Investment Recap and Outlook

4 Q 2 0 1 8

Much to our surprise and delight, September closed out one of the best-performing quarters for the year thus far. Driven by strong economic data,solid corporate earnings and improved clarity with select global tradingpartners, the broader U.S. equity indices hit new all-time highs. But as hasoften been the case, this underlying market support, while positive, hasgenerally been overshadowed by continuing political headlines anduncertainty relating to future trade agreements with China.

This past quarter marked the tenth anniversary of the beginning of theGreat Recession, which saw global markets move into one of the moredifficult financial and economic time periods in our collective memories. Adecade ago the global markets were overleveraged courtesy of cheap creditand overzealous investors, leading to a market resolution that, to say theleast, didn’t end well for either. The fallout from the market collapseultimately contributed to the collapse of several financial industry giants,the housing industry and investor bank accounts. Remembering back tothose days reminds us that while volatility is likely to remain a marketphenomenon, the longer term benefits of remaining invested wins out overinvestor panic. Since the Great Recession, the markets have more thanrecovered the dollars lost and while many have predicted the demise of theequity markets, the bull market hasn’t looked back beyond a fewhiccups. This seems to be a reoccurring theme.

Whether the markets end on a higher note by the close of 2018 remains tobe seen given some of the market concerns in the news today. Rates areheaded higher as is the potential for further trade jawboning. Add in a mid-term election and the result is quite a bit of uncertainty facing the marketsand impacting investor resolve. If history is a guide, we think there aresome positives to anticipate based on prior periods. The S&P 500 hasaveraged a gain of 3.06 percent in October for mid-term election yearsversus a gain of 0.34 percent in all other Octobers and, for the fourthquarter in general, the S&P has averaged a gain of 7.51 percent in mid-termelection years versus a gain of 2.86 percent in all other Q4 periods. Withthat said, as of this writing there is some ground that we need to make up inorder to match the prior history.

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Source: Bloomberg

By market capitalization, large caps outperformed small caps, whichis a departure from the first half of 2018. That change inperformance is representative of a perceived reduction in globaltrade risks, as large caps underperformed small caps during the firsttwo quarters of 2018 primarily because of trade concerns. From aninvestment style standpoint, growth once again outperformed value,as strong tech sector returns continue to help growth stylesoutperform, a consistent trend all year to date.

On a sector level, ten of the eleven S&P 500 Index sectors finishedthe third quarter with positive returns. Healthcare andindustrials outperformed the S&P 500 thanks to strong earnings withindustrials also being helped by a reduction in trade tensions.

Conversely, the energy and materials sectors fought headwinds fromthe stronger U.S. dollar, and that caused both sectors to relativelyunderperform the S&P 500 Index. Meanwhile, communicationservices was the lone S&P 500 sector to finish the quarter withnegative total returns.

Looking internationally, the third quarter was the first positivequarter for foreign markets in 2018, helped by a September reboundthat was fueled by a reduction in concern over Italian budgets,Turkish inflation, and U.S./China trade. Foreign markets still laggedthe U.S. market in the third quarter. Foreign developed marketsregistered small gains while emerging markets, despite a strongrebound in late September, closed firmly in negative territory.

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Source: Bloomberg, Frost, Russell

Turning to the fixed-income markets, continued strong economicgrowth, a reduction in stress in the European Union and a SeptemberFed rate hike all provided their share of headwinds in the thirdquarter. While the broader Bloomberg Barclay’s U.S. Aggregate BondIndex ended the quarter on a positive note, there was clear investorpreference for shorter-term maturities. High-yield bonds had positiveperformance for the second consecutive quarter as investors focusedon strong corporate fundamentals and solid economic growth.

The quarter ended with the FOMC hiking the Fed funds rate byanother 25 basis points (1/4 percent), moving its target rate to 2.25percent. One topic of conversation among market pundits regardingthe rate increase announcement was the removal of the term“accommodative” from FOMC speak. The current thinking is that thissignals that the Fed is closer to their neutral setting. Despite theoptimistic hope of rates settling for a bit, odds are still in favor ofanother hike by year-end.

The recent spike in 10 year Treasury yields to multi-year highs wastriggered by any number of events including soaring ISM non-manufacturing data, Fed rate hikes, tight labor markets and a stillgrowing economy. There’s another concern sparked by Fed ChairPowell who’s made a point of further rate ratcheting as the FOMCpushes towards “neutral” rates.

