Update August 2016

Shaken, Not Stirred

Despite Risks, the Global Economy Remains Resilient
Since the current economic recovery began, investors have contended
with a number of economic issues. The most recent risk has been the
extent to which the Brexit vote might trigger widespread contagion. So
far, it appears that outside of slowing growth in the United Kingdom,
effects have been limited.
Many are questioning the overall state of the world economy in light of
rising geopolitical instability, consternation over the upcoming U.S.
elections, questions about global monetary policy, relatively low
business confidence and a renewed slump in oil prices. Yet, the global
economy has been, and should continue to be, resilient in the face of
all of these risks. Global monetary policy remains supportive of growth
and the global recovery will continue, especially in the United States.
In the US, the outlook calls for moderate growth and low and modestly
increasing inflation. Job gains in June and July were strong, and
indicators point to increases in labor utilization in recent months. The
U.S. economy is projected to grow close to its potential capacity during
the rest of 2016 and continue at a similar pace during 2017. Consumer
spending is the main driver of economic growth, followed by positive
contributions from the housing and government sectors. Exports and
business spending are on the watch list. A moderate hiring momentum
should prevail and hourly earnings are likely to accelerate as labor
market conditions tighten. Inflation is expected to move closer to 2.0%
as economic activity registers further improvements.
There are serious risks from abroad that could affect the outlook,
whether a banking crisis in Europe, military confrontation in either the
South or East China Seas, or renewed capital outflows from China
generating currency tensions from a faster than anticipated
depreciation of the yuan. At home, the risk of intemperate comments
during the election campaign is high.
For the stock market, the first quarter likely marked a trough in yearover-year S&P 500 earnings per share growth. Second quarter earnings
came in above consensus and should be up slightly year-over-year
(versus down 5% in the first quarter). Excluding energy, second
quarter earnings should be up about 5% from the prior year.
Monetary policy has been vastly supportive and accommodative; for
now, the Federal Reserve is in a watch and wait mode, although it is
expected to consider raising the policy rate later in the year after

economic data confirm that underlying fundamentals are solid. The

latest Fed message confirms that external risks have diminished, which
enhances expectations of policy tightening.
While interest rates will likely stay lower for longer, allowing the U.S.
economy to continue its sluggish, low inflationary expansion, there are
some growing headwinds for corporate profits. During the first few
years of the recovery following the 2008 meltdown, corporate profits
grew rapidly as companies reaped the benefits of earlier cost cutting
and had the ability to refinance debt at lower interest rates. Profit
margins surged to record highs. Recently, however, profit margins
have begun to face headwinds as wage gains accelerated but
productivity gains stagnated. So while the basic forecast of anemic,
low-inflationary growth remains much as it has for the past seven
years, profit growth may be entering a less robust period. Given that
equity valuations are somewhat elevated (the market currently trades
at a multiple of 18.5 times earnings, vs. a historical average multiple of
15.5), this suggests the stock market could face some air pockets.
In light of the uncertainties occasioned by the Brexit vote and its
potential for disruption, our portfolios have been somewhat more
defensively positioned with lower than normal equity allocations. The
stock market has enjoyed seven-plus years of a bull market and stocks
are no longer dirt cheap. At the same time there are clear earnings
headwinds in certain sectors, so keeping some extra dry powder seems
sensible until better clarity on corporate earnings, economic growth
and geopolitical stability arises.
Looking forward, while many uncertainties exist in the economy and
markets, the fact remains that the U.S. economy is still expanding,
inflation and interest rates remain low and numerous companies are
still growing their earnings. Even in this challenged environment,
really strong market leaders continue to grow and increase earnings.

Amin Khakiani
August 16, 2016