CGM Mutual Fund increased 1.4% during the second quarter of 2017 compared to a return of 3.1% for the Standard and Poor’s 500 Index (S&P 500 Index) and 1.5% for the BofA Merrill Lynch U.S. Corporate, Government and Mortgage Index. For the first six months of the year, CGM Mutual Fund returned 4.7%, the S&P 500 Index, 9.3% and the BofA Merrill Lynch U.S. Corporate, Government and Mortgage Index, 2.4%.
The positive performance of U.S. stocks early in 2017 continued into the second quarter of the year despite some mixed economic news in April. Manufacturing activity continued to expand, but at a slightly slower pace according to the Institute for Supply Management. Since the end of the recession, businesses have been slow to increase investment which has led to sluggish but continued growth in the manufacturing sector. This is substantiated by the Commerce Department’s report on orders for durable goods which showed a monthly increase in March of only 0.7%. Despite March’s low unemployment rate of 4.5%, U.S. consumers demonstrated continued restraint in spending and the Commerce Department reported a disappointing 0.2% drop in retail sales for March and revised its February estimate to a 0.3% decline. This muted consumer demand contributed to the meager growth in gross domestic product which the Commerce Department initially reported as expanding at only a 0.7% annual rate in the first quarter though later revised to a 1.4% annual rate. But the GDP report also included other signs of increased business investment, rising consumer confidence and rising consumer income which may improve economic growth going forward.
Improving economic indicators in May continued to boost stock performance. While the manufacturing sector continued its slow expansion, the Institute for Supply Management reported accelerating growth in the non-manufacturing sector. Further evidence of economic growth came from the Federal Reserve’s report on April industrial production, which increased by 1% from the prior month in its largest monthly gain in more than three years. Commerce Department April reports on consumer spending showed improvement with monthly retail sales and the personal consumption rate each increasing by 0.4%. Additionally, the University of Michigan Consumer Sentiment Index rose to its highest reading since January reaching 97.1 in May. Increased consumer spending and strong consumer confidence suggest potential for expanding growth in the economy.
While the April Personal Consumption Expenditure Index (the index the Fed consults when planning interest rate adjustments) came in at 1.7%, falling short of the Fed’s desired 2%, some signs of upward inflation pressure emerged. The Labor Department’s April Producer Price Index for Final Demand, which measures the prices U.S. companies receive for their goods and services, grew to its highest level in five years, increasing 2.5% year over year. The Labor Department’s measure of import prices also experienced 4.1% annual growth in April from a year earlier. However these indicators were tempered by oil prices that dropped into bear market territory in June. Falling energy prices generally weigh on inflation and often drive investors to U.S. treasuries. Oil prices have declined through much of the year despite production cuts by OPEC and other oil producing nations. These cuts have been offset in part by increased production from the U.S. shale oil industry which has continued to increase its exports after Congress lifted its export ban in 2015.
Despite conflicting inflation indicators, low unemployment and continued economic expansion prompted the Fed to raise interest rates by 0.25% in June. The Fed indicated further economic expansion would allow it to begin reducing the portfolio of bonds and other assets that it purchased to stimulate the economy in response to the recession of 2007 - 2009. As this news was widely anticipated, it had very little impact on the stock market. Strong corporate profits and improving global economic conditions helped stock prices continue to climb through the end of the quarter. Technology stocks have outperformed other sectors through the first half of the year. These stocks pulled back at the end of the quarter while bank stocks rose on news that all of the 34 largest U.S. banks passed the Fed’s capital requirements test mandated by the Dodd-Frank Act. Several banks immediately increased their dividends. Accelerating global economic expansion sent stocks higher, especially in theEurozone and encouraged some central banks, including the European Central Bank, to suggest they may begin reducing their stimulus programs, which could increase yields on government bonds.
The yield on the 10-year U.S. Treasury bond started the quarter at 2.4% and fell as low as 2.1% before ending at 2.3% on June 30. Low inflation, the tepid momentum of the U.S. economic expansion and concerns about the Trump administration’s ability to push its tax and spending policies through Congress have all played a part in holding bond yields down. Additionally, the geopolitical uncertainties in North Korea and Syria and the lower yields offered by government bonds in Europe and Japan have drawn investors to U.S. Treasuries. The S&P 500 Index was priced at 24.2 times the trailing twelve month earnings as of June 30. While U.S. stocks remain expensive, we believe the recent increase in the global economic expansion combined with strong earnings reports in several sectors of the U.S. economy should offer ample opportunities in U.S. stocks.
On June 30, 2017, CGM Mutual Fund was 26.3% invested in short-term U.S. Treasury Notes. The three largest industry positions in the equity portion of the portfolio were in commercial banks, money center banks and broker/dealers. The Fund’s three largest equity holdings were Citigroup Inc., Bank of America Corporation (commercial banks) and Itau Unibanco Holding S.A. ADR (money center bank).
David C. Fietze
President
