We have written in the past about a world which is experiencing a spate of synchronized economic growth, which we expect to continue at least through 2018, barring any “Black Swan” event. This has provided a helpful backdrop for corporate sales, earnings and cash flows which have allowed management teams to increase dividends and equity buybacks and have encouraged investors to bid up stock prices around the globe. It has “felt good” to be an investor. But is that good feeling about to change?

To seek an answer, let’s look again at a relationship we mentioned in our Q3 letter in the US bond market – the biggest, most liquid market in the world and the obvious alternative for most investors for their investment capital.

Above, the reader will note two yield curves – one dating from December 31, 2013 and a more recent one dated September 30, 2017. Please note the shape of the respective curves, with the more recent curve being “flatter” than the 12/31/13 curve. In other words, there is less yield difference between the short and long maturities in 2017 than there was in 2013, which is anomalous as investors usually demand substantially more return (i.e. higher yield) for taking more risk as they extend maturities. This “flattening” of the yield curve is usually a signal to bond market “players” that the economy is about to deteriorate, especially when the curve “inverts” – i.e. when short rates are higher than long rates. It has been a pretty effective predictor. So we should pay attention to this sign. However, the bond curve is not yet inverted and typically a recession materializes about one year after a curve inversion.

So, if we still have some time before the next recession (which are never good for stock market performance), can equity prices go up with increasing interest rates?

We have used the above chart before and present it again because it clearly shows that increasing interest rates are not necessarily bad for equity prices as long as those interest rates are below 5%, as measured by the 10 year Treasury bond, which is currently at 2.35%.

To recap so far, we think that the world economy is doing well and we do not think that we are on the “cusp” of a recession. Moreover, we believe that stock prices can go up despite increasing interest rates and that we are still quite distant from when bonds will be competitive with stocks – i.e. reach a 5% yield on the 10 year Treasury. So where should one invest?

Overseas markets, especially the so-called Emerging Markets (think China, India, etc.) would seem attractive to us. Recently, these foreign bourses have come out of a “deep slumber”, outperforming the US so far in 2017. For years post the “financial meltdown” the only stock market in the world worthy of investor consideration seemed to be the American market. Perhaps it was nothing more than fear which kept investors at bay. Whatever the rationale, as can be seen by the above chart, the World (as represented by the All Country World Index ex-US) has trailed the performance of the US stock market by a significant amount and trades at a demonstrable forward P/E discount to the S&P 500.

Further, global stock market correlations have returned to normal, which means that by investing overseas, a US investor is getting real portfolio diversification, thereby reducing investment risk (see below).

So it would seem to make some sense that an American investor should have/enlarge international equity exposure to find value and decrease risk through increased diversification.

In spite of a year with “outsized” political noise, markets around the world rallied strongly in the face of real skepticism. Economies around the globe grew. Investors just about everywhere prospered! Stock prices are higher than they were – but that does not mean that they are about to go down. We need to be aware. Equity prices are no longer in the “bargain basement” bin – but there are still places in the world ex-US where value can be found and we think investors should own those markets.

We have been asked by people about our perspective on various cryptocurrencies, with Bitcoin being the most famous. Speculators are no doubt giddy about the meteoric price rise that Bitcoin has had over the past several months. But that “ride” has not been smooth or only in one direction. There have been days of collapse. Bitcoin is too volatile to be a reliable store of value. Typically, a currency is based on the real economic productivity of a nation. With a cryptocurrency, there is “no there/there”. There are no industries, no resources, no laws or regulations to back up this so called “medium of exchange” – only euphoric trust. But this trust is periodically undermined when “hackers” have breached repositories and stolen currency.

Further, the transacting of Bitcoin (as an example) consumes brobdingnag amounts of electricity (according to one recent estimate about as much as all of Denmark) in order to solve complicated mathematical equations which record transactions. This mechanism keeps the cryptocurrency scarce, but also means that huge server farms are tasked with wasteful calculations. Interestingly, some of the largest server farms used to “mine bitcoin” are located in China and the electric power generated there is fueled by dirty coal. We find it ironic that the youthful community which favors Bitcoin are also those who are supposedly environmentally conscious. Hmmmmm!

There is also a rather notorious crowd of drug dealers and capital regulation “evaders” who are heavy users of cryptocurrency to avoid authoritative “peering eyes”. This is why China has cracked down on exchanges. In fact the author can attest to Bitcoin being a “currency” of choice amongst criminals, as Bitcoin was demanded as payment during a recent attempt at extortion.

Related to the above, cryptocurrencies are going to run into immovable central governments who consider the issuance and operation of a national currency their inalienable right. Controlling a country’s currency is one of the most important ways for a government to control a country. Stripping a sovereign state of that power will not be easy.

In short, we are not at all sure that there is any future for Bitcoin or its “relatives” as a currency. Underlying these cryptocurrencies, however, is an interesting technology called blockchain which is being experimented with by various companies. This will be the focus of our attention.

1) S&P 500 corporate earnings +10% – 15% 

Yes – Throughout the year companies did better than expected

2) Inflation to range from 2.5% – 3%

No – Inflation did not “inflate” – A puzzlement

3) Business investment up due to cuts in corporate tax rates & overseas profits repatriation Yes – Delayed from earlier in the year, but with a tax bill passage it should continue into next year

4) Government spending up due to infrastructure investment

No – Infrastructure spending is supposed to be next, but we have doubts

5) Personal consumption up due to tax cuts & wage gains

Yes – Consumers are in a good mood

6) Real GDP growth +3%

No – Growth is more robust, but not quite 3% over a 12 month period

7) The Federal Reserve will raise the Fed Funds rate by 0.75%

Yes – As per plan

8) Bond prices will drop, yields rise (10 year Treasury yield 3.5% – 4.25%)

No – Pension demand has been strong for bonds

9) The Treasury will issue bonds with 40+ year maturities to take advantage of still historically low interest rates

No – Treasury gave up due to lack of market interest for a very long bond

10) Equity prices will rise on higher earnings & lower bond prices



1) Inflation will rise above 2%, using the Fed’s favorite measure

2) U.S. GDP >+3% and international GDP growth will accelerate

3) U.S. unemployment will decline to 3.6% and ex-U.S. unemployment will decline

4) U.S. corporate profits +12% with higher profit growth ex-U.S.

5) The dollar will drift lower

6) The U.S. bond curve will get “flatter” but not “invert”

7) Investment spending will rise again

8) Republicans will take a “political beating” in the midterms

9) Consumer confidence in the U.S. and abroad will stay strong

10) Equity markets will do well, while bond markets will stagnate


[1] A play on lyrics written by The Fifth Dimension, which obviously dates the author.

The opinions expressed in this Commentary are those of Baldwin Investment Management, LLC.  These views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. The reported numbers enclosed are derived from sources believed to be reliable.  However, we cannot guarantee their accuracy.  Past performance does not guarantee future results. We recommend that you compare our statement with the statement that you receive from your custodian. A list of our Proxy voting procedures is available upon request. 

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