Capital markets delivered a rare mix of results this quarter. There was a substantial rally in bonds, the S&P 500 Index hit a record high and so did the price of gold. It’s unusual for these asset classes to all perform well at the same time. While positive performance from multiple assets is good news for owners of diverse portfolios, it is also a sign of an indeterminate investment environment.
This is a market of mixed messages. Bonds are telling us the future looks dim, while stocks – buoyed by corporate earnings and low interest rates – forecast a brighter outlook. At the same time, gold is waving a caution flag on persistently loose monetary policies. This is an environment that could confound any investor. But as we have said many times in the past, the answer to uncertainty is not overreaction. Neither is it inaction. In this environment, investors will be helped by discipline, professional guidance, and the patience to stick with their strategy rather than trying to trade against a high degree of uncertainty.
Stocks Rise Amid Higher Volatility
After a good first quarter for US equities, and to a lesser extent international stocks, the gains continued in April. However, as we noted at our November 2018 client meeting, market sentiment was highly sensitive to the Federal Reserve and the outcome of trade negotiations. Positive or negative news on either front could rapidly change the market’s tenor. We saw that play out at the end of April and throughout May as stocks fell sharply on news that the Trump administration was not close to a deal with China. Confidence recovered in June, fueled by belief that the trade situation was not as bad as feared and by the Fed’s apparent decision to end monetary tightening. Stocks rallied and the S&P 500 Index ended the quarter up 4.3%.
US Still Leads as Global Economy Softens
The market’s myopic focus on trade and Fed policy drove second quarter results, but slowing economic growth was a factor as well. Compared to a year or so ago, the global economy has weakened. We had hoped momentum from the late 2017 US tax cuts would spur a round of business investment, providing a dynamic boost to the economic cycle. Unfortunately, uncertainty surrounding the administration’s trade policy left US and global CEOs reluctant to invest, dampening the full potential of the tax cuts. Still, the US remains one of the stronger global economies.
In early July, the current US economic expansion became the longest on record. We believe this cycle could last another year or two. However, signals such as the global production slowdown, flat yield curve, and the inversion of the 3- to 10-year segment of the yield curve tell us this is more late cycle than mid cycle. We do not think a US recession is imminent, but the risk has increased.
There has been concern about waning benefits from the tax cuts, but the likely impact on US growth appears minimal as other GDP components hold steady. Consumer confidence and spending are robust. (See Chart A.) Fiscal spending should also remain solid now that Congress and the president have come to terms on a budget deal. Given anemic corporate spending, GDP growth could be closer to 2%, rather than the 3%-4% the economy had the potential to achieve.
Central Banks Step Up to Support Economic Health
As the global economy slowed, markets looked to central banks for reassurance and most were willing to oblige, extending easy money policies or ending tightening sooner than planned. Clearly, the US Fed did not have the economic backdrop to keep raising rates, which it recognized after the December downturn.
When we visited Japan with the Wigmore Association a little more than two years ago, Japanese officials assured us that negative rates were working to stimulate their economy, but that was not the general consensus. At the time, we thought that was the peak of negative rates. However, today there is nearly $14 trillion of negative yielding sovereign debt, much more than in 2017. (See Chart B.) To get an idea of how low rates are, consider that Greece, a notoriously unreliable borrower, is paying only about 2%-3%. Low global rates create demand for the 10-year US Treasury, which is yielding about 2%, further flattening the US yield curve. Demand pressures, combined with the deflationary effect of trade fears, put additional pressure on the Fed to cut short-term rates and steepen the yield curve.
Because many central banks ended their tightening cycles before reaching normal interest rate levels, their ability to stimulate economic growth may be constrained. Not only are interest rate cuts delivering less of an economic boost than they did in the past, but with rates still so low, central banks have less fire power in their arsenals.
Corporate Earnings Bode Well for Stock Performance
Preoccupation with trade and Fed policy has well-earned attention from corporate earnings results. US corporations (and global corporations as well) have made great strides in many areas – for example, sales force development and data technology. The resulting earnings growth has supported higher stock prices.
First quarter earnings were better than many anticipated. Earnings had been expected to fall sharply from the same quarter of 2018 when tax cuts provided a 35% boost. We were optimistic that earnings would be more resilient, which proved to be the case. The forecast for second quarter earnings is again negative and once again, we think reported earnings will be somewhat better than that, probably flat or slightly positive.
Stocks Offer Best Potential in a Moderate Growth/Low Rate Environment
With the S&P 500 Index at a record high level, a lot of good news is already baked into stock prices. To sustain current valuations, equity markets require a few good things to happen through year end. On top of the recent federal budget deal, the market is also anticipating more than one Fed rate cut and a US/China trade deal. The best case scenario is that the market goes up another 3% to 4% through year end. If we get both the rate cuts and the trade deals, there could be another significant upward move.
