With 2017 in the Rear View

I started my last year’s letter with “What a year…” amazed with the differences in three market regimes that 2016 was divided into. Now I am saying “What a year!” because the market regime in 2017 could not have been more even and steady. The returns were remarkable. S&P 500 went up 21.83%, MSCI a little more to 23.97%, and even the bond investors enjoyed a positive year with the US Aggregate Bond Index finishing at a positive 3.54%. We, the investors, enjoyed one of the best years in history. The economic expansion is now global. It was not just the US with the economic growth, like in 2016; it was every major region growing and some of them with bigger numbers than were expected. And yes, the main reason for this growth is the economic cycle. Just like the US did earlier, Europe and other parts of the world have finally shaken off the left over burdens of the great crisis of 2008. All the central banks, just like our FED, made money available and interest rates low. Their easing policies did provide the conditions for economic growth and bull markets. We are now in one of the longest bull runs in history. Of course, the expectations of the corporate tax cut in US and the final passage of the legislation made the year even better. We finally started seeing increased fund flows from retail investors into the market. That of course helps growing prices further. Confidence in the global markets is high and corporations are investing in growth. Innovation is fueling technology, interest rate growth and tax cuts are helping financials, industrials and energy are profiting from both tax cuts and the confidence. So, the question on everyone’s mind is “How much longer?”

The things we are scared of are not too different than last year:

Populism and tribalism are still spreading around the world. Regions and countries are getting more divided and politically we get even more polarized. Even with surprisingly positive growth numbers last year, Spain is still not settled in the relationship with Catalonia. In the case of United Kingdom, new elections could bring Jeremy Corbyn into 10 Downing Street and a left leaning government is formed. Italian elections push aside all traditional parties and elect a government that threatens with another euro exit. In the US, the mid-term elections turn out to be referendum on Trump Presidency and possibly make republicans lose control of both houses.

Even though the world economy is doing very well and possibly better than last year, speculative investing could grow and eventually be spooked by something we don’t see now and create a double digit correction in the stock market. For now, we expect earning to continue expanding. Without a major systemic problem even with interest rates rising, the market can recover from such a blow. There have been no increased tariffs with Mexico and China and NAFTA is still in place. Hopefully we don’t have to calculate the risks of disrupted work trade, but we have to be careful.

Inflation is still an issue of concern. As GDP growth continues globally, it will put pressure on commodity prices and create wage increases. With higher inflation, interest rates will continue to rise. The FED will possibly increase its short- term rate three to four times this year and gradually shrink its balance sheet. The US Treasury 10-year yield will move over 3%, and any number over 3.5% could create concerns in equity markets as the high-yield spreads widen. Just like we were in last two years, we have to be careful with the fixed income side of our portfolios.

China, China, China…still so important to the world growth. We continue to watch her evolution carefully. The 19th Party Congress in October was a stage for broadening the authority of the leader. Xi Jinping’s legacy is being built and his rule is becoming more direct and unquestioned. He might use his newfound super power to proclaim a war against the Chinese credit problem in order to ensure sustainability of China’s growth over years to come. This would slow business borrowing and slow down the economy. Fewer jobs would be created than expected, but is could still maintain a lower positive GDP and help in the long run. Keep in mind that many regions are dependent on Chinese growth to continue.

So, we do not know how much longer. No one does. I just listed some of the risks I am looking at, but all of the data is pointing to an economically very good year. We feel we are positioned correctly in our portfolios at each of the risk levels. We will continue to be active and tactical to try to produce good results at our targeted levels of risk.

I talked about a new world power system for a long time now. The phase that the US stated after the WWII and won in the two-power system (because of its pursuit and enforcement of the world order based on rules, democracy, protection of rights and property, open communication and trade-created mostly by us and for our long-term benefit) transitioned into a super-power system. For a long time our country created and enforced the rules others had to follow. Single super-power system opened the possibility for globalization. This process, as criticized as it is by some from both developed and developing world, made our country and our investors the biggest beneficiary of its spread. Arguably, it also did a lot to improve the situation of many people around the world and bring billions into middle-class pools that the marketing machine can now target and turn into consumers. It was only natural that with better communication, education and increased wealth, some of the other actors on the world scene start emerging as regional (and world) powers determined to either revive their historically-based claim to the power status, or realize their potential and set themselves on the course towards becoming a brand new power. Most of the creators of our foreign policy, both academic and practical, correctly predicted this process and steered US into the lane of the gradual, planned adjustment and pull back. There is nothing wrong in accepting that China, India, Russia, Turkey, Iran and a combination of South American states are becoming important world actors like US and Europe (as fractured as it is) are. Global economy can go bigger and there would be some wealth for all, as long as the new balance of power once reached stays stable. Many of the current global conflicts are a result of this system change and the vacuum created by US adjusting its global power position. Some of these conflicts rest on the problems caused by mistakes made in setting up the former world orders, like Middle East and North Africa. I am from Balkans and trust me, these could be generational processes. Balkans had multiple wars at the time of the sunset of the Ottoman Empire which did not end until the end of the WWI and the settlement of the Vienna Congress, which was not done right, so it all repeated itself with the fall of the Berlin wall that marked the end of the two-power system.

