Client Letter

Market Data for year-end 2019:

• S&P 500 Stock Index: 3231, up 28.9%
• Ten-year Treasury Note Yield: 1.92%, down 0.76%
• Gold: $1,523 per ounce, up 18.9%
• Oil: $61 per barrel, up 35.6%

Virtually every major investment asset class, from stocks and bonds to real estate and commodities, advanced strongly in 2019, as increased global central bank liquidity measures, and a seeming truce in the US-China trade war to end the year, provided a rising tide that lifted all boats. The strong gains were further enabled by the low starting point of December 31, 2018, a year where the converse was true: nearly all asset classes were depressed due to market fears of constricted liquidity and an escalation in trade hostilities. The stocks that performed the strongest in 2019 tended to be the ones that were hit the hardest in 2018, so our more defensive posture in stocks led to a moderate underperformance in stock portfolios in 2019 relative to a solid outperformance in 2018.

For the coming year, we expect further gains in stocks, although not nearly of the same magnitude of 2019 given that the market is beginning the year at all time highs, and not at the end of a major correction, as was the case for the year just passed. We are presented with moderate economic growth, low inflation, and accommodative central bank policy. This set of fundamental conditions has traditionally been an environment that is supportive of higher share prices, as witnessed by the previous decade.

As always, there are caveats to this benign forecast. We see two distinct risks that could send shares lower in the coming year: trade war reescalation and geopolitical risks.

The truce in the US-China trade war may not hold. The ongoing trade hostilities between the world’s two largest economies have created a high degree of uncertainty for the global industrial and technological supply chain, thus suppressing corporate investment. As mentioned above, a de-escalation of the trade war to close out the year was a major factor in driving 2019’s outsized gains. Both the Trump Administration and the Chinese government say they have arrived at a “Phase 1” deal that involves no further import tariffs and the modest rollback of some that were already on the books. The phase one deal does not cover any of the most contentious issues between the two economies, e.g. industrial subsidies and forced technology transfers, so arriving at a “phase two” deal will be more fraught. If the President feels frustrated that the Chinese are not negotiating in good faith, he may go back on the tariff war path, creating further uncertainty and sending stocks lower.

On geopolitical risks, America’s relationships with both Iran and North Korea have deteriorated over the course of 2019. On Iran, the US left the international nuclear deal with Iran in 2018 and unilaterally imposed crippling economic sanctions. Iran has felt the need to resist and in 2019 engaged in multiple aggressive actions, from seizing Western oil tankers to attacking a Saudi Arabian oil processing facility. In both cases, the Trump Administration did not respond in a forceful manner. Because of this, the Iranians believe they have the initiative and are likely to further seek to provoke the United States. While we strongly believe President Trump does not want a war in the Middle East while running for reelection, miscalculations on either side are always possible. A shooting war with Iran would likely send oil prices sharply higher and, consequently, share prices lower.

Concerning North Korea, the “bromance” between President Trump and the brutal North Korean dictator Kim Jong-un appears to have been put on ice. While having agreed to a nuclear weapons and ICBM test moratorium in exchange for the suspension of US-South Korea military drills, North Korea has continued to develop and expand its nuclear arsenal. Frustrated that the Trump Administration does not seem to be willing to offer further concessions at this time, particularly on economic sanctions against North Korea, Chairman Kim has said he no longer feels bound by any earlier agreements and has suggested a recommencement of weapons tests is imminent. This could anger the President and may lead to a further escalation in hostilities between the two sides. Once again, while we feel confidently that the President does not want a war during an election year, miscalculations are possible.  A war on the Korean Peninsula would result in significantly lower share prices.

Given the above points, our attitude could best be described as cautious optimism. For 2020, we see the US stock market, as represented by the S&P 500 stock index to trade in a range of 3000 to 3600. It closed 2019 at 3231. We see interest rates moving modestly higher and expect gold to continue to advance on the back of a weaker US dollar, as a solid global economy in 2020 will likely lead to the relative strengthening of foreign currencies and commodities.

We appreciate the business you have given us. We thank you for the continued confidence you have placed in us. Please do not hesitate to contact us with any questions or concerns you may have. We wish you a very healthy and prosperous 2020.

Sincerely,
Patrick Mauro, Daniel Mauro, Henry Criz

For the eighth year running, we are pleased to have been named a Five-Star Wealth Manager as described in Chicago Magazine.  A detailed description of the award can be found in the November 2019 issue of Chicago Magazine.  More details are available at Fivestarprofessional.com

Privacy notice:

Patrick Mauro Investment Advisor, Inc. (PMIA) is a registered investment advisor registered with and regulated by the Securities and Exchange Commission, Washington, DC. PMIA must collect certain nonpublic information regarding your financial assets and net worth. We must do this to help you develop a mandate in managing your account. This information and any other information for which you disclose to PMIA for the purposes of granting access to your brokerage account is treated this way:  PMIA discloses this information to no one else, that is to no third party. Your information is kept confidential and secure at the corporate office of record, 38 Mockingbird Lane, Oak Brook, IL 60523.

