Third Quarter /30/2018 1

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1 Third Quarter 2018 The third quarter saw strong returns for U.S. equity investors. The S&P 500 returned 7.7% and year to date is up 10.6%. At 114 months and counting, as measured by the S&P 500, the current bull run is now the longest on record, surpassing the 113 month bull market that began in Somewhat ironically, the most recent new market highs and the seizing of the longest bull ever title roughly coincided with the 10 th anniversary of the Lehman Brothers bankruptcy that triggered the Great Financial Crisis. It has many market observers, including us here at Guyasuta, asking the rhetorical question: how much longer can it continue? In our view, the short answer is for a while, but not indefinitely. The U.S. economy currently is doing very well by almost any measure. Second quarter real GDP growth was just over 4% annualized and corporate profitability is strong. 80% of S&P 500 companies beat consensus earnings estimates in the second quarter, and they are estimated to report full year 2018 earnings and revenue growth of approximately 20% and 8%, respectively. Capital expenditures for the S&P 500 are forecast to accelerate 25% year over year for 2018, and will be at record levels in absolute terms. The S&P 500 is currently trading at approximately 18x forecasted 2018 earnings and 16.5x 2019 earnings estimates, levels that we would characterize as full but not bubbly. At 3.9%, the unemployment rate is at levels last seen briefly in 2000 and for a more sustained period in the 1960 s. The broad basket of leading economic indicators remains healthy, inflation is moderate, and consumer sentiment is strong. Market internals, such as breadth and the advance-decline line are also healthy. In short, we remain constructive on the economy and equity markets in the near term, and none of the indicators that we follow that have historically been warning signs are flashing. That being said, there are several areas that we are watching as potential sources of trouble going forward. Interest rates/fed Policy: In a move widely expected by markets, the Federal Reserve raised the Federal Funds rate by twenty five basis points on September 26 th. This was the third such move this year, and the eighth since the Fed began to move the overnight rate off of the zero boundary at the end of At %, the Federal Funds rate stands at a level last seen in the fall of Additionally, the Fed continues to shrink its balance sheet by $50bn per month by letting securities acquired through three rounds of post-crisis quantitative easing mature without reinvesting the proceeds. Thus far, U.S. equity markets have taken a glass half full view of the Fed s tightening of monetary policy, with the S&P 500 returning just over 15% annualized from the first post-crisis interest rate hike in December 2015 through September 30, Though higher interest rates do seem to be causing some softness in housing and auto sales, both of which are interest rate sensitive, the overall economy is handling higher rates well. This is consistent with past experience: rates rising at a moderate pace is generally a sign of economic strength and rates are still quite low by historical standards. Looking abroad, however, there are signs that tightening U.S. monetary policy, resulting in rising rates and a stronger dollar, is causing some trouble for weaker emerging markets. In particular, countries where large amounts of dollar-denominated debt (both sovereign and corporate) have more recently been issued, such as Argentina and Turkey, are feeling the pain. These dislocations are consistent with past periods of monetary tightening. 9/30/2018 1

2 The yield curve also remains a salient concern. Broadly speaking, interest rates at the short end of the yield curve have moved up much faster than at the longer end, leading to concerns about an inverted yield curve. The Fed s dot plot projects the overnight rate will be at 3.125% by the end of Ten year Treasury yields are currently 3.06%. Historically, an inverted yield curve has been a reliable predictor of forthcoming recessions and bear markets, and we will be watching this indicator carefully. Labor market/inflation: With unemployment below 4%, the labor market is tight. Whether it be on company earnings calls or in discussions with business owners and managers, it is clear that companies are having a hard time finding and retaining workers, and this is starting to show up modestly in wage data. At around 3%, wage growth is at a peak for this economic cycle. Historically, rising wages and inflation have gone hand in hand. With the core PCE (the Fed s preferred inflation metric) hovering around 2%, wage pressure is not visible in the aggregate inflation number at this time. However, inflation is a phenomenon that is difficult to identify in advance, can arrive quite suddenly, and once in the system, can be pernicious and difficult to combat. There is a reason that central bankers are vigilant about inflation and we believe monitoring developments carefully. Trade: Starting with the good news on trade, the Trump administration has reached an agreement for a renegotiated NAFTA with the Mexican and Canadian governments. Known as the United States-Mexico-Canada Agreement (USMCA), it is more of a tweaking and updating of NAFTA than a wholesale reworking of the trade arrangements with Mexico and Canada. As part of the new pact, U.S. agriculture, particularly the dairy sector, will gain broader duty free access to the Canadian market and the auto industry will be subject to stricter standards for sourcing and wages. It is still early innings, and the full impact of the USMCA will take months, if not years, to unfold, but we think that reaching an agreement with our neighbors is a positive outcome. In a less positive development, the intensity of the ongoing trade tension between the U.S. and China ratcheted up another notch recently with the Trump administration levying a 10% tariff (set to increase to 25% in 2019) on an additional $200bn of Chinese imports. The Chinese responded by imposing a levy on $60bn of U.S. goods. In total the U.S. has imposed duties on $250bn of Chinese imports and the Chinese have imposed levies on $110bn of U.S. exports. Talks between the U.S. and China have, at least for the time being, been called off, and the threat of the U.S. going all in and placing tariffs on the remaining $267bn of Chinese imports remains. Making accurate assessments about the Chinese economy is always difficult, but Bloomberg economics estimates that the tariffs, as structured today, will trim 0.5 percentage points (p.p.) from Chinese GDP, and if the all in scenario develops, could shave 1.5 p.p. from Chinese growth. On the U.S. side of the equation, consumers, by design, were not greatly impacted by the first round of tariffs, but should the tariff conflict escalate from here, likely will begin to feel the pain, and there will be upward pressure on inflation. The integration of the global economy has lifted millions of people out of poverty globally, and in the aggregate, the U.S. economy has benefitted from free trade. However, as we have discussed in prior iterations of the Market Comments, there are legitimate and long unaddressed concerns with Chinese trade practices. We think, however, that there are better ways to address the negatives of free trade than through tariffs. We worry that increased costs and uncertainty have the potential to dent economic growth both in terms of directly measurable economic costs as well as by dampening the so called animal spirits that give businesses and consumers the confidence to invest for the future. 9/30/2018 2

