September 30, 2017

For the third quarter the Montag & Caldwell Mid Cap Growth Composite gained 3.72%, gross of fees, beating the 3.23% return for the S&P MidCap 400 Index and lagging the Russell Midcap Growth Index return of 5.29%.  Year-to-date, the Composite is up 14.16%, gross of fees,  compared to a 9.41% gain for the S&P 400 and a 17.29% return for the Russell Midcap Growth.

The stock market’s steady march higher continued in the third quarter, defying the old market adage “sell in May and go away”.  This adage is a reference to the market’s tendency to struggle seasonally in August and September, the two worst performing months for the S&P 500 historically.  However, the market was able to glide through with barely a ripple.  With the exception of a brief spike in August as the rhetoric between the U.S. and North Korea heated up, the CBOE Volatility Index (VIX) has remained rather docile, hovering at or below 10, the low-end of its historical range.  Many would interpret this as a sign of investor complacency, which is surprising considering the host of troublesome headlines thrust upon us during the quarter including North Korea, hurricanes, earthquakes, a massive cyber security breach placing half of Americans’ personal credit information at risk, and another failed attempt to repeal and replace Obamacare, one of three major legislative initiatives for the Trump administration.

The market’s continued buoyancy in the face of all this can be attributed to ongoing improvement in economic growth and corporate profits, continued Central Bank accommodation, low interest rates, and the possibility of forthcoming tax rate relief.  Government reports showed the economy picked up some steam during the second quarter with U.S. Real GDP growth registering +3.1%, up from +1.2% in the first quarter.  Preliminary estimates for the quarter just completed indicate the economy grew in the 2.0 – 2.5% range.  While the ravages of hurricanes Harvey and Irma are sure to make economic data somewhat uneven in the weeks ahead, the underlying 2%+ growth trend of the economy is likely to remain intact.  Moreover, economies across the globe appear to be showing renewed vigor with the International Monetary Fund increasing its forecast for global GDP growth in 2017 to +3.5%, an acceleration from last year’s +3.1%.  A synchronized global expansion is one key factor helping to drive better than expected corporate profit growth.  Second quarter profits surprised to the upside with S&P 500 EPS growth coming in at 10.5%, above the +7-8% growth that was expected.  We would not be surprised to see similar upside in the third quarter as positive preannouncements are already tracking above normal.

With repeal and replace dead for now, Washington has turned its attention to tax reform.  The September release of the Republicans’ blueprint included significant reductions in corporate rates, repatriation of stranded overseas profits, tax code simplification, middle class tax relief, and abolishment of the “death tax”.   Many details remain to be seen and there is ample skepticism about the prospects of passing such an ambitious package given slim Republican majorities in both houses of Congress and pushback from deficit hawks, but there does seem to be widespread belief that a more modest tax bill will get passed given the importance for Republicans to show some legislative successes ahead of next year’s mid-term elections.  Growing expectation for at least modest fiscal stimulus led to a September rally in cyclical sectors such as energy, industrials, financials, and materials that was reminiscent of the “Trump trade” in the immediate aftermath of Trump’s election.  It remains to be seen how long this trade will last.  It will obviously hinge on Republicans’ ability to navigate the complexity of the budget reconciliation process and a tight legislative window.

Despite the September rebound in names most likely to benefit from tax reform, namely smaller cap, domestically-focused, economically-sensitive value stocks, we did see continued leadership from growth stocks across the market cap spectrum for the full quarter.  Within midcaps specifically, the Russell Midcap Growth index rose 5.3% for the quarter, compared to 2.1% for the comparable Value index, and year-to-date, Growth remains comfortably ahead of Value, 17.3% versus 7.4%.

Looking ahead, we continue to be concerned with elevated valuations, investor complacency, and suppressed market volatility, although these remain pre-conditions to a market decline.  We expect the market could continue to be supported in the near-term by low recession risk, improving corporate profits, a better global economy, accommodative Central Bank policies, a gradual and predictable increase in interest rates by our Federal Reserve, and the possibility of fiscal stimulus.    Changes to any of these factors, however, could be a cause for the market to sell off.

In September the Federal Reserve confirmed its plans to begin shrinking its balance sheet by allowing maturing bonds to run off.  This begins the process of what is now being referred to as Quantitative Tightening (QT), the reverse process of Quantitative Easing (QE) which has supported asset prices for the past decade.  It is worth noting that the market sold off at least 7% after the Fed ended each round of QE, which merely halted the expansion of the balance sheet.  Thus far, the market has not even declined 3% in response to the prospect of declining liquidity.  In fact, the market hasn’t suffered a 3% decline since right before the presidential election, and has not seen a 5% correction since June 2016, the longest such stretch in over 20 years.  It seems highly unlikely that this relative tranquility can persist for much longer.