Volatility Returns but Economic Data
Points Towards Continued Growth

With the first half of the year behind us, we want to provide you with our thoughts on a couple of the current financial headlines that could impact the markets in the second half of 2018. In our portfolio construction we start with a bottom-up investment process that focuses on companies and industries, not broader macroeconomic trends. That said, we do need to have a well-informed view of the broader macroeconomic picture to help avoid mistakes.

Trade and Tariffs: The big financial headlines over the last month have been related to trade and tariffs. In our view, the best thing for the U.S. stock market in the short-term would be an immediate de-escalation of trade and tariff rhetoric and a return to the status quo with all our trading partners. However, many of the complaints directed at China, such as theft of intellectual property, forcing Western companies to partner with Chinese companies, keeping markets closed, providing government assistance to failing companies, etc., are entirely valid and harm U.S. companies. In the long-term, forcing China to back away from these actions could be a significant positive development for U.S. companies and the broader stock market. But convincing China to make these changes is not easy. Our view is that the U.S. will eventually back down from many of these tariff threats after securing some nominal changes in global trade.

Treasury Rates: Another topic that is gaining attention is the flattening and potential inversion of the yield curve. Starting with the basics, the yield curve shows the yields (interest rates) of bonds with different times to maturity. Typically, shorter term bonds have lower yields than longer term bonds. However, at certain points in the economic cycle, longer term bonds can have lower yields than shorter term bonds, which is called an inverted yield curve. An inverted yield curve is often viewed as a predictor of recessions, but its ability to predict the future is not perfect. For reference, the chart below shows the yield on the 10-year U.S. Treasury note minus the yield on the 2-year U.S. Treasury note. The darkened areas show when the U.S. was in a recession. The chart shows that the yield curve often turns negative before the U.S. enters a recession. As of the end of June, the reading is at the lowest level since 2007, but remained above zero.

Bond Yield

Relating this back to the stock market, we note that the S&P 500 Index© tends to peak 10-11 months after the yield curve inverts. So even if the yield curve were to invert today, it would not necessarily be a cause for immediate panic. The bottom line is that U.S. economy is doing well: profits are up, companies are increasing their capital expenditures, buybacks remain strong, and personal incomes are rising. Yes there are risks to this outlook, but we do not believe now is the time for investors to become overly cautious.

Turnover and Taxes: We have long prided ourselves on being buy and hold investors, not “fast money” looking for a quick trade. This is reflected in our relatively low annualized portfolio turnover ratios: 34% for our small cap Emerging Growth strategy and 37% for our large cap Total Quality Management (TQM) strategy (5-year average for both). These turnover ratios indicate an average holding period of about three years in both strategies. This is consistent with our strategy of searching for companies that we believe can outperform the market on a risk adjusted basis over the next 3-5 years. Our actual holding period is on the lower end of this range as sometimes our ideas work faster than we expect, and sometimes adverse changes in company fundamentals require that we exit a position earlier than expected. Our turnover ratios are well below historical mutual fund averages, particularly for our Emerging Growth strategy. Importantly, historically low turnover and a bull market that is nearly a decade old has created large, unrealized gains in many of the holdings in our client accounts. In 2018, our portfolio turnover may be higher than our historical averages and that may result in client accounts realizing more capital gains than is typical. If you have a taxable account managed by us, please do not be surprised if your 2018 capital gains are higher than prior years. We will continue to closely monitor realized gains as we move closer to year-end. If you have any specific tax concerns that we should know about, please be sure to contact us.

—Adam Engebretson
Senior Portfolio Manager
July 2018



Kopp Investment Advisors 8400 Normandale Lake Boulevard Suite 1450 Bloomington, MN 55437 Tel: 952.841.0400 / 800.333.9128