August 6, 2018 – From its early days, we have described the current bull market as one of the most unloved in history and today, this bull is still waiting for an invitation to dance. I have never seen such a bull market run with so many individual investors still largely on the sidelines considering that the Russell 3000 Index returned 14.8% over the past 12 months, has a 13.2% annualized return for the last five years, and has a 10.2% annualized return for the last 10 years as of the end of the second quarter 2018. Yet, aside from a brief period last fall, investors just aren’t feeling the music. And while that’s terrible for their investment performance, it could bode well for the life of this bull market since excessive investor exuberance is a key sign of a bull market’s impending demise.
Amid the lack of love, the Russell 3000 Index managed a 3.9% return in the second quarter as strong economic fundamentals squared off against a cacophony of geopolitical noise. The biggest change between the first and the second quarters was a deepening fear of global trade war. What didn’t change: The Fed’s steady and measured effort to raise interest rates to more normal levels so it is fully prepared to handle a future recession, whenever that may be.
Long-term Impact of Global “Shocks” Likely to Be Milder Than the Market Predicts
In a quarter chock full of geopolitical news – from the US/North Korea summit to elections in Italy and Mexico to an escalating war of words (and tariffs) between the US, China, and other trading partners – markets found plenty to worry about. But market angst is a terrible predictor of long-term impact. The market has overestimated the negative impact of every major global event since 2008, a list that includes the European debt crisis, the UK BREXIT vote, Japan’s tsunami, the US debt picture, and the Fed’s super abundant liquidity.
The same will likely hold true for this quarter’s main source of worry – tariff fears. Yes, the potential risk to the US economy has risen. Based on analysis by Strategas, estimates now place the possible negative economic impact at $120 billion, up from about $80 million when we wrote last quarter. However, that still pales in comparison to the counterbalancing positive effect of last year’s tax stimulus, estimated at $800 billion.
Predicting future economic consequences is always difficult, but when you add a layer of politics, compounded by the Beltway drama associated with the current presidential administration, it is nigh impossible. In hindsight, I think we will find that the events of this past quarter were overblown and investors who stayed the course will have been much better served than those who gave in to fear.
Yield Curve Flattens with Powell’s Steady Hand on the Fed Wheel
In last quarter’s letter, we noted that the Federal Reserve’s normalization of interest rates and how the late stage bull market handles the rising rate environment would be a key determinant of where markets are a year from now. So far, I am impressed by the performance of new Fed Chair Jerome Powell. Under his leadership, the Fed continues to be guided by data rather than politics and has plainly signaled its intentions to the markets (including the likelihood of two more interest rate increases this year). The Fed’s steady path and forthright communication have enabled equity markets to absorb the rate increases without major disruption, while bond markets have held up better than anticipated.
In the current climate, the fixed income yield curve is a topic of considerable interest. As short-term yields have risen more than long-term yields, the curve has flattened, reducing the income advantage for owning bonds with longer maturities. This flattening has many pundits chattering about inverted yield curves, a known negative indicator for equity returns. But let me stress that flat is not inverted! In the mid 1990s, the market climbed meaningfully higher with a flat yield curve.
We look at the yield curve as a thermometer that tells us how things are going. As the yield curve flattens, many take that as a sign that things are weakening. Today’s flat yield curve is being impacted by a number of unique influences that are sending investors false signals. Despite the flatness of the curve, they are going well. Last quarter’s 3.2% GDP growth was strong enough to support the long end of the yield curve and the second quarter GDP just came in at 4.1%. Chart A shows the US economy’s recovery following the recessions of 2000 and 2008 and the recent upward spike is impressive. Higher GDP growth, combined with record low unemployment and few inflationary pressures, is a Goldilocks scenario that should let the Fed maintain its measured pace of rate increases without undue stress to the markets.
Focus on Healthy Economy Keeps Politics and Fear at Bay
In 2010, a number of Republican politicians downplayed a very real economic recovery for political purposes. At the time, I pointed out the risks of mixing politics and investing. A similar mindset may be influencing current views. There seems to be a meaningful correlation between people’s opinion of the presidential administration and their positive or negative perception of prevailing economic conditions. As I have done many times in the past, I urge you not to let politics drive investment analysis or decisions.
Objective assessment shows that the US economy is heating up, not cooling down, and that the global economy, while experiencing a few pockets of weakness, remains quite strong. As we said above, current forecasts have US GDP growth accelerating in the 3% to 4% range through year end. US corporate earnings are robust, unemployment is at its lowest level since the year 2000, and initial jobless claims are at their lowest level since 1969.
Globally, the picture is not quite as rosy as it was in January and February of this year when we talked about a true synchronization of global growth, with economic momentum in all regions of the globe. During the second quarter, we saw political dislocation in some areas of Europe, while emerging markets struggled against the strong US dollar, rising interest rates, and decreasing global liquidity. Economic activity in the European Union and emerging markets has slowed a bit; however, the overall global economy is still strong. The Chinese have taken steps to stimulate their economy in the past weeks, preemptively addressing any interim weakness by attempting to bolster internal demand in the face of a potential slowdown in trade. There are still many questions regarding Mexico and the recent elections there, but the market has reacted more favorably to the change than many had forecast. We await signals to see how the new administration’s policies are accepted by the global markets.
Rhetoric and actual trade issues have stirred concern that an out-of-control trade war is a potential threat to global growth. It remains to be seen whether US negotiators see recent tough talk as a strategy for backing into a sensible agreement or are willing to stand by the rhetoric and take near-term pain to make their point. Regardless, the ability of US stocks to deliver a positive return for the second quarter, despite a wave of unsettling geopolitical news, is a tribute to the healthy underlying fundamentals of the US and core global economics.
