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Q3 2019 QUARTERLY LETTER – OCTOBER 2019

Rasputin, Central Bankers, and Other Mystics

In this quarter’s letter, we review the strong performance across most asset classes year to date, the driving force behind the performance, recent industrial weakness globally, the state of the US consumer, and overall debt levels. We also step back to continue to develop a longer-term outlook which contrasts with the environment of recent decades. Are corporate margins sustainable at current levels given a likely change in the global trade structure? We have updated our coverage of evolving policy proposals from Presidential candidates looking towards next year’s elections. With financial markets once again ebullient over the perception of the infallibility and sustained prowess of central bankers to solve all market woes, we look to historical examples of governments so dependent on such empirically unproven counsel and oversite. Strangely enough, Netflix’s mini-series, “The Last Czars” provided a fascinating analogy in its capture of Russian history. We can’t help but think of the figure of Rasputin, the infallible perception the Romanov family held of him, and his ultimate role in the collapse of the monarchy and the beginning of the Bolshevik revolution. Thank you for your time and please read on to find out more. -Mathew Klody, CIO

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2019 and the Near-Term Debate Thus far, 2019 has been a good year for both conservative and risk tolerant investors with most types of bonds and equities rallying materially.

As we have been noting, correlations have increased significantly across asset classes with both fixed income and equities rallying sharply, reversing the severe pull back seen in both towards the second half of 2018.

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Source: @CharlieBilello

As we have begun to discuss recently, this price action is not the assumption or foundation of what traditional portfolio theory and asset allocation models are built on. These models generally depend upon lower - or even negative - correlations. While others in our position won’t necessarily highlight this, the world has changed, and asset management needs to change with it. This most recent price surge has come primarily on the back of a shift of the promise of global central banks as actual global industrial economic activity has softened. The European Central Bank is resuming easing later this year to the tune of printing €20BN a month. The US Federal Reserve has begun lowering rates and Chairman Powell hinted in the press conference following the Fed decision on September 18th that balance sheet expansion may soon be necessary once again. As a result, year-to-date, fixed income has been on a tear - particularly longer duration, higher quality fixed income assets.

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The amount of negative yielding debt globally hit a new record in early September with over $15TN in debt yielding a negative return. Simply put, we have no historic precedent for this type of situation. Monetary policy experiments by global central banks continue. Please refer to our section entitled “Rasputin and Central Banks” at the end of this letter for our thoughts on this. Bloomberg Barclays Aggregate Negative Yielding Debt Market Value

Source: Bloomberg

German Bond Yield Curve

Source: Bloomberg

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One thing that has to be remembered is that rate cuts are not always a panacea for assets as shown by the chart below:

Source: Bloomberg, Crescat Capital

Global Industrial Activity Has Slowed Fundamentally speaking, we are in the midst of a global industrial slowdown, likely in part due to tariffs and trade war concerns, but also due in part to the age of the global industrial cycle after a very long expansion. The following charts demonstrate that US and global manufacturing indicators have noticeably slowed, and inventories are in the process of adjusting as well. You can also see that semiconductor sales peaked late last year and have been trying to find stabilization.

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Source: Bloomberg, William Blair While industrial activity has weakened globally and has yet to see a bottom, the consumer generally remains resilient and has thus far kept us out of a broader recession.

US Consumer Remains Resilient Thus Far, Keeping Us Out of Recession The resilience of the consumer will determine whether we enter a recession or if this is simply a mid-cycle slowdown. The US consumer has done a pretty good job of deleveraging over the past decade which has placed them in a more resilient position. Although retracting recently, consumer confidence remains fairly high and household debt-to-income has come down since the financial crisis. Despite the fact that roughly 30% of the population still has a subprime credit score, overall scores are higher than a decade ago.

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Unfortunately, the same cannot be said for global governments and corporations which have taken on significant additional debt during the past decade.

Source: Deutsche Bank

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Of course, part of this outcome depends upon current trade negotiations and tariffs.

