During the first quarter of 2018, the stock market, as measured by the S&P 500 Index, had a total return of minus 0.8%. Despite the roughly flat performance for the quarter, volatility spiked to levels not seen in several years. January started strong, as the market surged 7% to start the year, but it quickly reversed itself, dropping into negative territory less than two weeks later before recovering modestly. While 2017 saw volatility fall to all-time lows, this year has seen it return with a vengeance.
Given rising volatility, what should investors expect going forward? We’ll attempt to answer that by revisiting the key questions we posed last October. In addition, we’ll explore an important secular trend, namely the expanding role of technology and its impact across the economy.
The key questions are as follows:
- Can the economic expansion continue?
- Can inflation remain quiescent?
- Will the Federal Reserve (the Fed) be measured in tightening monetary policy?
- Are equity valuations too high?
In the last six months, the global economic expansion accelerated, driven by growth in both emerging and developed markets. In addition, both consumer and business confidence hit new highs. In March, the Michigan Consumer Sentiment Index improved to 101, the highest level since January 2004. According to Evercore ISI, this confidence is broad-based with strength across consumers, builders, CFO’s, small businesses and big businesses. Economic strength is driving job creation, lowering unemployment rates and causing more people to enter the workforce.
We are closely watching developments in Washington D.C. The recent tax cut and the newly adjusted tax laws that allow for faster expensing of capital investments will likely add a tailwind to the economy by spurring spending on capex later this year. Despite concerns about potential trade disruptions and the risk of accelerating inflation, we believe the U.S. economy is in good shape going forward. We do not believe that President Trump’s protectionist trade rhetoric will actually result in economic slowdown and higher inflation. The recently announced tariffs may not have much impact if they are limited in size and very targeted. At this time we do not see Trump’s bluster leading to a full-blown trade war, the consequences of which would be ugly.
As we have discussed in earlier Outlooks, inflation has remained tame despite a long economic expansion. This “goldilocks” phenomenon currently appears stable, as low unemployment and strong job growth have not yet led to significant wage pressure. This could be a function of technology and automation reducing the need for people in higher paying jobs (e.g., online chat bots replacing support reps) while increasing lower paying jobs in some areas. Other than wages, some companies are seeing input cost pressures, but it’s hard to know exactly how widespread this is. While modest inflation is generally regarded as good for the economy and the stock market, a significant acceleration would not be. We remain vigilant as, of course, does the Fed.
We believe the Fed, under its new Chairman, Jerome Powell, will continue to raise interest rates gradually – essentially reflecting a strong economy. Fed officials are unlikely to increase rates so aggressively that they choke off the expansion, unless and until inflation increases beyond their comfort zone.
This leaves us with the difficult question of whether equity valuations are too high. Certainly, they are at the higher end of their historic range. But they appear reasonable, given the current, still-low level of interest rates, and relative to the expected growth in corporate profits. Since interest rates are probably in a cyclically rising trend, stock prices will likely reflect a push/pull between rising rates on the one hand, and corporate profit growth on the other.
Currently, we remain sanguine that the goldilocks economy – strong economic growth coupled with moderate inflation – can continue. Therefore, we do not believe that we need to overreact to the fear of future Fed rate increases. We do, however, believe that it is important to be pragmatic and monitor the situation closely. If there are signs of unbridled economic growth, or if the inflation outlook changes so that it will likely force the Fed to act aggressively on rates, we will adjust portfolios to address the changing economic conditions. It is worth noting that we took action late in 2017 to reduce exposure to interest-sensitive securities, as a shift to gradual interest rate increases appeared imminent.
As previously mentioned, we feel the increased use of technology to establish and maintain client relationships is a trend that could both extend the current economic expansion and benefit some of the largest IT firms in the industry. Last quarter, we discussed technology in terms of its ability to help companies drive down costs as well as its role in creating a winner-takes-all economy. In this outlook, we want to examine technology as a disruptor and a catalyst of secular change. The secular changes driven by technology are meaningful in size and still in the early innings. As we have already seen, the transformative impact of technology enables new entrants to disrupt long-established business models, putting market leadership at risk.
The start of the change dates back 20 years ago to the dot.com boom, as access to the Internet shifted from dial-up telephony to broadband, which enhanced the user experience and vastly augmented the amount of data that could be exchanged. The development of e-commerce and advertising platforms, social networks, online video and other technologies has created powerful tools that enable us to absorb news and events, work more efficiently and effectively, socialize, advertise, get from place to place, and of course, purchase goods. The leaders – Amazon, Facebook and Google – have matured, gained scale, achieved dominant positions in the internet and are now among the biggest firms on the planet.
Older e-commerce and internet technologies are now converging with new emerging technologies, which include artificial intelligence (AI), Cloud, Software as a Service (SaaS), Internet of Things (IoT) and Machine Learning (ML). Not only is each of these newer technologies a powerful force by itself, but their convergence is having a revolutionary impact.
