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Investment Climate April 2017

The investment climate continued to improve over the course of the first quarter 2017, reflected by the increasing value of stocks, particularly those companies who have the greatest growth prospects in their underlying businesses. Our portfolios experienced one of the best quarters in recent years led by our positions in core technology, especially those companies tied to the build out of data centers, both “enterprise” (businesses in general) and “hyperscale” (Amazon, Facebook, et al). This is long awaited as we have been expecting this and positioned ourselves for this reality some time ago.

The markets have embraced the idea of a more “business friendly” environment emanating from Washington DC, despite the failing on the part of the Trump administration and Republicans in Congress to pass legislation “repealing and replacing” the Affordable Care Act (Obamacare). Healthcare legislation is likely to be revisited before the mid-term elections but investors will likely pay much closer attention to tax reform which they certainly hope has a better outcome than the healthcare debacle. While investors appear to have given a “pass” to the failure to make progress on repealing Obamacare, the failure to make progress on reforming the tax code will not likely be well-received by the market.

Another very significant issue that went largely unnoticed recently was an article in the Wall Street Journal on Friday, March 31, 2017 which suggested that the US Federal Reserve (the Fed) is beginning to set the stage for the “unwinding” of its over $4 Trillion balance sheet that ballooned in the wake of the 2008-9 financial crisis.

We have long suggested that the Fed gets far too much attention for its perceived ability to affect growth in the economy. We tend to believe they can mess things up, but they can’t “create” growth. Entrepreneurs create growth! However, we have also suggested that the massive balance sheet the Fed has amassed since the crisis is akin to a pile of dry hay in the barn with a lit kerosene lamp right next to it.

Why the concern? This massive balance sheet is reflected in dollars that banks have on reserve at the Fed. Thus far, banks have been reluctant to lend those funds to their customers. However, as the economy gains more steam in the wake of an improved policy environment, banks could become much more aggressive and those reserves could become fuel for excessive inflation. While most observers are fixated on what the Fed does with interest rates, as the Wall Street Journal reports, it is the fate of the Fed’s balance sheet that is the elephant in the room. At present, we believe whatever mistakes the Fed makes will be manageable. While we believe they have been “behind the curve” for a very long time on hiking interest rates, we are glad to see there appears to be a recognition at the Fed that they also need to act on the size of the balance sheet and the excess reserves they have left available. We will be monitoring these events closely as they unfold over the coming quarters.

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