In my opinion, it is wise to generally avoid pessimists and political provocateurs. Yes, they are right sometimes (and how they love to tell you when they are), but their stock-in-trade is to tell you how the American economic system is going down the tubes. Rather, I prefer to focus on being objective and optimistic. The American economic system is a very powerful engine. When good companies run by talented leaders grow their revenues and earnings, it can produce an impressive market environment.
Equity markets posted another strong quarter. Corporate America reported earnings that met, and in many cases, exceeded our expectations. Their forward guidance on revenue and earnings growth are the center of our optimistic market outlook for the fourth quarter and into 2018.
Revenue growth among larger companies still exceeds mid and small firms, but the gap is narrowing. Year over year revenue growth for large companies increased to 7.6% in the second quarter (from 7.4% in Q1). For mid-sized companies year over year revenue growth increased to 7.3% in the second quarter (from 6.0% in Q1). We see four things here. One, increasing revenue is the single best source of support for continued earnings growth. Two, there is a sizable gap between earnings and revenue growth which reveals the continuing positive effect of cost cutting implemented in past years. Three, larger companies have greater operational leverage that usually manifests itself first in a growing economy, but mid-sized firms are now starting to catch up. Four, while companies with foreign exposure have done better than those who don’t thus far, that is changing as companies with greater relative exposure to domestic markets are reaping the benefits of a growing economy.
This highlights the increased synchronous acceleration in economic growth rates around the world which takes some pressure off the U.S. Not only in Europe and Japan, but a growing collection of data suggests that this may be the first year that we will see acceleration in both developed and emerging economies since 2010, when nearly everyone was coming out of a recession. Trading at 18.4x 2018 earnings, we would characterize the valuation of our stock market as full but fair. With fundamentals strong and growing, we see continued appreciation through year-end, though likely at a slower pace.
Sector divergence wasn’t as wide as last quarter. Technology continued its run with another leading performance, which continued pushing market indexes higher. Following closely was energy. Little has changed in energy fundamentals; a growing supply is still running slightly ahead of growing demand. However, much is explained by short-term supply interruptions due to hurricane effects as various refineries were taken off-line as a precaution or due to damage, which contributed to an increase in the price of oil from $46 to $51.
Telecom also had a good quarter. Rumors about Sprint and T-Mobile combining rose again. Investors like the idea, thinking that merging two irrational and money losing wireless operators into one (hopefully) rational operator that makes money would be good for the three that remain. This irrationality was partially blamed for a drop in inflation earlier this year as they cut prices to keep their existing customers and acquire new ones. Stay tuned. On the bottom end was Consumer Staples, the only negative sector. Investors view the entrance of Amazon, with the Whole Foods purchase, bringing their scale and margin compression as yet another issue in a space already dealing with its own disruptions.
And now a review of our equity strategies.
Mitchell Capital All-Cap Growth advanced over 6% for the quarter and more than 18% for the year. We sold several companies whose future prospects have dimmed, including Middleby, a restaurant equipment supplier, IPG, who offers creative advertising services and First Interstate Bank, a regional bank operating in the US Northwest. We added to existing positions as recent releases confirm our original bases for investment. Constellation Brands had a nice quarter and is executing their strategy well. Woodward continues to earn new aircraft sub-contracts to leverage their capital investments and NV5, an engineering consultant, continues to expand its footprint domestically. We also added two new names in different sectors. Royal Caribbean is benefitting from increasing disposable income and the growing interest in favoring experiences over more possessions. 2017 has seen strong growth in their sector and 2018 bookings look strong as well. We also added Citigroup. Now that the banking industry has fortified their balance sheets, we believe larger banks will offer a better opportunity to grow revenues given their multiple product lines and geographic exposures.
