Investment Commentary: October 2019

  • October 9, 2019

Third Quarter Market Recap

BY: FRANK HOSSE
Director of Investments – Argent Trust Company  |  615.385.2720

The third quarter seemingly packed a year’s worth of market action into three fast moving months. Regardless of your stock market, interest rate or economic viewpoint, there was something for everyone. Now familiar themes included: on-again/off-again U.S.-China trade war headlines, weak global growth, recession fears, and central bank monetary policy.

On a month-by-month basis, larger-cap U.S. stocks rose in July, fell in August, then rallied in September. The S&P 500 ended the quarter near an all-time high. Fast growing companies have provided much of the leadership in this long running bull market. Once a year in each of the last four years, cheaper value stocks have unsuccessfully tried to lead the way, but any strength in those cheaper value companies has proven temporary. This scenario played out again in the third quarter as value stocks outperformed growth stocks. Time will tell if this leadership change will hold.

Meanwhile, U.S. core investment-grade bonds were flat in July, rallied sharply in August, then dropped in September as interest rates rebounded from historic lows. Overall it was a remarkable quarter as the benchmark 10-year Treasury yield dropped to below 1.5% in early September as trade war and recession fears crescendoed. It then sharply reversed, then dropped back, ending the quarter at 1.68%, down from a 2% yield at the end of the second quarter. For the quarter, our non-core positioning continues to perform well adding to gains in both high yield, up 1.3%, and emerging-markets, up 1.5%.

Despite a rebound in September, foreign stocks posted negative returns for the quarter. Developed international stocks were down 1.1%, European stocks were down 1.8%, and emerging-market (EM) stocks lost 4.2%. The U.S. dollar appreciated 2% to 4% versus other currencies during the quarter, which was an equivalent drag on foreign stock market returns.

Because our balanced portfolios are diversified beyond large cap U.S. stocks and bonds, the overall market trends in the third quarter were a drag on our relative performance. Rising interest rates brought losses to core bonds, while our flexible fixed-income and high yield funds had gains. Better news on the trade front also boosted more cyclically sensitive international and EM stock markets as well as U.S. value stocks, all of which have lagged the S&P 500 market index the past several years.

Trade Policy vs. Monetary Policy Tug of War

Global economic growth remains weak and consensus expectations are for further slowing. During the third quarter, both the Organization for Economic Co-operation and Development and the International Monetary Fund cut their projections for 2019 and 2020 global gross domestic product (GDP) growth (again), citing the negative impact of the U.S.-China trade war on manufacturing, exports, and business investment spending.

While measures of global manufacturing activity remain in contractionary territory, services (non-manufacturing) activity, which represents upward of 70%-plus of the global economy (and more than 80% of U.S. GDP), still looks solid, as shown in the chart above. (Note: PMI above 50 denotes expansion and below 50 denotes contraction.) This is a key difference with the 2001/02 and 2008/09 periods, when the service sector collapsed in lock step with manufacturing activity. Household balance sheets and consumer spending also remain healthy, supported by low unemployment and solid wage growth.

Of course, there are hundreds of economic data points that can be selectively marshalled to support almost any macro view. Suffice it to say, the data is “mixed.” But one might not be far off the mark boiling things down to a tug of war between the contractionary effects from U.S. trade policy and accommodative/expansionary global monetary policy. Expansionary fiscal policy may soon enter the global picture in Europe and China.

On the monetary policy front, global financial conditions have eased significantly this year, largely due to the sharp decline in bond yields. As shown in the chart to the right from BCA Research, looser financial conditions are positive for global growth. This, along with BCA’s view that both China and U.S. president Donald Trump have an incentive to make a trade deal before the U.S. election, lead them to expect global growth to rebound in 2020 and, with it, strong performance from foreign and cyclical stocks. A weaker dollar would likely accompany a rebound in global growth, which would further loosen financial conditions, enabling a positive feedback loop between the financial markets and the economy. A weaker dollar would also benefit foreign stock market returns for U.S. dollar–based investors.

In response to the weak global economic environment and the impact of trade policy on U.S. business sentiment and capital expenditure, the Fed followed its late July interest rate cut with another 25-basis-point (bp) cut in mid-September, bringing the federal funds rate down to a range of 1.75% to 2.00%. Also, earlier in the month, the European Central Bank (ECB) cut its policy rate 10 bps, to negative 0.5% and announced it would launch a new open-ended asset purchase plan (i.e., quantitative easing) at a rate of €20 billion per month starting in November. Departing ECB President Mario Draghi also implored eurozone governments to undertake fiscal stimulus to boost the region’s growth, signaling monetary policy may be reaching its effective limit.