Most long-duration fixed income assets appear to already be pricing in a material slowdown. We aren’t sure there is a lot more upside if we do enter a recession. However, if a trade deal is reached, tariffs fade, and growth reaccelerates, these assets are likely to underperform and potentially give up some of the large year-to-date gains. As such, it seems to make sense to shorten duration and high-grade credit quality. While the consumer balance sheet has improved, the amount of corporate debt outstanding has doubled due to share buybacks and a robust private equity environment. We are finding it difficult to find much value in that space currently. The level of BBB rated corporate debt has more than tripled over the past decade. If just 10% of this were downgraded to high yield, the junk bond market would increase by over 20%. This in an environment where junk yields are at all-time lows.

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As we began to see last month, defensive assets and other assets that benefit from low interest rates (long-term bonds, technology, and utilities) have begun to underperform cyclical and value assets. We may have seen a near-term peak in these defensive assets and, from a tactical perspective, it may be time to take some profits and redeploy to value (energy being one potential area).

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The Long-Term I noted above that the US consumer has been resilient, generally confident, and holding less debt to income compared to a decade ago. One element of this confidence likely has to do with the tight labor market which finally appears to be boosting wages at the lower income levels. While this is undoubtedly good news for those households who have struggled mightily in recent decades, it could represent a challenge to the margins of many companies which have benefitted from generally stagnant compensation for the past twenty years. Note that these charts originated from a Bloomberg Opinion piece from September that can be found at the following link. I am highlighting the key ones below. https://www.bloomberg.com/opinion/articles/2019-09-12/the-good-news-about-income-inequality-in-america

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In my opinion, this dynamic is the primary factor driving US politics, global trade discussions, and longer- term markets. It is becoming plainly clear that the “China Shock” 2000-2012 time period isn’t sustainable over the long-term for a variety of reasons. Severe political and socioeconomic side effects have arisen over this period. The outsource to China game is in its later innings (not necessarily in terms of Chinese growth, but in terms of outsourcing leading to multinational margin expansion). This also doesn’t mean

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that one can’t be quite bullish on the Chinese consumer given the growing middle class and consumer there. The game is clearly changing though. Both sides of the most divided political aisle since the Civil War in the United States are generally aligned on the China issue. What are the implications?

Profit Margins May Have Reached the Upper Bound… Structurally This is a stark statement, but one that really needs to be examined. Expanding profit margins for much of the past thirty years have driven enormous gains in equities and private equity. A portion of these gains have come from the deflationary wage pressure China has exerted on the globe. A peak and reversal of that would not be positive for many companies in those asset classes.

Bottom Line – It’s Going to Get Harder from Here…Returns May Be Harder to Come By Below is a chart of capital market assumptions recently published by Northern Trust. With fixed income yields so low and domestic equities pricey on a normalized basis, the projected return range is quite compressed. Some of the highest forecasted returns are in the emerging arena, which we have written about in recent letters as a significant long-term opportunity and diversifier away from the unsustainably strong dollar.

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2020 Election Update In the near-term (next one to two years), one of the most important factors driving markets will be the outcome of the 2020 election. We wrote about this extensively in our 1q19 letter that can be found here. Recent polls show Biden, Warren and Sanders as the top three, all of whom would beat Donald Trump in a general election according to these polls:

Colleague Derek Feilmeier has been tracking policy proposals, particularly as it relates to changes in income and capital gains tax rates. You will find his latest overview on this below. The bottom line continues to be the same: taxes on corporations, individual income, and capital gains will go up materially if a Democrat candidate wins the election.