Mitchell Capital All-Cap Value advanced more than 3% for the quarter and just under 9% for the year. Activity was light again this quarter. We repositioned our financial exposure, starting with a sale of Wells Fargo based on their growing list of regulatory and public perception hurdles. We also sold Bank of the Ozarks whose loan book is too concentrated in construction activity for our liking. Following the thinking above, we put the proceeds to work in existing financial names we think will see better success in the coming environment. State Street enjoys advantages in several back office processing functions and benefits from healthy demand for both ETF products and foreign investing. JPMorgan is one of the largest credit card operators and offers growing wealth management and capital markets operations. And PNC, a super-regional bank, has a strong business in the mortgage sector. Each of these examples have developed expertise in diverse areas that diminish their reliance on the standard bank lending operations that can be so cyclical. You can also check out our post on www.mitchcap.com that reflects our thoughts on Value stocks in general.
Mitchell Capital International Equity advanced nearly 6% for the quarter and more than 26% for the year. We sold Criteo, a display advertising firm, after we decided their future revenues would be challenged. We added to our AstraZeneca position initiated in Q2 on weakness after a clinical trial setback. Their product pipeline remains large and robust and will benefit the firm over the next several years. We added a small position in KBC Bank, a multi-channel bank in Belgium that focuses on small and medium-sized business. We like the client focus and believe it will provide a measure of stability to the portfolio. We also purchased Diageo, a multinational alcoholic beverages company. With a relatively new management team they are reevaluating their US business and have tremendous upside in emerging markets as disposable incomes rise across the world. And we also purchased Omron, a Japanese electronics company that makes sensors and motion control devices, primarily for the automated factory segment.
Mitchell Capital Strategic Allocation advanced nearly 4% for the quarter and more than 10% for the year. We made a small shift in the quarter, increasing the international and large cap segments and decreasing mid and small. We think the reemergence of international performance in 2017 will continue into the next year and will be a driver for portfolio growth. In the domestic portion, we decided to increase our core allocation to large cap names. While we continue to believe that mid and small cap will outperform over time, large cap names that are more heavily exposed to foreign earnings will likely continue their strength.
Moving on to fixed income markets.
In fixed income the U.S. Treasury 10-year note started the quarter at 2.30% and ended the quarter at 2.31%, basically flat. We thought the third quarter would be unremarkable, and it was, but September brought Fed decisions that will set the table into the next year.
When the Fed last met in September, they made an announcement that matched the outlook from our last letter; they would begin to wind down their balance sheet by not reinvesting a small portion of maturities. This very small portion would start at $10 billion per month and grow to $50 billion per month by next September. They hinted at this in June, but the broad market was skeptical that they would take action so soon.
Then they made an announcement that did surprise the market, but not us; they forecast another interest rate rise in December, 2017, taking into account the usual caveats. Fed Chair Janet Yellen then gave a speech on September 26, warning against moving up the overnight rate too gradually. It was a subtle, but very definitive, change in her prior guidance.
Further complicating the future is the announced retirement of another Fed Governor, Stanley Fischer, and the associated handicapping of who will play what role after February when the next Chair will be sworn in. At this point, there could be up to five new Governors out of a possible seven. Few administrations have had the ability to impact the Federal Reserve to such a degree in such a short period of time. Who sits in which chair will be less important than the general composition of the Federal Open Market Committee. The forthcoming leadership is collectively expected to carry out a more conservative, or less accommodative, agenda for monetary policy, so this is shaping up to be a transformative period.
Inflation in 2017 has received a lot of attention from the Fed for generally moving between 1.5% and 2.0%, but not being at their 2% target, originally set in 2012. Identifying a target suggests the Fed thinks they can fine tune inflation by dialing up this knob or pulling back that lever. They can’t. You can check out our post on www.mitchcap.com, which explains why we think the Fed should dispense with the target and measure their success by a range of 1.0 – 2.0% instead. Inflation is in a sweet spot and the Fed should stop using it as an excuse to hold off plans to remove their unprecedented accommodation.
Job growth remains solid, economic growth continues and inflation will push up again towards year-end. Despite a shortened period to year-end, we continue to see higher rates and will manage your portfolio consistent with that outlook.