3 Mid-term elections: Just in case you haven t heard: there is a mid-term Congressional election in November. The consensus among political forecasters, both Democratic and Republican, is that the Democrats will regain control of the House and that the Republicans will retain control of the Senate. It s unclear what this means for investors, though it seems likely that if the Democrats regain control of the House, and particularly if they are able to also regain control of the Senate, that the tax and regulatory environment would likely be less business-friendly than under unified Republican control. That said, we think that investors are best served by keeping their political views separate from their investment process, and are merely pointing out that the upcoming election results may not be fully priced into the market. Debt and deficits: The Congressional Budget Office s baseline forecast is that U.S. s debt to GDP ratio will increase from 78% today to 100% of GDP by 2030 and 152% by Last year s tax cuts are projected to be roughly revenue neutral for fiscal year 2018, with falling corporate receipts offset by rising individual receipts. Nevertheless, the deficit is projected to increase to $793 billion due to escalating interest expense and demographically-driven entitlement spending. Increases in discretionary spending, largely doled out as sweeteners to get the tax cut bill passed also contribute, though to a smaller degree. There is currently ample demand for Treasury debt and the dollar s status as the world s reserve currency remains safe for now. However, if markets did finally balk at U.S. deficits and force a rebalancing of the Federal budget, the necessary discretionary spending and entitlement cuts, as well as tax increases, would be extremely unpopular, and in the current political environment, perhaps impossible. The current debt and deficit situation was years in the making, and will likely take years to fix. While the odds of debt-driven dollar crisis appear remote at the moment, it is an area of concern that we will be observing closely. So what do investors do going forward? For equities, our philosophy remains the same: focus on companies with strong free cash flow generation, strong balance sheets and competitive moats. Even in markets that are in the aggregate fully valued and picked over, we continue to look for, and occasionally find, companies that meet the aforementioned criteria and have attractive valuations that provide a reasonable margin of safety. Our equity portfolio remains defensively positioned, and we are comfortable that it will participate if the market continues to grind higher and protect capital in the event the market weakens. For fixed income, we continue to focus on high quality municipal and corporate bonds and our average duration remains relatively short. With benchmark yields grinding higher and the yield curve flattening,we have been finding more opportunities in shorter to medium term corporate and taxable municipal bonds. In the world of tax-free municipal bonds, however, the yield curve is steeper, and we think that bonds in the seven to ten year maturity range represent attractive opportunities on a taxable-equivalent basis for investors in the upper income tax brackets. We continue to believe that fixed income can play an important role as a source of liquidity and a volatility dampener, which are especially important for investors with known near to medium term capital requirements and/or lower volatility tolerance. 9/30/2018 3

4 A Very Long Bull 9/30/2018 4

5 and overall returns for this bull market have been substantial 9/30/2018 5

6 Valuations are just barely above average and the banking system is sound 9/30/2018 6

7 With the tax cuts, corporations have increased buybacks more than dividends or capital spending 9/30/2018 7

8 Investors have become less risk averse Defensive stocks as a % of S&P 500 market cap (Defensive includes pharmaceuticals, utilities, consumer staples and telecommunications) 9/30/2018 8

9 No politician is willing to face this huge issue 9/30/2018 9

10 Fortunately, recent shortfalls have been funded internally What happens in the next recession? 9/30/

11 As our Market Comments discuss, it is hard to tie politics to the economy or the stock market 9/30/