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As you are probably aware, without a last minute agreement for a short term resolution, it appears that the US government is heading for a “shut down” at midnight tonight. The more significant date is October 17th, which is the due date for raising the US debt ceiling.   Without an agreement or resolution by this date, the US government would effectively default on its obligations.  A short term resolution could raise the debt ceiling into November.  “Kicking the can” or some longer term agreement will be the most likely outcome.   As long as the domestic economy is not damaged by this debate, fundamentals and corporate earnings suggest that the stock market is within a reasonable range of value; larger dips in prices should be looked upon as opportunity to invest.  With the US economy running at near 2.5% growth, the Federal Reserve using a “show me the data” stance and the “noise” coming from Washington, it may be helpful to consider the context of the debate within the economic environment.    A split country can lead to a perception that does not give weight to improving economic data.   Despite increased regulation and Washington headwinds, domestic and global economic date continues to show stability on an improving trend line.  Low inflation, low interest rates, and global recovery are tail winds to this market that supports values and the trajectory for new market highs.    The misalignment of values, due to artificial reasons (Federal Reserve Quantitative Easing, record corporate debt refinancing funding  corporate stock buy backs) and the enormous US Debt are serious concerns for the mid and long term economic outlook.    However, looking at the next 3-12 months, beyond October and the Washington noise, 4th quarter earnings may suggest stock values being sustained and going higher.   Thus, we have held more cash in portfolios for just such a pull back and opportunity to redeploy at possible lower market prices.  Also, with the recent drop in interest rates, it is another  opportunity to sell bonds that are of a longer duration and move to shorter durations/less sensitive to interest rate risk .   Asset classes consisting of short term bonds and cyclical sector – technology, industrials, and energy, select consumer discretionary, select healthcare - are focus areas.  Also, the economies of Europe (Germany) Japan and Mexico continue to show some valuation promise.   With the reasonable expectation of a stronger global economy, the emerging markets and eventually materials look valuable.

Global/US Economic Environment
China and Europe are showing some light.  US domestic unemployment continues on a decreasing trend, construction and consumer spending continues to be sustained or is improving.   Labor cost are about flat, productivity continues to be stronger than expected.   There has been a global turn in manufacturing, work week and overtime increasing, and the private sector continues to grow faster than Federal Reserve consensus.  Though the decrease in the US work force is a concern, changing demographics, rise in participation rate of older females working, delay in younger people being skilled enough to participate in the workforce and the more affluent society, particularly with baby boomers, can help explain this decrease in the participation rate of workers.   In more affluent societies, citizens do not want to work as much.  Leisure industries are booming.    Moderate but unclear drops in discouraged workers and the part-time workforce is encouraging.   The increase in interest rates may be the result of the global improving economy.  Labor markets are strengthening, getting back to levels before the sequester(forced government spending cuts).   The rate increases/bond markets are telling us things are getting better.  The US has moved from number 7 to number 5 in terms of competitive ranking - economies/manufacturing, etc.    Russia, India and Brazil continue to have problems and are still stimulating their economies but will be helped by China’s growth.  Japan is growing at about 3% vs. flat or contracting.   Recent tailwinds to the US stock market have been the recent change in likely new head of the Federal Reserve (YELIN), no bombing of Syria and the short term effect of the no taper without evidence of solid recovery by the Federal Reserve. 

Fixed Income/Bonds:
Still negatively impacted by the increase in interest rates, although recently since no Federal Reserve tapering, rates have come down some/bond prices coming up.   Muni bonds continue to be effected by rate increases and headline risk- recent City of Detroit bankruptcy and credit downgrade of Puerto Rico.

Recent Data:
Productivity data from China is at a 6 month high.  This is helping commodity prices and those countries associated such as Australia.  China continues to move to a service economy and not just a consumer of goods.    Cyclical stocks – industrials, technology and energy – still in the limelight.   Merkel’s recent reelection should be favorable for Europe.  She will be building a coalition and can be looked as not just a leader of Germany but of Europe.   Germany is acting as an anchor bank for Europe/Greece.   Domestic indexes continue to show improvements.    Company revenue increases are a concern as well as declined earnings estimates for the 3rd quarter – reporting starting soon.    The Federal Reserve’s delay in tapering/ reduction spending/printing money, can be viewed as lack of confidence in the state of the US recovery, help to get through the Washington debate, or a way to communicate that the US recovery is ahead of the Fed’s expectation and rather than discuss future rate increases, they will simply comment about the current state of economy.   Actually, unemployment has declined faster than the Federal Reserve forecasted.   So, a rate increase may happen sooner now than later.   Is this really a message that the economy is not recovering?   Certainly no taper has led to a lowering of interest rates and perhaps that was the Federal Reserve’s intent.  The recent dollar weakening is good for our exports as the emerging markets work to promote internal growth. The impact of increasing growth in demand in Europe and other countries for US goods and services is significant, accounting for as much as 40-60% of sales for large US technology, industrial and energy companies! 

Beyond the budget fight, debt ceiling drama, and challenging 3rd quarter earnings, the last 2-3 months of the year may prove to be promising and a catalyst for market increase into 2014.  Accelerating growth as the Sequester fades (government job cuts, etc.) could lead the US GDP to go from about 2% to 3-4% range for 2014.  

Noise from DC will increase volatility but historically has been a time to buy on the declines.  

Steve Erken, Principal
September 30th, 2013



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