E C O N O M I C R E V I E W A N D O U T L O O K C O M M E N TA R YT H E F E D , I N T E R E S T R A T E S , A N D T H E F I X E D I N C O M E M A R K E T

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Other news at the quarter’s end included the release of the final GDPreport for Q2, reiterating a 4.2 percent growth rate for the secondquarter. There weren’t many surprises in the report, with continuedstrength in consumer spending, durable goods orders and labormarkets. As a follow on leading into Q3, the durable goods orderswere up 4.5 percent, although somewhat inflated by an uptick of 69percent in aircraft orders. One possible detractor for Q3’s initial GDPestimate will be an increase in the trade deficit given the recentincrease of +0.7 percent in imports and a drop of -1.6 percent inexports.

Given the current economic and credit environment, high yield creditspreads have become tighter and are increasingly susceptible tomarket risk. This also makes a case for Investment grade corporatesbut to a much lesser degree.

While still muted, we do expect Inflation to rise over the nextseveral months courtesy of improving economic growth and greaterwage gains. Improving global technology competition should help inmaintaining overall consumer prices.

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While job growth slowed in September courtesy of an activehurricane season, the U.S. labor market continued to gaintraction. Unemployment levels are at multi-decade lows, whilebroader measures, including labor force participation, continued toimprove. Breadth of jobs was positive given the most recent reportfor the quarter, as roughly 61 percent of the private industriesreported an uptick in hiring. Growth was led by the construction andmanufacturing sectors, while the slowest growth reported was in theservices industries (likely hurricane related).

With unemployment sitting at a 3.7 percent level, Householdemployment was up by 420,000 new jobs and the labor forceparticipation rate held constant at 62.7 percent. During the thirdquarter jobless claims also fell below the 300,000 hurdle for a record195 weeks and below 250,000 jobless claims for 50 weeks (longeststreak since 1969). Continuing claims fell by 3 percent, the largestdrop since May and now reporting in as the lowest point since1979. Tighter job markets foretell future wage inflation and morerate hikes.

Average hourly earnings were up 0.3 percent on a monthlycomparison, rising 3.3 percent at an annualized rate over the past sixmonths, the fastest since the recovery started. The increase inaverage wage data was the fastest move since January 2009. Andwhile wage growth is still lackluster for the recovery, theimprovements will most likely lead to increasing pressure on the Fedto speed up rate normalization, barring some outlier economic eventthat would side-track Fed tightening plans.

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The overall consumer mood was optimistic this past quarter, with thesentiment best characterized by the recent Conference Board’s ConsumerConfidence Survey which hit a new 18-year high. In terms of overallconsumer health, much is explained by job growth and improving wages. Atthe close of September wages were up an annualized rate of 3.3 percentwhile the unemployment rate fell to another new +/- five decade low.

It’s been difficult lately to find good news on housing markets but onepositive was that inventories in the resale markets were up 2.7 percent overthis time last year, the first increase in three years. Median home priceswere also up 4.6 percent over the prior year, with first-time buyers makingup 31 percent of the sales activity. Another positive to report was a jump inhousing starts up over 9 percent on a monthly comparison, primarily drivenby multifamily starts.

On the negative side of the ledger, last quarter housing affordability fell to a10-year low, according to the National Association of Realtors. Might helpexplain the possible peaking of existing home sales. At quarter’s end wealso noted a reported drop in pending home sales, falling to their lowestlevel since 2014.

There are mounting concerns that the slowdown in the housing markets isharkening to a slowdown in the economy. The weekly/monthly housingdata has become somewhat volatile of late, and is indeed slowing downfrom what was an accelerating recovery post-recession. Housing is lessaffordable than post 2009 and rates have started moving up as havehousing prices. On the positive side, some of the housing slowdown is fromlack of supply. The nation has also weathered several dramatic weatherevents across the U.S impacting general economic activity, including homebuying. In the ensuing months this will be countered by the improving jobpicture, better wages and consumer confidence. While the housing marketmay be in for a slowdown, this is not the beginning of a housing bust in ourview.

