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Capital Market Summary & Outlook
After a tumultuous end to 2018, almost all asset classes have performed well thus far in 2019 as the global markets rebounded from the sell-off at the end of last year and the bond market responded to central bank policy actions. Stock indexes around the globe have posted double digit gains along with a large rally in the bond market that pushed the yield on the ten year Treasury note from a recent high of 3.24% last October down to a low 1.46% in September.
Despite all of the volatility and upside in 2019, stocks have failed to make real gains in the past eighteen months. Global stocks are still below the highs set in January of 2018 and the S&P 500 remains within a few percentage points of the January 2018 highs due to concerns over trade negotiations, manufacturing data (and service economy data to a lesser extent), political dysfunction in Washington and the Brexit overhang.
Much of the performance thus far in 2019 has been front loaded and the performance in the second half of 2019 looks much different than the first half as the secular fears around US-China trade negotiations and Brexit weighed heavily on international and emerging market stocks. Additionally, defensive and value stocks have begun to outperform as investors reposition their portfolios to be more resilient. The chart below from Blackrock illustrates the tale of two halves:
Beginning in 2014, a number of global central banks enacted negative policy rates to spur inflation, lending and growth. Unfortunately, the policy has had the opposite effect as income investors increased their savings rates (lowering spending) to offset the low interest rates, lending remained weak as low rates ate into bank profits and inflation has remained low across the globe. The central bank actions abroad spread to the US bond market in 2018 pushing rates considerably lower and yields around the world are near or at five year lows as seen on the chart from Fidelity:
Additionally, bond yields briefly inverted this past summer. An inversion in the yield curve happens when short term rates are higher than long term rates due to investors anticipating that near term economic conditions are stronger than the longer term outlook. Historically, a yield curve inversion has been a harbinger of recession with recessions coming 4-18 months after a yield curve inversion. The recent inversion may be different than the historical norm due to the negative interest rates and central bank action having a non-market pressure on yields. Furthermore, credit spreads remain indicative of expansion as do many of the consumer indicators. The overall signal is one of caution, not recession.
While the US economy is indicative of the late stages of the business cycle, we don’t see the traditional signs of an economy overheating. Unemployment rates remain at historic lows, but the wage growth normally associated with an economy at full capacity hasn’t been present leading to lesser inflation expectations than normal late cycle environments. Additionally, the Federal Reserve has been lowering rather than raising rates as would be typical for an economy at full employment. Given this backdrop, we believe that central bank policy has extended the end of the cycle and while we may see (or already be in) an economic slowdown, full blown recession risks remain low.
Stock market valuations also remain within normal bounds and are not cause for much concern. The price to earnings ratios of US companies are above their long-term averages, but the dollar’s strength and low interest rate environment can justify the slightly elevated valuations. Abroad, both emerging markets and international developed market stocks remain below their long-term averages as seen on the chart from Fidelity below:
Ferris Capital also believes that rates will stay lower for longer and we do not anticipate a rapid rise in yields due to tame inflation forecasts as well as an anticipated lower growth environment. There is also a strong possibility of the Federal Reserve cutting rates again in 2019. However, the board of the Federal Reserve is split on monetary policy views and there are a wide variety of potential outcomes as economic indicators are somewhat of a mixed bag. Further, many of the potential market drivers are secular, human influenced factors. Much of the recent downturn in stocks has been due to manufacturing activity entering a contraction and the service economy experiencing a slowdown in expansion while staying above contraction territory as seen in the chart from Franklin Templeton:
The potential for manufacturing and services to contract further is one of our major causes for concern, but much of the slowdown in manufacturing can be attributed to the effect of the US-China trade tensions and this highlights our main investment thesis: the primary market movers will be mainly secular trends brought about by a high degree of political risk.
Major Index Returns for the Third Quarter of 2019
- S&P 500 Index (Large Cap Stocks): 1.70%
- Russell 2000 Index (Small Cap Stocks): 2.40%
- MSCI EFAE Index (International Stocks): 1.078%
- MSCI All Country World Index (Global Equities): .03%
- Barclay’s Aggregate Bond Index (Fixed Income): 2.27%
Uncertainty surrounding the US China trade negotiations and the Brexit has led companies to hold off on capital expenditures cutting into growth. Attacks on oil operations in Saudi Arabia exemplify the risks in the region. Chinese growth remains unclear and is further hindered by the recent uprising in Hong Kong. Europe is still being held hostage by the Brexit which must be resolved by October 31st or extended until January 2020. All of the major sticking points are not market fundamentals, but human activity. As such, we would like to position and anticipate the resolution to each of these issues.
First and foremost as it relates to investment returns are the US-China trade negotiations. Increased trade war tensions could push the world into recession, but Trump’s political self-interest might force him to capitulate to the Chinese. It is our belief that Trump will do all he can to prop up the stock market ahead of next fall’s election. Previously, we had identified three likely avenues for Trump to pursue towards that end:
- Resolution of the China negotiations
- Fiscal stimulus in the form of an infrastructure bill
- A push for another tax cut.
Given the recent political turmoil around the Ukraine, we believe that the only path open at the moment is a deal with China.
Nevertheless, we anticipate continued volatility through the beginning of 2020 normally associated with the later stages of the business cycle. There are also expectations of a 5% YoY drop in corporate profits for the third quarter earnings season. A surprise to the upside could help drive stock prices in the near-term while longer term analyst outlooks have double digit earnings growth expectations for 2020, with energy having the highest expectations. However, there will need to be some resolution to trade wars to drive resurgence in manufacturing.
The best case scenario would be a trade war resolution, orderly Brexit, continued central bank easing and Chinese stimulus which would likely push stocks higher in 2020. Late cycle tend to favor the inflation resistant assets and the upside has been historically limited when compared to mid and early cycle trends. The anemic yields in the bond market also further the case for meaningful allocations towards stock.
As such, we favor owning high quality US companies for the earnings growth potential, smaller allocations to international developed market stocks in the case of a strong Brexit resolution, building a position in emerging markets companies in the case of a US-China trade agreement and long term growth, Master Limited Partnerships for the income and upside with the price of oil and high credit quality bonds as a potential portfolio ballast.
Lastly, although we have been in lengthy economic expansion, we do believe there is still room left on the runway due to the lower growth during this cycle. The chart above from Clearbridge demonstrates how the current trend is not an outlier for length but is an outlier for magnitude suggesting that there is still room to go.
Ferris Capital Market Commentary is prepared by Ferris Capital, LLC. Sources include Blackrock, Fidelity Investments, Clearbridge, and Charles Schwab. Ferris Capital considers these sources to be reliable; however, it cannot guarantee the accuracy or completeness of the information received. This commentary represents the opinions of Ferris Capital, contains forward-looking statements, and presents information that may change due to market conditions. It is general and educational in nature and is not intended to be, nor should it be construed as, investment advice. In accordance with SEC regulations, we request that you contact us in the event that there have been any material changes in your financial circumstances or investment objectives. All investing carries a risk of loss that clients should be prepared to bear. Registration as an investment adviser does not imply any certain level of skill or training. For a more complete discussion of Ferris Capital, please review our Form ADV, available at www.sec.gov. Past performance is not necessarily indicative of future returns.
The performance described in this report is based on investment selections for the period in question. There is no guarantee that these same investments will continue to perform as described. All investing carries a risk of loss, including principal that clients should be prepared to bear. Clients are advised to inform us of any changes in their circumstances as such changes may materially alter the appropriateness of the investments selected by Ferris Capital.