Stimulus Reset May Send Slowly Evolving Economic Cycle into Higher Gear
We have said this before, but it bears repeating – every single factor in this post-2008 economic cycle has been extremely slow in developing. We have now had 34 quarters of slow US economic expansion. We actually have to look back more than two decades to 1995 to see a US economy as robust as what we’re now close to achieving.
Some liken 2018 GDP results to a sugar high, brought on by the tax law stimulus. I disagree. I think the stimulus could have a long-term effect. US corporate earnings have been universally strong. Among the first 11% of S&P 500 companies reporting second quarter earnings, there were 92 positive earnings surprises. That is virtually unheard of. What will companies do with these higher earnings? The best choice for sustained economic growth is for companies to reinvest earnings to increase capacity and we are finally beginning to see real capital expenditure.
It is certainly important to note that the economic picture is not without risk. This is a long-running cycle and with each month or quarter that passes, risk creeps in, but there is also merit to the argument that the late cycle stimulus hit a reset button that could extend this economic expansion. If these long-running trends of slowly evolving market factors are real, there may well be a few more years before any economic downturn.
Stocks and Bonds Poised to Block and Tackle Their Way Through 2018
Following robust returns in 2017, US and global stocks seemed to have gotten ahead of the fundamental economies. Now the opposite may be true, which may reflect a bit of catching up. The fact that markets did not fall sharply on the big news events of the quarter shows there’s still support and that’s important. However, markets don’t like uncertainty and between the trade situation and the upcoming mid-term election, we have plenty. I do not see ready tinder for a runaway bull market, so it’s plausible that this will be a year of blocking and tackling.
Looking longer term, it’s also possible that markets are setting up for a good year in 2019. Given current interest rate levels and valuations that came down a bit in February, neither US nor global stocks seem excessively overvalued. Rising corporate earnings and stable stock prices augur well for valuations. There has been some conversation about narrow leadership, a scenario where a limited number of US stocks deliver a disproportionate percentage of return. This has raised the specter of 1999 and 2008, but our analysis shows that market breadth remains considerably wider than it was in those years. Chart B shows the year-to-date return distribution for US stocks, as measured by the Russell 1000 Index. While the largest companies (notably the tech giants known as FAANG (Facebook, Amazon, Apple, Netflix, and Google) have performed well, they are not the best performers in the market. All but the smallest stocks within the Russell 1000 Index have played a role in the index’s gains.
For a more optimistic take, I would compare 2018 to 1994, another year when the Fed was resetting interest rates and stocks were digesting recent gains. That year set the stage for a very strong market in 1995.
Turning to fixed income, bonds yielded no major surprises this quarter. In fact, the bond market has been the poster child for the slowly evolving cycle discussed above. We have been on alert for inflation and bond market weakness market since 2009. It’s 2018 and we’re still waiting. Though the bond market has grappled with this year’s rate increases, it has not given way. The Bloomberg Barclays US Aggregate Bond Index was flat for the quarter and down slightly so far this year, evidence that bond markets are holding their own, having already priced in the expected rate increases. Fixed income is vulnerable to a potential future Fed misstep, but to this point has been more resilient than expected.
Preparing for a Recession with an Uncertain ETA: Keep Those Dancing Shoes On
How do we prepare for the inevitable next recession and market turndown? Let’s start with some historical perspective. The recessions of 2002 and 2008 and their corresponding market downturns are at the top of everyone’s minds. Each saw a 50% equity decline. But look beyond those two recessions and we find that most recession-related equity declines are more in the 15%-22% range, still significant, but much less dramatic.
At some time in the future, a recession will happen and equities will definitely decline. But who’s to say when that will be or, more pointedly, how far stocks will rise between now and then. How many advisors have steered their clients away from equities over the last 10 years and at what cost?
Whether stocks produce double-digit return over the next two to three years or begin their long-awaited move into a recessionary cycle, Pitcairn’s goal is to move asset allocations through the next recession, rather than fruitlessly attempting to pick the right time to step around it. It behooves all of us to think and act like long-term investors. To Pitcairn, that means when the probability of recession is high, slightly turn down the riskiest postures, turn up sectors and positions that are more protective, and modestly bolster cash. We would never advise deviating completely from your plan and moving fully out of the market. That’s the core of Pitcairn’s philosophy, the core of multi-generational success in investments. Make the market your servant, rather than being the servant of the market.
Participation with Discipline is the Way to Win in the Unloved Bull Market
Over the next few months, perception of the rationality and progress of trade negotiations will be a significant factor in market behavior, while media attention will likely shift to the mid-term elections and Supreme Court confirmation process. In contrast, Pitcairn’s focus will be on economic growth, Federal Reserve policy and the 30-year Treasury yield because those factors will be most relevant to your portfolio.
Certainly, US and global politics have cast shadows over the capital markets, but if the worst fears about the current environment are political in nature, then we must keep that in the proper perspective. Back in 2009, we preached the value of placing fundamentals above politics. That has served our clients well over the last decade and we think it will do so again in today’s contentious political environment.
Here we are at the halfway mark of 2018 and the most unloved bull market in history is still waiting to be asked to dance. With some investors still sitting on the sidelines and others ready to bolt as soon as the music starts to fade, we are confident that Pitcairn’s strategy of participation with discipline is the best way to stay on the dance floor as long as there’s music playing.