Part 2A, Form ADV:

Every client should know that Rule 204-3 under the Investment Advisers Act of 1940 imposes disclosure delivery obligations on investment advisers. Each year, PMIA offers each client through this letter Part 2A of its Form ADV. This disclosure document may be obtained by writing PMIA and requesting a copy be mailed to you.  A firm brochure and supplemental brochures for Daniel and Henry can be requested as well.

Market Data for year-end 2018:

• S&P 500 Stock Index: 2507, down 6.3%
• Ten-year Treasury Note Yield: 2.68%, up .27%
• Gold: $1,281 per ounce, down 2.1%
• Oil: $45 per barrel, down 24.3%

increased investors’ sense of uncertainty, pressuring returns across almost all major asset classes. Stocks and corporate bonds had their worst annual performance since 2008, while basic commodities such as oil and copper experienced significant declines. Compared to the historic placidity of 2017, US stocks had two major corrections of greater than 10% in 2018.

The factors pressuring markets alluded to above are primarily threefold:

1. Economic and corporate profit growth are decelerating. 2018 began with economies around the globe experiencing a synchronized expansion. In the US, economic growth and corporate profits surged on the back of the Trump/GOP corporate tax cut and increased federal spending. As 2018 came to a close, however, economic growth in the major economies of Europe and Asia was faltering, while US economic and corporate profit growth were projected to decrease substantially as the stimulus from the tax cuts and increased spending began to wear off. US economic growth in 2018 was approximately 3% in 2018, yet is expected to decelerate to 2.5% in 2019, and 2% in 2020. Similarly, corporate profits are seen decelerating from growth of 22% in 2018 to 8% in 2019.
2. Liquidity (money available for lending/investment) in the financial system is being removed. The US Federal Reserve raised its target for the federal funds overnight interest rate a full percentage point in 2018 to over 2.25%. At the same time, it is effectively liquidating the substantial bond portfolio it accumulated during the post-crisis policy of “quantitative easing”, thus increasing the supply of debt on the market while simultaneously withdrawing funds from the banking system. Further compounding the liquidity draining activities of the Federal Reserve, the US Treasury is having to significantly increase its issuance of bills, notes, and bonds to finance the above cited tax cuts and increased spending. This all has the net effect of decreasing the funds available for private lending and investment.
3. Trade tensions are suppressing corporate investment. In 2018, President Trump followed through on his promise to initiate trade wars on US trading partners. He began by putting on an across the board tariff on all aluminum and steel imports and then a 10% tariff on over $200 billion of goods from China. He has also held out the threat of further tariffs on Chinese imports and European automobiles, as well. Given the highly integrated nature of the global industrial supply chain, such threats are substantially disruptive, creating uncertainty for corporate executives, and decreasing corporate investment. Ultimately, decreased trade leads to higher prices and lower economic output, a lose-lose situation for all involved.

Whether or not 2019 turns out to be a better year for financial markets hinges primarily on the actions of the Federal Reserve and the trade agenda of President Trump. As the US economy is already decelerating, the market does not believe further monetary policy tightening is necessary. The Fed said in December that it sees itself raising the overnight interest rate a further half of a percentage point in 2019 and continuing to sell bonds from its portfolio. If they stick with their stated agenda, there is an elevated likelihood of an economic recession and lower share and corporate bond prices. Similarly, if President Trump cannot de-escalate the trade tensions he has injected into the global economy, we would expect corporate investment and global growth to continue to suffer, leading to further decreases in the prices of risk assets such as stocks and corporate bonds. Speaking more broadly, the President’s erratic behavior has become a distinct source of concern for the markets beyond any specific policy item.

We are admittedly agnostic on the points discussed above. The Federal Reserve has a poor track record of managing a decrease in liquidity without causing a recession, while President Trump’s inherent instability makes predictions on the outcome of the trade wars a highly fraught endeavor. In such an environment, we will stick to our strategy of focusing on investments in high quality companies, diversification, value, and patience. Such a strategy held up well in 2018, and we are confident in its continued performance regardless of the macroeconomic environment. For the remainder of the year we expect the US stock market, as represented by the S&P 500 stock index, to trade in a range of 2200to 2800. It closed 2018 at 2507.

As always, we thank you for the trust and confidence you have placed in us. Please do not hesitate to contact us with any concerns you may have. We wish you a healthy and prosperous 2019.

Sincerely,
Patrick Mauro, Daniel Mauro, Henry Criz

For the seventh year running, we are pleased to have been named a Five-Star Wealth Manager as described in Chicago Magazine.  A detailed description of the award can be found in the November 2018 issue of Chicago Magazine.  More details are available at Fivestarprofessional.com

Privacy notice:

Patrick Mauro Investment Advisor, Inc. (PMIA) is a registered investment advisor registered with and regulated by the Securities and Exchange Commission, Washington, DC. PMIA must collect certain nonpublic information regarding your financial assets and net worth. We must do this to help you develop a mandate in managing your account. This information and any other information for which you disclose to PMIA for the purposes of granting access to your brokerage account is treated this way:  PMIA discloses this information to no one else, that is to no third party. Your information is kept confidential and secure at the corporate office of record, 38 Mockingbird Lane, Oak Brook, IL 60523.