If that happens, it might be time to tap the breaks. At Pitcairn, we are continuing to put more defensive rather than aggressive managers into our searches and portfolios. And, our conversations revolve more around how and when to reduce risk, rather than how to squeeze a bit more out of the spurts in this late-cycle rally.
Let me say emphatically that tapping the brakes doesn’t mean shunning equities. Given US GDP growth in the 2% range, bonds may do okay, but stocks are likely to do better and cash will be terrible. With interest rates more likely to fall than rise, we may be moving back to the T.I.N.A. environment we talked about a few years back. If you recall, T.I.N.A. is shorthand for There Is No Alternative to equities. Jason Trennert of Strategas coined the term and his firm is forecasting a return to that environment. Global economies are not in free fall, but without corporate spending, they are not growing robustly. That is still an environment where equities are likely to outperform over the intermediate term.
In recent years, some investors have held extra cash or moved to cash more quickly because they fear another recession like 2008, during which equities declined about 50%. However, there’s a good chance the next recession will not impact equities as severely. The 2008 recession was a rare balance sheet recession where repricing of assets shocked banks and other lenders, paralyzing liquidity. In contrast, typical recessions are demand-driven where fear causes companies and individuals to curtail spending. The average equity decline during demand-led recessions is 25%. Certainly painful, but far milder than 2008. Furthermore, investors who have stayed in the market and captured the gains of the last five years have more assets to help them weather any decline.
History says that patient investors who stay in the market almost always have better results. We think the right strategy is to invest through, not around the next recession. We are working to expose our clients to late-cycle opportunities, but in an informed way that allows for defensiveness on a marginal basis.
Fixed Income Strength Surprises Market
The first half of this year brought a strong rally in corporate bonds and decent rallies in municipals and the rest of the bond market in general. Those gains will be hard to replicate in the second half of the year. However, the abrupt end to monetary tightening and quick resumption of easier policies has given bond markets a reprieve from the weakness we have anticipated for so long. For the short term, we don’t anticipate any meaningful fixed income decline, but we don’t see a significant rally in the cards either.
As lack of inflation keeps bond markets robust, I equate the precautions we took in our portfolio with buying hurricane insurance – we haven’t needed it, but under the same conditions, we would buy it again.
Keeping a Watchful Eye on Geopolitical Hazards
As investors became more optimistic about a trade deal between China and the US in late June and early July, equities responded with a big upward move. But optimism is just a feeling. It will be harder to get an actual deal. US negotiators are scheduled to visit China in August, which is a good sign, but it is extremely hard to forecast the outcome of politically driven macro events. We could be surprised with a deal tomorrow or this could drag into next year. Even beyond a US/China deal, we believe trade and tariff concerns will stay on the radar and be a moderate depressor of GDP growth. The president is likely to focus on tariffs as a toll in trade battles because this is an area where he can effect change without involving Congress. Looking ahead, trade issues with Europe and Latin America are certainly possible.
In addition to trade, we are monitoring other geopolitical situations that could affect global markets. China reported second quarter GDP growth of 6.2%, its lowest in 27 years. But consider this: 15 years ago, a trade war would have pushed China’s economy into decline. Generating over 6% growth with constricted trade shows significant progress in the Chinese economy’s maturity. Moving forward, Fed rate cuts and a weaker dollar could give China’s equities (as well as other emerging markets) a strong second half of the year.
In the Middle East, tensions with Iran have flared in recent months, particularly following the seizure of a British tanker and the disputed US downing of an Iranian drone. Though oil prices have been complacent through these events, that might change quickly if the situation deteriorates. Higher oil prices could spur actual inflation, potentially influencing Fed policy, although we see that scenario as unlikely. A Middle East meltdown is not a fait accompli and the situation doesn’t yet merit a strategy change, but it certainly warrants our attention.
In a Market of Mixed Messages, Depend on Patience and Policy
The environment of the past few years has been highly conducive to macro-economic forecasting. Our clients have benefited from Pitcairn’s effective forecasting of consumption, corporate earnings, overall global economic growth and, more precisely, the countries that would contribute to that growth. Conversely, this year has been more challenging for macro forecasters because capital market performance has been less about fundamentals and more about perception, politics, and the future of politics.
As we work our way to the end of this very long, very slowly evolving cycle, two things will be especially important: patience and the ability to recognize that the most draconian possible outcome for any situation is rarely the most probable. And even when the worst happens, the impact on markets is often transitory.
Wherever the markets go, there will be opportunities for long-term investors and there will be challenges. So when there is uncertainty, hold tight to principle and policy. In a period where stocks, bonds and gold are all rallying, it’s more vital than ever to stick to your strategy. I think 2019 will be another year where patience, discipline, professional guidance and adherence to strategy will lead Pitcairn families closer to their goals.