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Here at home the economic improvement is continuing. RegionalFed surveys are generally positive, and in some instances are hittingnew cycle highs. Case in point were reports from both the Richmondand Philly Fed, with the former reporting new highs in theirManufacturing Index and the latter noting positive spikes in theirBusiness Conditions Index resulting from increases in new orders,shipments and business outlook. In terms of capital spending, anumber of Fed regions reported drops in spending expectationsrelated to the potential negative impacts of threatened tariffs.

Here in Texas the news from the Fed was mixed. Althoughexpectations were positive, actual manufacturing activity slipped toits lowest level since this past May. While time will tell whether thefears of trade tariffs play out, in the near term recent economicstrength has helped push tax receipts up over the prioryear. Strengths were strong sales and job growth (impacting statelevel tax receipts).

While oil is near record levels of production courtesy of both the U.S.and Saudi Arabia, prices are still subject to regional volatility anddemand spikes. As reported by the International Energy Agency(IEA), this past August the world pumped more than 100 millionbarrels of oil a day with the U.S. contributing 11 million of thosebarrels. Demand for oil is still strong though (and likely to continuefor a bit longer) as refineries are producing record amounts ofdistilled products. The issues adding to the volatility are geopoliticalimpasses with both Iran and Venezuela. The latter having beensubject to mismanagement and political interference (expecting tosee a drop in oil production by 1/3 of their past daily production) andthe former (Iran) facing export curtailments courtesy of U.S. ledsanctions. The impact, volatile oil prices.

E C O N O M I C R E V I E W A N D O U T L O O K C O M M E N TA R YM A N U F A C T U R I N G A N D R E G I O N A L S U R V E Y S

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E C O N O M I C R E V I E W A N D O U T L O O K C O M M E N TA R YG L O B A L D Y N A M I C S

Global trade issues were a much talked about concern earlier thissummer, but we’ve seen several critical resolutions during the thirdquarter that put to rest a number of trade questions. Recall back inJuly that the United States and the European Union reached a tradeagreement to work toward preventing retaliatory tariffs, followed bypromises to explore further trade opportunities between the twoglobal partners. This was followed in August with Mexico and the U.S.agreeing to a trade framework to replace NAFTA, and on the final dayof September, Canada and the United States reached an agreementfor Canada to join the existing U.S./Mexico deal, settling anotherpotential trade dispute. China soon, maybe.

At the quarter’s end, the global economy was still in an expansionmode, with 85 percent of the countries reporting still in positiveterritory (versus 98 percent in February). Emerging market woeshave been prominent in the headlines recently, with the MSCIEmerging Markets Index dipping into bear-marketterritory. Argentina, one EM constituent country, spiked itsbenchmark interest rate up 60 percent in an effort to halt a sharpslide in the value of the peso, which had earlier fallen to record lows.

The quarter also witnessed currencies for both India and Indonesiafalling to long-term lows, and the gap in the performance betweenthe U.S. equity markets and emerging markets continuing to widen infavor of the domestic markets. While today’s financial markets andeconomy are less susceptible to the emerging markets, IF there is asudden flight to quality across the global markets, it will be a sharedflight experience.

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This commentary is furnished for informational purposes only and is not investment advice, a solicitation, anoffer to buy or sell, or a recommendation of any security to any person. Managers’ opinions, beliefs and/orthoughts are as of the date given and are subject to change without notice. The information presented inthis commentary was obtained from sources and data considered to be reliable, but its accuracy andcompleteness is not guaranteed. It should not be used as a primary basis for making investment decisions.Consider your own financial circumstances and goals carefully before investing. Certain sections of thiscommentary contain forward-looking statements that are based on our reasonable expectations, estimates,projections, and assumptions. Forward-looking statements are not indicators or guarantees of futureperformance and involve certain risks and uncertainties, which are difficult to predict. Past performance isnot indicative of future results. Diversification strategies do not ensure a profit and cannot protect againstlosses in a declining market. All indices are unmanaged and investors cannot invest directly into an index.You should not assume that an investment in the securities or investment strategies identified was or will beprofitable.

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D I S C LO S U R E S

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D I S C LO S U R E S (continued)

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Economic factors, market conditions, and investment strategies will affect the performance of any portfolio and there are no assurances that it will match or outperform any particular benchmark. Indexes are presented to provide you with an understanding of their historic long-term performance, not to illustrate the performance of any security. The indexes themselves are not investments, are unmanaged and do not incur the various fees or expenses incurred by an investment portfolio. It is not possible to invest directly in an index.

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