Part 2A, Form ADV:

Every client should know that Rule 204-3 under the Investment Advisers Act of 1940 imposes disclosure delivery obligations on investment advisers. Each year, PMIA offers each client through this letter Part 2A of its Form ADV. This disclosure document may be obtained by writing PMIA and requesting a copy be mailed to you.  A firm brochure and supplemental brochures for Daniel and Henry can be requested as well.

Market Data for year-end 2017:

• S&P 500 Stock Index: 2674, up 19.4%
• Ten-year Treasury Note Yield: 2.41%, down .04%
• Gold: $1,309 per ounce, up 13.6%
• Oil: $60 per barrel, up 11.1%

Global stock markets advanced strongly nearly across the board in 2017, as solid economic growth and corporate profits were paired with continuing low inflation and interest rates. In the United States, stocks had the added impetus of a large corporate tax cut that is seen by analysts as adding up to seven percent to earnings per share for the S&P 500 stock index. Long-term bond yields continued to hover near historically low levels as inflation remained subdued. With this benign backdrop, realized and implied volatility in both stocks and bonds reached record low levels.

Moving into 2018, there is reason to expect that the environment will be more difficult for the stock market. While we are not forecasting significant weakness due to continued strength in the economy, stocks are facing increased headwinds on two fronts: valuation and liquidity. On valuation, the stock market is expensive. Sentiment is widely positive with expectations for earnings and economic growth elevated. While the momentum coming out of 2017 is formidable, high valuations and sentiment increase the scope for disappointment and losses. The market’s margin for error, basically, is substantially reduced.

In terms of liquidity, stocks are going to face increased competition for investor funds from bonds. To date, a significant component of appreciation in the stock market has been driven by global central banks purchasing large numbers of bonds (known as quantitative easing or “QE”), effectively removing them from the market. With fewer bonds available for purchase by investors, stocks benefited with the consequent reduced competition for investment dollars. This process is now being thrown into reverse. The Federal Reserve is unwinding its bond portfolio by effectively selling bonds onto the market, while the European Central Bank has significantly reduced its bond buying program and may continue to taper it over the course of the year. Furthermore, with the passage of the tax cut in the US, the US Treasury is going to have to issue a greater supply of bonds to make up for the lost revenue. The bottom line is that to the extent stocks benefited from central bank bond purchase programs, they will likely be negatively impacted by their reduction and reversal.

Further risks to stocks include an increase in wages and inflation, financial instability in China, and war. On wages and inflation, the US economy is moving into the ninth year of an economic expansion, with unemployment coming in at 4.1%. Standard economic models would expect to see stronger wage gains and inflation with these conditions than has yet to be realized. We believe extensive global industrial capacity and additional workers still available to come into the workforce have suppressed wages and inflation, and may continue to do so. It is a risk, however, that further economic expansion will start to elevate wages and prices, and that would be a negative for stocks through increased costs for labor and capital.

As we have discussed before, Chinese economic growth has been driven increasingly through an ever expanding mountain of debt. Debt financing is inherently unstable, as was witnessed in the US housing crisis of 2008. With debt levels elevated, the Chinese economy walks an increasingly narrow tightrope to continue its expansion. Thus far, Chinese authorities have been able to keep the music playing. As they are not omniscient, however, there is the possibility for error that would destabilize the Chinese financial system and significantly weaken economic growth. As China is currently the world’s second largest economy, weakness in China would negatively impact global financial markets.

A large scale war either on the Korean Peninsula or in the Persian Gulf could have significant negative economic implications, possibly leading to global recession. Such an event would severely impact stocks, likely leading to losses in excess of 20%. However, as President Trump’s only leg to stand on politically is the strength of the US economy and financial markets, (as he reminds us almost daily), we find it unlikely that he would risk the negative economic and financial impacts of war with North Korea or Iran. We put the probability of such an event at under ten percent.

On balance, we expect the US stock market to continue its advance into 2018 but at a reduced rate and with greater volatility than 2017. For 2018, we expect the S&P 500 stock index to trade in a range of 2500 to 2900. It finished 2017 at 2674. Thank you again for the confidence and trust you have placed in us. As always, please do not to hesitate to contact us with any questions or concerns. We wish you a happy, healthy, and prosperous 2018.

Sincerely,
Patrick Mauro, Daniel Mauro, Henry Criz

For the sixth year running, we are pleased to have been named a Five-Star Wealth Manager as described in Chicago Magazine. A detailed description of the award can be found in the November 2017 issue of Chicago Magazine. More details are available at Fivestarprofessional.com