“True strength is delicate”-Louise Nevelson
Most major equity indices were flat in the first six months of 2018 yet volatility in the markets has returned signaling greater investor anxiety. The S&P 500 has experienced a daily change greater than one percent 36 times year-to-date compared to 3 one percent moves by this time last year. Market participants are conflicted. Will the economy remain strong, or are the nine years of business expansion about to end? Will President Trump’s “America First” policies create a trade war that could push us into a recession? Uncertainty prevails and in this note we’ll comment on why we are constructive on the investment environment.
The minutes from the most recent meeting of the Federal Reserve indicate the economy continues to expand, unemployment remains low, and the intent of the Fed to raise interest rates while also ending quantitative easing bond purchasing remains. Inflation as measured by the consumer price index has accelerated to 2.8%, slightly ahead of the Fed’s target rate. In the second quarter the economy is projected to grow 3.8%. Forward looking economic measures, such as the Institute of Supply Management’s Purchasing Manager’s Index (PMI) remain favorable with the most recent measure at 55.4. (Anything over 50 indicates the economy is expanding.) Average hourly earnings is trending modestly higher at 2.7%, unemployment is low at 4%, and initial jobless claims and continuing unemployment claims are at multi year lows.
Corporate earnings are reflecting the strong economic backdrop. In the first quarter of 2018 earnings growth in the S&P 500 companies increased 24.8%, and is projected to expand over 20% in the second quarter. While the corporate tax cut has helped drive some of the earnings improvement, business revenue growth of 8.7% is the highest since the third quarter of 2011. Rapid earnings growth combined with flat equity prices has lowered the previously extended valuation to a more reasonable level of a price to earnings ratio of 16 which is in the middle of the historic range.
We believe market volatility has been driven by several factors. First, President Trump’s review of existing trade agreements introduces uncertainty into the market and could evolve into a trade war. This would impact American businesses since over 40% of the sales generated by S&P 500 companies come from international operations. If overseas economies slow or geopolitical events interrupt the global economic expansion then a recession could result. Second, the Federal Reserve is slowly ending its program of buying government bonds. This quantitative easing tool was implemented in 2009 and we agree that it should end, but the termination of the program removes some marginal liquidity. Finally, we think that it is natural for investors to worry about the duration of our current economic expansion. Investors are demonstrating quick trigger fingers as they look closely for signs of a future recession. Our strategy does not involve market timing. Instead, we seek to own quality companies that generate solid cash flow and deploy it in shareholder friendly activities as the antidote to the inevitable business cycle.
During the quarter we sold client positions in General Mills Company. The company has been working hard to reposition its product portfolio but results have been disappointing. We purchased shares in Alarm.com Holdings Inc. The company provides interactive security solutions for homes and businesses. The software developed by the company has the potential to allow homeowners to control all connected appliances and devices in a home remotely. Client retention is high and the cash flow dynamics of the business are strong.
Looking forward, we will continue to exercise our long term oriented investment strategy and seek out opportunities when market dislocations occur. Thank you for entrusting Ayrshire Capital Management LLC with your investments. We look forward to speaking with you in the coming quarter and wish you an enjoyable summer.
JM Sam Nevin, Jr.
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