What does the second Fed rate cut mean for the stock market in the near term (next 12 months)? Not surprisingly, the answer depends on whether the economy is heading into a recession. What we know for certain, though, is Fed rate cuts do not necessarily prevent a recession from happening. The last three recessions—in 1990, 2000, and 2008—all occurred despite the Fed cutting rates prior to the recessions’ start. Bear markets coincided with each of those recessions.

Looking further at monetary policy, Ned Davis Research analyzed Fed rate cuts going back to 1921. They concluded that when the Fed cut rates twice and the U.S. economy avoided a recession over the next year, the stock market gained an average of 18% in that year. This has happened seven times in the past. However, in the three instances (1990, 2000, and 2008) when two Fed rate cuts were closely followed by a recession, the stock market dropped 11% on average over that year.

So, based on history we see two widely divergent market outcomes. This again highlights why we believe it is important to incorporate a wide range of scenarios in our portfolio management process. The most effective way to do this is through diversification across multiple asset classes and investment strategies that have different risk exposures and different sources of return. Of course, this also means that not every position will perform well in every scenario or macroeconomic environment. That’s the definition of portfolio diversification and the essence of risk management under uncertainty. The most important point is that a portfolio needs to maintain a balance because each asset in it has a defined role and no one knows how to time market tops or bottoms.

Positioning for Global Risks

Over the coming years, we see a wide range of potential outcomes for global economies and markets. Some are positive, and some are negative. It is completely plausible that global economies and financial markets could experience positive developments that feed more positive developments, thus supporting continued growth and strong market returns, a least for a while longer.

However, the risk of a global recession and a bear market for stocks has risen. Economic growth in Europe and China may be decelerating, driven partly by the United Kingdom’s messy negotiations regarding their exit from the European Union and the trade war between the United States and China. The U.S. economy has grown for a record number of consecutive years, raising worries about how long this growth can continue. The prices of riskier assets such as U.S. stocks are high relative to their historical valuations, making their prices more vulnerable to disappointing news, such as recent events in U.S.-China trade relations.

Today investors must consider several unique risk factors when building a balanced portfolio:

  • Higher regulation and political risk: Income and wealth inequality has widened this cycle to a point where historically high corporate profit margins are inviting greater regulatory and political scrutiny and actions against corporations and investors.
  • Protectionism risk: While trade tensions may resolve in the shorter term, we think there is a good chance we will remain in a heightened environment of global trade friction for an extended period. This will weigh on business and investor sentiment and increase the cost of doing business for companies.
  • Inflation risk: This risk may be higher for investors than in the past three decades. We believe the risk of inflation may be significantly underappreciated. It appears “stagnation” or “disinflation” is fully priced into markets wherever we look—stocks, bonds, commodities, real estate, etc. Ultimately that’s what matters to an investor—what’s likely priced in and over what duration.

We position our client portfolios for both positive and negative events. Our goal is to capture returns from markets or asset classes where we see stronger potential while maintaining the diversification necessary to manage the downside from negative events. As we give more weight to the risk side of the equation, we will make incremental adjustments to our portfolios.

Closing Thoughts

Better economic data and meaningful progress on trade negotiations will be necessary for stocks to move sustainably higher. As such, the concept of taking money off the table in large cap U.S. equities and reallocating (rebalancing) it somewhere else (international stocks, bonds, cash, etc.) makes sense after the big run up in stocks over the course of this year. While our outlook on the economy, interest rates, and corporate earnings remains constructive, we continue to emphasize that negative risks to that outlook have increased in our opinion and have recommended that investors reexamine their risk tolerance.

Our investment mandate is to compound our clients’ wealth while remaining mindful of the risks we take in achieving that goal. We don’t know exactly how the future will unfold. As a result, in our portfolio decisions we weigh various risks our portfolios may be exposed to. We consider risk by analyzing a wide range of positive and negative economic and market scenarios, the impact they may have on each client’s portfolio, and the likelihood of them occurring given current fundamentals and how we see them likely evolving.

The current U.S. equity bull market has done the compounding part of our job well. But we believe we are now at a point where risks have gone up significantly. We think it’s prudent to be a little defensive, to preserve some capital so we can deploy it when valuations in relation to long-term fundamentals are more normal. Today they look far from normal.

Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Argent Financial with permission. Reproduction or distribution of this material is prohibited, and all rights are reserved.