2nd Quarter, 2019
It may be better to let the aging bull go and prepare for the next recovery.
THE MARKETS
The equity markets continued their rebound in the second quarter with the S&P 500 and Dow Jones Industrials advancing 4.3% and 3.2%, respectively. Stock gains were not limited to domestic markets, with the S&P Global 1200 Total Return Index returning 4.1%. Equity gains were well supported by continued economic growth and falling interest rates. During the quarter, the yield on 2 Year Treasury notes fell from 2.20% to 1.79% while yields on the 10-year Treasury declined from 2.50% to 2.03%. These are actually continuations of longer-term trends. The 2-year Treasury yielded 2.98% as recently as November of 2018 and the 10-year Treasury 3.26% only last October.
The quarter’s overall positive equity returns masked meaningful intra-quarter ebbs and flows. April optimism about an accommodative Federal Reserve and a resilient U.S. economy gave way in May to concerns over slowing global growth and the possibility of an all-out trade war between the U.S. and China. More recent investor sentiment has been positive following dovish statements by the ECB’s Mario Draghi and the possibility of some sort of trust between President Trump and Chinese President Xi Jinping on trade issues. Inflation and job data appear to have been sideshows in influencing investor sentiment. A continued ballooning of the Federal deficit in a period of full employment remains a shadow story, garnering little or no interest. Likewise, for the risk associated with the deterioration of corporate credit. The IPO market continues on rocket fuel as does the ability of private equity funds to raise record amounts of new capital for illiquid investments. The Fed seems determined to keep the aging bull alive with the elixir of cheaper money, apparently more willing to risk higher inflation than the deflationary effects of a recession.
On a fundamental basis, equity markets appear fully priced, with expectations of lower corporate profit growth implicit in third quarter GDP forecasts of 1.2% to 1.5%. Dividend growth is beginning to reflect the realities of reduced growth in cash flow, and any burst of market euphoria following the G20 U.S.-China trade truce risks carrying the markets into overbought territory. The major concern that lies ahead is a decoupling of market sentiment from economic trends, which are demonstrating late cycle realities. It may be better to let the aging bull go and establish a basis for the next recovery.
THE ECONOMY
Domestic and global growth face increasing risks of being bedeviled by excesses in the bond markets. Otherwise, the U.S. economy continues to move along at a somewhat reduced level of activity due to concerns about the corporate impact of tariffs and the ongoing pressure on exports from the strong dollar. Wage gains continue to support rising personal consumption spending, and savings inflows remain strong. There are supply chain bottlenecks as would be expected in any economy with full employment. At present, logistics issues exist in several industries. Particularly noticeable is the shale production glut which shows little sign of abating.
In the traditional automotive industry, a broad based restructuring is underway due to rising demand for electric cars and the cultural preference for trucks and SUV’s versus sedans. Auto restructuring will have a long time horizon and will increase pressure on many small businesses to adapt to a new norm. Housing remains fairly healthy and at this time seems to evidence little concern about materials inflation. The longer view of housing favors home ownership versus renting as interest rates remain at historic lows. The major challenge is affordable housing in areas where demand created by thriving technology companies has far exceeded the supply of quality, affordable housing.
Retailing continues to undergo a shift from “bricks and mortar” static display and fixed location offerings to internet commerce. The success of Amazon and the tribulations of retailers like Sears, Neiman Marcus, and J.C. Penny highlight the challenges in the sector; however, the consumer continues to be the winner with lower prices and benign inflation.
Financial services, particularly payment processors, are thriving in the current environment as consumer credit growth continues and digital payment options proliferate. Of concern is what happens in an economic downturn when consumers focus on the real cost of the effortless payment systems. The present environment puts the banks with reasonably high regulatory standards in direct competition with the largely unregulated FinTech field. Both groups will fight strong competitive battles for the consumer’s cash flow in the next few years. In time, a regulatory framework that is all-inclusive will be developed.
The most significant risk the economy faces from financial services lies in the opaque realm of shadow banking where lending standards and leverage are rarely visible and the sources of capital remain largely unknown. This lack of transparency increases the likelihood of trouble from a mismatch in the duration of assets and liabilities, the extent of which will only be known in a downturn.
For the balance of 2019 we expect a continuation of the current expansion but at a declining rate of growth, leading to reduced profit margins. Consumer spending in the absence of inflation should remain stable except for the influence of higher energy costs if non-U.S. oil producers succeed in limiting output.
As the 2020 election cycle heats up we should expect some pressures on financial markets as nearly 100% of campaign rhetoric tilts in favor of new spending and austerity faces the threat of removal as it has no place in the lexicon of political correctness.
INVESTMENT STRATEGY
In a market dominated by short term risk on and risk off considerations such as the U.S.-China jousting for economic and political dominance, the irrational stretch for yield and the gaming of central banks, it becomes very challenging to keep one’s focus on the long term strategy of building value from real growth and income streams. The primary investment focus should be on the real economic facts of life, not on strategies that are fueled by cheap money.
We are close to the end of the longest period of economic expansion in a hundred and twenty years. The current cycle grew out of the rubble from the financial house of cards crash of 2007-2008 and the ensuing 2008-2009 Great Recession. As in all business cycles, excesses creep into the system and build up quietly over time – leading to a let sleeping dogs lie philosophy or ignorance is bliss! Yet the risks are real and continue to grow.
Of primary concern now is the market risk to maintaining genuine liquidity in our portfolios and preserving the value built up over the last ten years. Our strategy of holding a core portfolio of high quality, low beta stocks with sustainable dividend growth is intact, and we remain vigilant for new ideas that sow the seeds of future growth. These ideas may be sourced from 1) harvesting gains from a successful investment that has grown to be an out-sized position or 2) selling a stock whose investment thesis is no longer viable. Although there may be tax expense associated with such changes, they are important to maintain a healthy portfolio with proper diversification, which becomes an investor’s best friend when sentiment turns gloomy.
As regards fixed income, we continue to limit duration, sometimes at the expense of current income, in the belief that credit risk continues to rise as the cycle ages and a liquidity challenge would lift the principal risk on longer dated maturities. The currently narrow spread between U.S. Treasury and high grade corporates leads us to favor the former with selective use of the latter.
The current state of yield fixation is worrisome; particularly as credible central bankers are warning about systemic risk. Bank of England Governor Mark Carney warns that some of the $30 trillion of global closed end money funds are often trapped in illiquid assets, stating, “You can see something that could be systemic… These funds are built on a lie, which is that you can have daily liquidity for assets that fundamentally aren’t liquid.” Accordingly, for cash reserves, we limit exposures to Treasury bills or open end money market funds that invest solely in government securities. We believe caution is warranted until these concerns abate.
As always your comments and questions are welcome. We wish you a happy Independence Day 2019, our 244th.