August to 1.5% in September, primarily on the rebound in oil prices. The core reading declined slightly from 2.3% in August year-over-year to 2.2% in September. The August reading for the Core PCE, the FED’s preferred measure, stands at 1.7% year-over-year.

Employment continues to be a bright spot with September payrolls up 186,000; a noticeable improvement from August’s 162,000 gain. The unemployment rate currently stands at 5.0% and the
4-week moving average of unemployment claims measures 253,500, the lowest since November 1973 when the jobs market was 46% smaller than today. Employment trends and their correlation to personal consumption continue to be of major importance to economic growth given weakness in investment, which declined 7.9% in the second quarter annualized, and government spending, which declined 1.7% in the second quarter annualized.

It is likely this recovery has peaked and will be viewed as one of the weakest on record. Corporate profits and profit margins have both peaked and are declining as labor cost growth continues to exceed revenue growth. Two years of declining profitability implies slowing or declining employee compensation in the near to medium term, which will negatively impact consumer spending. The recession of 2008 modified the behavior of consumers towards savings and living within their means, therefore this recovery has differed from historical trends in that consumers are spending based upon wage gains and expectations rather than gains in net worth. With continued negative trends in investment and government expenditures, any slowdown in wages and therefore personal consumption would have a dramatic negative impact on economic growth. Expectations are for GDP growth of 1.5-2.0% in both 2016 and 2017.

Oil has risen above $50 for the first time since June on declining U.S. inventory levels and hopes for an OPEC quota agreement amongst member nations. U.S. oil stockpiles fell below 500 million barrels for the first time since January as gasoline demand improved over the summer months. It is notable that the discussed OPEC target reductions are exactly offset by targeted increases from member nations exempted from the quota. The recent rise in prices has put select U.S. shale fields back to work with the rig count rising 39%. Recent new discoveries in Alaska and the Permian basin highlight continued technological advances made in discovery and extraction techniques which push the U.S. further along the path towards energy independence.


Valuations in the U.S. stock market remain elevated due to low interest rates, corporate stock buybacks, and the investment income requirements of institutions and private investors throughout the world. The current year price/earnings ratio on the S&P 500 stands at 18x with earnings forecast to rise to $118 by year end, representing an expected earnings growth rate of approximately 8.6% for 2016. With the S&P 500 having experienced several consecutive quarters of year-over-year declines in earnings, achieving the forecasted earnings growth by year-end would be a positive milestone.

Market participants are generally skeptical the market can propel higher in the absence of organic revenue growth. Aggregate revenues have declined since 2014. Further, record corporate leverage has been utilized to buy back stock resulting in prices increasing at a rate unsupported by fundamentals. Increasing leverage has not only increased potential corporate risk profiles but it has gone towards unproductive buybacks rather than investment in capital expenditures. Declining corporate investment has resulted in declining corporate productivity. Thus, profitability of future investments is reduced and the earnings potential of the stock market is structurally reduced.

Recognizing these observations is not to imply the stock market is ripe for a downturn. Markets need not fall for valuations to correct. The market could potentially tread water until such time as revenues, earnings and cash flows rise to levels more reflective of current prices. Around the globe where various economies are earlier in the recession/recovery cycle vis-à-vis the U.S., markets with cheaper valuation metrics potentially offer good entry points for stock investors.


The Federal Funds Futures market continues to price in an increasing likelihood of one interest rate hike by the Federal Reserve prior to year-end 2016. As of 10/21/2016 this probability stands at 68%, up from 9% at the end of the second quarter. This increasing probability is due to several factors including Federal Reserve member commentaries regarding employment levels having reached the intended threshold and the expectations of inflation rates meeting the intended threshold over the medium term. Additionally on the minds of market participants and Fed members is the need to hike rates to ensure policy flexibility going forward given the inevitability of an eventual recession. Many leading economists postulate a recession is likely within 3 years.

The Fund continues to be positioned for inflation protection and expectations of rising rates. Inflation protection is achieved via the fund’s holdings in Treasury Inflation Protected Securities, in which principal and coupon payouts are indexed to inflation. Because we anticipate interest rates to rise over the short and medium term and given that interest rates and fixed income prices move inversely, the fund’s holdings are currently comprised of just over 40% ultra-short Treasuries. This both reduces our duration, a measure of interest rate sensitivity, and provides the opportunity to reinvest at higher rates in the future. The fund’s current holdings are reflective of the investment objective to provide current income consistent with the preservation of capital.