As we are tracking these super cycles in history and economy, it is hard not to find some possible patterns that emerge as little cycles inside the super ones. I do get worried that the pendulum does truly swing back and forth politically and economically as a result of these historical changes. When technological innovation disrupts the wealth distribution at the time that world order is transitioning a lot of things can go wrong if the powers to be make mistakes. Just as electricity, railroad and industrialization changed the world at that time, the internet of things and artificial intelligence are changing it now. The scale of wealth creation and the degree of inequality are very similar. Globalization, immigrants and outsourcing get blamed and the anger of those who feel left behind and forgotten fuels populism. The divide in the society grows and risks disruption to the development and growth. It took years, but in the 19th century the system stabilized into what we call the Progressive Era where popular demand radically remade the balance between state and market by creating social protection, progressive taxation and antitrust legislation, which still supported the capitalist philosophy while creating a basic safety net and redistributing enough to slow down the rampant wealth divide. Some other regions were not that lucky. The political mistakes leaders made to satisfy the populous started a world war and a revolution. The consequences of the nationalism and soviet style communism of the time resulted with world wars and changed the world forever erasing massive amount of European wealth created over centuries. Sad to say, but it does seem that great wars and natural disasters are the ultimate wealth equalizers.

If I am correct, the populist pressure will turn on the tech companies. Politicians will compete for the points scored for limiting the reach of these companies, making them pay large fines and taxes because they limited competition and got involved in every aspect of our lives - similar to what President Teddy Roosevelt did with his trust busting. These things have already started in Europe under pressure of right-wing populism. However, the pendulum does swing eventually, and the left-wing populism could grow next. Maybe we see a stronger showing of the left in democratic primaries in US, and quite possibly we see true socialists elected to run British government next. Danger here is in the possibility that the great wealth divide causes a surge of new solutions to the problem invented by the state, disrupting a more natural progress and development. As investors, we always look for stability of the system and a gradual change. We will just have to keep all these processes in mind as we move forward and pick our investments and allocation.

We believe that we are positioned correctly across the whole range of our portfolios. Being cautious of the bond market, we have over the last three years cut our bond exposure, shortened our duration, and moved our most conservative clients in wealth preservation model to a more balanced position. We moved our accounts invested aggressively into a more market growth-oriented global positioning with more focus on developed international equities and emerging markets than before as we were going through the 2017. Weak dollar and rising interest rates might create pressure on the US stock market. Our Balanced Income Opportunity portfolios were heavier on the equity side for a while now and I don’t think that its allocation will change too much this year. Being more active will become more important as the volatility comes back. Measuring how you are doing on the way to reaching your goals is becoming an ever more important focus for us. Having updated plans and acquiring tools that can help us measure your success and progress at any time will be key this year, and I hope you will be seeing even better reports produced by us by the end of 2018.

The wealth management industry is still changing. Other firms, like ours, are adjusting to the expected future regulation environment where advisors will have fiduciary responsibility to every client for every account. As many of you know, the Labor Department created the regulation that was supposed to be in effect this year requiring fiduciary responsibility for all retirement accounts. The Trump administration delayed this regulation for a while now, hopefully, to allow all our regulatory bodies to come up with a plan that would greatly benefit you, the clients, and allow our industry to serve you without limiting your investment choices and without increasing costs while erasing all possible conflicts of interest between us. Our group will always, as it did so far, work with you in a way where the client comes first. We treat every family we serve as our family. Our goal is for you to reach your goals most effectively and most efficiently, while as much as possible limiting the risks you are facing. Focusing on planning every step for every goal, fixing problems and providing solutions is what we want to do. We would like to think our relationship is always open, direct and growing. We will be the ones who will continue to stand by you as you negotiate new jobs, buy or sell your businesses, send your kids to college or marry them, retire, buy your dream places and do all those things you were dreaming of for a while. Hopefully, we are trusted by your next generations in the same way that you trust us, and we continue to guide them as they excel in life.

You should expect to see us this year again for your two review appointments. Some of you we will see more because we might be working on your plan or an issue that could come up. Vanessa will be emailing you a reminder and the agenda a week prior to your appointment. Allie will be calling two days earlier to confirm the time and the office we are meeting at. I hope we will be seeing many of you at our Portfolio Management Process Seminars that will be held in March, and that most of you will be able to make it to our annual seminar in September. Our Client Advisory Board will be meeting a couple times this year to continue to help us in improving our process and services. Please help Vanessa and Allie with their job by providing answers or documents they require by replying or calling back as soon as you can. As always, please reach out through our website, email or a phone call with any questions, requests or comments you might have any time. Amela, Matt and I are proud to be your advisors.

Yours,