Brief Tax Plan Summary for Top Five Democratic Candidates: Former V.P. Joe Biden

• Repeal Trump tax cuts • Increase top marginal income tax rate on long-term cap gains to 39.6% for taxpayers earning more

than $1 million annually • Eliminate “step-up in basis” that allows decedents to pass cap gains to heirs without tax

repercussions

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o Death would be considered a realization event, triggering cap gains taxes on appreciated assets paid at ordinary income tax rates

• Pledges to “get rid of hundreds of billions of dollars in tax loopholes” Sen. Bernie Sanders

• Reduce the threshold that the estate tax applies from $11 million to $3.5 million o Bernie estimates this will raise $2 trillion

• Add new tax brackets as follows: o The current 35% rate would become 40%. Then add new tax brackets of 45%, 50%, and

52% with the final rate applying to income over $10 million • Impose a 4% income-based premium at each level • Cap gains and dividends for those earning over $250,000 would be taxed at the same rates as

normal income Sen. Elizabeth Warren

• Proposed a new “Wealth Tax” that would impose a yearly tax as follows: o 2% tax on households with a net worth of $50 million or more o 3% tax rate on net worth above $1 billion

• Proposed a new corporate tax called “Real Corporate Profits Tax” that would apply to corporations reporting over $100 million, where “every dollar would be taxed at 7%”

Sen. Kamala Harris

• Proposed LIFT (Livable Incomes for Families Today) Middle Class Act o Nearly $3 trillion plan to provide middle and working-class families with tax credits as

follows: Tax credit of up to $6,000 per year for couples making a combined income of

$100,000 or less $3,000 tax credit for individuals earning $50,000 or less.

• Advocating a pay increase for teachers, who are paid 11% less than other comparable education jobs

o Proposal would increase the estate tax and “crack down on loopholes” to pay for a $13,500 raise for teachers

Mayor Pete Buttigieg

• Buttigieg has not released any formal proposals and has been generally unwilling to commit to specific policies. Some ideas he has endorsed in public appearances:

o Endorsed single-payer health care system, starting with a public option or all-payer rate setting

o Called the Green New Deal “sound framework” o Defended AOC’s proposed 50% effective marginal tax rate (but stopped short of openly

committing himself to a particular rate) o Said he supports a wealth tax, arguing that it was not much different from a property tax o Said he is “intrigued” by a top marginal rate of 49.9999%

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Sources: Tax Foundation Overview https://taxfoundation.org/2020-democratic-presidential-campaign-tax-plans/ Reviewing the Democratic Tax Plans (Tony Nitti – Forbes) https://www.forbes.com/sites/anthonynitti/#7b7d41087a36 Democrats Want to Tax the Rich. How Those Plans Would Work (or Not). – NYT https://www.nytimes.com/interactive/2019/09/24/business/economy/wealth-tax-rich.html

Rasputin, Central Banks, and Other “Mystical Healers.” With my Steelers off to a 1-4 start and their starting quarterback out for the season, I’ve been forced to modify my Fall television viewing. Luckily, I found something other than football to keep my attention. Netflix recently produced an interesting docu-drama series called “The Last Czars” which provides a fascinating exploration of pre-revolutionary Russia in the early 1900s. A key character in the series is Rasputin.

GRIGORI RASPUTIN

Grigori Rasputin (1869-1916) was a famed Russian peasant-turned-mystic healer and self-proclaimed holy man. Rasputin’s unexpected influence over Czar Nicholas II (the last Czar of Imperial Russia) and his family arguably facilitated the end of the monarchy and the beginning of the Bolshevik Revolution which ushered in the communist era and Soviet Union.