While it may seem as if digital technologies have been adopted by companies across the economy for a long time, what we are seeing and hearing from our portfolio companies is that many of them are just now increasing their investment in digital. We believe that the tipping point has been reached and now most companies recognize that they need to move beyond simply having a web presence. They must create deeper digital relationships with their customers and suppliers by developing processes for collecting, analyzing and using digital data to enhance their selling, manufacturing and purchasing capabilities. If organizations do not develop a digital relationship with customers, they risk having no relationship at all. As a result, we see an increased wave of investment that is driving adoption of new technologies. Following is an example from a recent Jefferies Research note* discussing the importance of investing in next generation technologies for consumer companies.
To succeed in an environment where technology evolves even faster, operating models will need to be overhauled, requiring investments in next-gen capabilities. For large CPG (packaged goods) companies to succeed in the rapidly changing consumer environment we believe they need to overhaul their operating model to center around data. Investment in next-gen capabilities and a bigger risk appetite are required to successfully overhaul operating models. Companies that are successful at doing so will not only win but will do so much more efficiently.
From an investing perspective, we believe the importance of technology for businesses will only increase. As a result, we see significant opportunity for both continued growth and for evolving leadership. That said, this change is likely to take place over an extended period measured in years, if not decades, and most certainly through multiple business cycles. In short, while this is an important opportunity, we will be patient and wait for investment opportunities that fit our investment style.
Given this, how are we currently positioned for the changing technology landscape? It is hard for us to envision companies developing and nurturing digital relationships with customers without a way to communicate and reach them. This implies that digital advertisers are, and will continue to be, a critical part of the solution. We have positions in the current leaders, Alphabet (parent company of Google) and Facebook, which have the scale to provide their customers the highest return on investment on their marketing spend. Moreover, both companies are reasonably valued, should generate significant free cash flow and have multiple opportunities for growth ahead of them.
Critical to the digital relationship is the ability to collect and analyze data, activities which require software solutions. AI and ML are important examples of the most modern, effective approaches. We have exposure to software and AI/ML through our investments in Microsoft, Alphabet and Intel.
Amazon and Alphabet have built massive networks of data centers to support their digital businesses. Their scale and focus gives them benefits in cost and in the speed in adopting new technologies. They and other Cloud computing providers are offering storage, analytics and computing power externally to companies, governments and other institutions, allowing those organizations to transform themselves digitally with pricing and capability superior to their internal resources. Jefferies Research estimates that the market for Cloud computing is large at $90 billion and growing rapidly at a projected 30% compound annual growth rate through 2020. Microsoft and Alphabet, in addition to being critical software and AI leaders, also have the second and third largest Cloud offerings.
A lot of these technologies and new software platforms are being designed and implemented by IT service companies. We have exposure to this trend through Cognizant Technologies, an IT service company that has been accelerating its revenue growth through its exposure to digital services while at the same time expanding its margins.
Furthermore, all these technologies require households and businesses to have internet and data connectivity. The infrastructure providers of this connectivity tend to have dominant market positions with significant barriers to entry and should see years of future growth. Our positions in cable provider Charter and cell tower and fiber provider Crown Castle offer exposure to this theme at what we view as attractive valuations.
In conclusion, while the economy looks very strong, we are carefully monitoring risks as we enter the back end of the economic cycle. As we have already seen, volatility is on the rise and we expect that to continue. While volatility can be disconcerting, it also provides us with opportunities to make compelling investments in reasonably priced, competitively advantaged companies that can generate significant free cash flow and have clear opportunities for long-term growth. We continue to believe that we are in a winner-take-all economy that is being spurred and driven by technology. As always, should our outlook for the economy change, or inflation appear to accelerate, we will make adjustments to portfolios to address the changing market conditions.
If you have questions, please give us a call. We appreciate your continued confidence in our management.
Sincerely,
John Osterweis
*Jefferies, Consumer Products: Brands Still Matter, But Brand Owners Might Need A Software Upgrade, Akshay Jagdale and Stephanie Wissink, 3/20/18.
Past performance is no guarantee of future results. Index performance is not indicative of fund performance. To obtain fund performance call (866) 236-0050 or visit osterweis.com.
This commentary contains the current opinions of the author as of the date above, which are subject to change at any time. This commentary has been distributed for informational purposes only and is not a recommendation or offer of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but is not guaranteed.
The S&P 500 Index is an unmanaged index that is widely regarded as the standard for measuring large-cap U.S. stock market performance. One cannot invest directly in an index.
The Michigan Consumer Sentiment Index (MCSI) is a monthly survey of U.S. consumer confidence levels conducted by the University of Michigan. It is based on telephone surveys that gather information on consumer expectations regarding the overall economy.
Capital Expenditure (Capex) are funds used by a company to acquire, upgrade and maintain physical assets such as property, industrial buildings or equipment.
Free cash flow represents the cash that a company is able to generate after laying out the money required to maintain and expand the company’s asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.
As of 3/31/18, the Osterweis Fund held Alphabet (parent company of Google) (5.64%), Microsoft (3.55%), Facebook (2.42%) and Intel (1.72%).
Holdings and sector allocations may change at any time due to ongoing portfolio management. References to specific investments should not be construed as a recommendation to buy or sell the securities by the Osterweis Fund or Osterweis Capital Management.
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© Osterweis Capital Management
© Osterweis Capital Management
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