Things have been pretty darn good for US equity investors. The S&P 500 just finished the best quarter since 2013, rising 7.7%. In September, unemployment hit the lowest level since 1969 at 3.7% and average hourly earnings rose 2.8%. For the second quarter US GDP rose 4.2%, the best level since 2014. Apple and Amazon became the first two companies to cross the $1 Trillion market cap level. Despite many negative headlines surrounding tariffs, trade wars and political turmoil, the market has been strong, benefiting from continued earnings growth which was enhanced by the new tax bill. One could focus on only the recent data and be optimistic about a bright future ahead, or focus only on the potential risks from inflation, higher rates, and political headlines and run for the exits. Looking at them together we believe is best and a cautious and patient approach is warranted.
“Perhaps a cautious but patient approach is warranted…”
With all of the positive economic and market data, why are investors nervous? Many are unhappy with the state of politics in the US, the increasing fiscal deficits, and the deteriorating position of the United States in the global market and at the extreme, concerned that geopolitical disagreements may end in military action. Others are nervous simply about the length of the bull market citing the Newtonian fear “what goes up must come down”. While the length of the bull market puts us on alert, that alone is not compelling enough to take us out of the market. The other factors may impact economic activity in the future, but currently we are not seeing a significant impact. It is wise to continue to review the more coincident data to determine the proximity of risk. Taking the current strong state of the US economy and incorporating the risks into our outlook we remain optimistic on the US equity market but with a cautious approach. In order to acknowledge the tail risks in the market we continue to maintain a level of put protection on approximately 20% of equity exposure in client accounts.
Inflation, could it be on the horizon due to tariffs?
Inflation is always a key factor to monitor for equity markets. Typically it results from strong economic growth that naturally pulls up prices due to strong demands on labor and inputs. Interventional policies such as tariffs, have also been inflationary and currently, we are facing possible tariffs on all Chinese imports. Inflation is dangerous for markets in part due to the mandate of central banks to control inflation by adjusting interest rates in an attempt to slow or accelerate the growth in the economy. When coupled with strong economic growth, as illustrated by the generational low in unemployment, the Fed has ample reason to use further rate increases as a tool to combat inflation. Depending on the strength of the economy, rising rates increase the risk of a recession. That being said, the level of tariffs will likely determine the impact on inflation.
Over the past half century almost all tariffs have been removed from US imports. The question is did we go too far? Many economists would ascribe the adoption of free market capitalism as the driver of the incredible economic growth that has occurred. However, a market which is too “open” creates risks. Recently the issue of intellectual property has been brought into the topic of tariffs which typically had been related to national defense and labor protection. Protecting intellectual property and ensuring our technology is not tampered with is important but it is unclear if tariffs are the correct motivational tactic to elicit a more positive response from China. If there are economic imbalances, tariffs can be useful and not necessarily catastrophic. The balancing act of protecting US businesses while not restricting globalization and free trade will be difficult to navigate and the impact on the market will be important to monitor.
Looking to the mid-term elections and beyond
Political headlines around trade and other topics of debate are only likely to ramp as we head into the November mid-term elections. Likely surprising to many, the fourth quarter of a mid-term election year has on average seen the strongest stock market return in a President’s term. Usually, this comes after two tough quarters for the market, but this time it comes after the best quarter of this Presidency. We will see how things play out but when Congressional control shifts to the party not in office the market historically has moved significantly higher. Since 1942 the market was down only once in the fourth quarter which included a mid-term election. We look forward to see if the results remain consistent with history.
The global rally that wasn’t
As mentioned, the US stock market is up significantly this year and continues to be a standout around the world. Emerging Markets, in contrast, are down by 7.7% YTD as a result of rising rates and a strong US dollar. At the end of last year we were excited to see consistent growth across the globe. We had hoped that would continue and drive the US market even higher as multi-national companies had lagged technology stocks and those more domestically focused. Unfortunately that has not been the case with China and Europe slowing and some of the Emerging Markets falling into trouble surrounding their debt and currency. While the US Federal Reserve has aggressively raised interest rates the majority of Central Banks have not while most have maintained monetary stimulus. This has driven the US dollar notably higher and put pressure on particular Emerging Markets which have a high percentage of their debt issued in US dollars. This makes debt more expense to service in their local currency and has led to concerns about their ability to stay solvent, driving up interest rates on their debt and pressuring their local currency; a vicious circle. Our continued underweight position to both Developed International and Emerging Markets has benefited client portfolios.
“As long-term investors, and perhaps as important, individual taxpayers, we do our best to resist the temptation to time what we view as shorter term moves in the markets….”
Although often overshadowed by equities, debt is what drives market cycles. Cheap credit fuels economic growth and expensive debt and default are the ingredients of bear markets and recession. Domestically, credit spreads have compressed dramatically both in the public and private markets and the terms have eased; signs of a maturing credit cycle. The recent increase in short and mid-term rates will start to flow through and impact the cost of capital. Some of the weaker parts of the market likely will see an expansion in spread. We cannot find justification to take credit or duration risk in our clients’ fixed income holdings at this time; we continue to prefer high quality short term bonds in the US but we are looking for an opportunity to extend maturities and increase returns as rates rise.
As long-term investors, and perhaps as important, individual taxpayers, we do our best to resist the temptation to time what we view as shorter term moves in the markets. We review data continuously looking for a change in an asset class or a holding’s long-term growth outlook or a significant increase in risk before making a change in the portfolio. Our goal is to select investments that over the long term will deliver a strong investment return even though they may be hurt in the short term by market movements.
We believe the critical element is to continuously review and adjust the risk exposure in the portfolio. Over the last 12 months we have trimmed and repositioned our technology exposure in names such as Facebook, Amazon, and Alphabet due to over optimism and increased uncertainty due to potential increased regulation. Also, you may remember in 2014 we made a decision to reduce our exposure to energy as we saw supply building at a rate that significantly outpaced demand. As that dynamic improved, we started adding back to our position last year and as the data continued to show strength, we moved to a neutral weighting earlier this year. While the energy sector remains down roughly 25% from the 2014 highs, our holding in EOG Resources which we maintained through the cycle as we believed it had defensive and differentiated strengths, is up 13% while also paying a dividend. Internally we use the baseball analogy of consistently hitting singles and not swinging recklessly for home runs.
Although it is easy to get consumed by the headlines of the day, superior investment results have been generated through a bit of patience and long term focus. In 1781 the Bank of North America became the first publicly traded company to hit a $1 million market cap. In the last century AT&T hit $1B, GM $10B, GE $100B, and Cisco $500B making investors fortunes along the way. The newest addition to the list is Apple which narrowly beat Amazon in the race to $1 trillion this quarter. It would be easy to add this to the list of contrarian indicators for which we should be bearish, but another way to look at it is innovation is rewarded. Through good and bad times the stock market has marched higher as the next leader emerges and takes indices higher. We believe in taking a long term perspective and identifying those companies which are leaders in innovation.
MARKET COMMENTARY DISCLAIMERS
This commentary contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This commentary has been distributed for informational purposes only and is not meant to convey a current or past recommendation, investment advice of any kind, or a solicitation of an offer to buy or sell securities or investment services. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Individuals will need to consider their own circumstances before making an investment decision.
Information contained herein, including market forecasts and forward-looking statements, are derived from proprietary and nonproprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness or accuracy of the information obtained from these sources.
Past performance is not a guarantee of future results.