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Rasputin was born to a peasant family in the Siberian village of Pokrovskoye, Tyumen Oblast. He had a religious conversion experience during a pilgrimage to a monastery in 1897. He has been described as a monk or as a "strannik" (wanderer or pilgrim), even though he never held an official position in the Russian Orthodox Church. After traveling to St. Petersburg, Rasputin captivated some church and social leaders. He soon became a society figure, meeting the Tsar in November 1905. In late 1906, Rasputin began acting as a “healer” for Alexei, the only son and male heir to Tsar Nicholas II and Queen Alexandra. Alexei suffered from hemophilia, which was kept secret from the public. Entrusting the heir to Rasputin, his influence and power grew immensely over the following decade, with Alexandra believing Rasputin was critical to Alexei’s health. As his authority grew, Rasputin became an increasingly divisive figure, seen by some Russians as a mystic, visionary, and prophet, and by others as a religious charlatan. Rasputin’s status as the mystical “healer” of the heir to the throne of Russia solidified his position in the court, and soon he was advising on all sorts of matters that he was clearly unqualified for. The high point of his power came in crisis in 1915, when Nicholas II left St. Petersburg to oversee Russian armies fighting World War I, increasing both Alexandra and Rasputin's influence. As Russian defeats in the war mounted, however, both Rasputin and Alexandra became increasingly unpopular. This became particularly acute as rumors grew of Rasputin’s sexual exploits with Russian socialites, including potentially the Queen herself. In December of 1916, Rasputin was assassinated by a group of conservative noblemen who opposed his influence over Alexandra and the Tsar. The fall of the Romanov dynasty (founded in 1613) and Russian Revolution came not long after. Sources:

• Source: Wikipedia • Smith, Douglas (2016). Rasputin: Faith, Power, and the Twilight of the Romanovs. Farrar, Straus and Giroux. ISBN 978-0-374-

71123-8. • Smith, Douglas (2017). "Grigory Rasputin and the Outbreak of the First World War: June 1914". In Brenton, Tony (ed.). Was

Revolution Inevitable?: Turning Points of the Russian Revolution. Oxford University Press. p. 62. ISBN 978-0190658939. • Smith, Michael (2011). Six: The Real James Bonds 1909–1939. Biteback Publishing. pp. 203–. ISBN 978-1-84954-264-7. • Wilson, Colin (1964). Rasputin and the Fall of the Romanovs. Farrar, Straus.

While Rasputin clearly was not the primary cause of the Russian Revolution, there are lessons to be learned. Czar Nicholas II had been resisting the social upheaval sweeping his country in the early 20th century. The Russian elite had become increasingly out of touch with the masses. Mismanagement, poor decision making, inflexibility and the sheer wackiness of examples like Rasputin meant a revolution grew to be inevitable. At Nicholas’s coronation, thousands were trampled to death in a stampede to get some of the free gifts they were handing out. The inaugural ball and celebrations went on as planned as horse-drawn carriages removed thousands of bodies in the background. The royal family was actually waving to the deceased at one point until they realized they were corpses.

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When I think of the go-to solution for the past decade (three decades, if you are Japan) of government reliance on unorthodox and radical monetary policies to magically solve economic, political, social and even geopolitical imbalances, I can’t help but think of Rasputin giving advice to the Romanov’s on how to manage Russia and the war effort against Germany. Unproven and unsuccessful policies sustained and amplified by unproven central bankers seem quite similar to Rasputin’s mystical advice. There was an excellent podcast that Grant’s Interest Rate Observers issued this summer. In “He Begs to Differ”, they interviewed Tuomas Malinen, PhD (econ). Tuomas Malinen is the CEO of GnS Economics and an Adjunct Professor of Economics at the University of Helsinki. He specializes in economic growth, economic crises, business cycles, monetary unions, and central banks. To paraphrase, macroeconomics needs a major overhaul. Macroeconomists have been wrong for decades but never to the extent they currently are, nor with the power they currently have. Their basic models are wrong, but they can’t admit it because the largest employer of macroeconomists are the policymakers themselves (central banks). With real sciences such as medicine, math, and biology, if you are proven empirically wrong you must adapt. Yet the same rules don’t seem to apply to macroeconomics, which appears to be more of a pseudo-science than something revealing immutable laws. Perhaps this is why it can be “mystified” by those claiming authority. Central banks’ obsession with low and negative rates goes back to the 1990s, where in Japan they created a zombie economy with zombie banks which has stifled Japan for a quarter century. Japanese Bank Index (Topix 1) Down 80% over past 30 years

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This is empirical evidence that quantitative easing and zero rates don’t work. The experiment has failed. European banks aren’t doing so well with this experiment either. European Bank (STOXX) Index down 50% over past decade

Interest rates impact the growth prospects. If central bank meddling actually inhibits the growth potential of a whole country, the whole model needs to be rethought. Central banks are the biggest employers of macroeconomists in the world, meaning most macroeconomists are disincentivized to critique the status-quo. This would be the same as Rasputin acknowledging that his mystical magic was ineffective to the King and Queen. Clearly, in the interest of self-preservation, he wouldn’t do that. What then, would be the value of Rasputin?

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Keebeck Viewpoints One modification this quarter is the overweight energy exposure given the extremely weak performance and value opportunity.

• Overweight international and emerging markets and non-dollar securities • Underweight corporate debt and heavily leveraged securities • Underweight private equity • Overweight value vs growth • Overweight short duration vs long duration • Overweight domestic housing • Overweight energy

Conclusion In conclusion, thus far 2019 has proven a strong comeback to the weak performance seen in the second half of 2018. Most assets classes from conservative to higher risk have benefitted. Going forward, the outlook grows more complicated and more challenging. Navigating these waters will be difficult but focusing on areas where more fundamental value exists should help serve as a compass, a true north if you will. Sincerely,

Mathew T. Klody, CFA Chief Investment Officer Keebeck Wealth Management, LLC mklody@keebeck.com * As this newsletter is for informational purposes, the strategies and opinions included herein may not be reflected in the management of your specific investment account(s). We manage accounts on an individualized basis, taking into consideration each client’s unique financial situation. If you have any questions regarding your investment accounts or our specific investment strategies, please contact us.

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Biography Mathew T. Klody, CFA is the Chief Investment Officer at Keebeck Wealth Management, LLC. Mathew is also an adjunct professor of finance at the University of Notre Dame. Prior to joining Keebeck, Mathew was the Founder, Managing Partner and Portfolio Manager of MCN Capital Management, LLC, the advisor to a private long short investment partnership. Mathew was the Senior Vice President and Analyst at Chicago-based Sheffield Asset Management, a long/short equity hedge fund from 2007-2012. From 2003-2007, Mathew was an Investment Analyst at the holding company of Alleghany Corporation (ticker "Y") covering the equity portfolio, corporate development and the reinsurance portfolio. Mr. Klody began his career as a credit analyst at the Global Corporate and Investment Bank at Bank of America. Mathew has been selected to speak at a number of industry events, including the Spring 2017 Grant’s Interest Rate Observer conference, Invest for Kids - Chicago (Fall of 2017), and the MOI Global - Best Ideas Conference (2018). He has served as a guest lecturer to the Notre Dame Institute for Global Investing, the Behavioral Finance and Applied Investment Management programs at the Mendoza College of Business. He serves as a member of the Parish Council at St. Joan of Arc Church in Lisle, IL. Mathew graduated summa cum laude from the University of Notre Dame with a degree in finance and business economics. Mr. Klody is a Chartered Financial Analyst.

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This document may contain forward-looking statements relating to the objectives, opportunities, and the future performance of the U.S.

market generally. Forward-looking statements may be identified by the use of such words as; “believe,” “expect,” “anticipate,” “should,” “planned,” “estimated,” “potential” and other similar terms. Examples of forward-looking statements include, but are not limited to, estimates with respect to financial condition, results of operations, and success or lack of success of any particular investment strategy. All are subject to various factors, including, but not limited to general and local economic conditions, changing levels of competition within certain industries and markets, changes in interest rates, changes in legislation or regulation, and other economic, competitive, governmental, regulatory and technological factors affecting a portfolio’s operations that could cause actual results to differ materially from projected results. Such statements are forward-looking in nature and involve a number of known and unknown risks, uncertainties and other factors, and accordingly, actual results may differ materially from those reflected or contemplated in such forward-looking statements. Investors are cautioned not to place undue reliance on any forward-looking statements or examples. None of Keebeck Wealth Management or any of its affiliates or principals nor any other individual or entity assumes any obligation to update any forward-looking statements as a result of new information, subsequent events or any other circumstances. All statements made herein speak only as of the date that they were made.