As we begin the third quarter of 2019, we are impressed by how the equity market climbed a considerable wall of worry, with the major US indices sitting at all-time highs. The bull market was tested as it navigated the 4 key factors we discussed in our last letter: company earnings, pending IPOs, trade tension, and Federal Reserve policy. In each case, expectations had been lowered, a low bar was met, and markets moved higher. It would be nice to say that all issues have been resolved and clear skies are ahead, but uncertainties remain. If positively addressed, markets may move higher.
We continue to see the Federal Reserve as a key driver of the markets. It is almost a certainty that at their July meeting the Federal Reserve will reverse course and lower rates. As the Fed raised rates in December, they acknowledged the strength of the US economy and concerns about inflation. More recently, Chairman Powell cited concerns about global growth, trade tension and declining business confidence to justify the change of heart. As this accommodative stance became clear, the market moved higher to close the quarter at record levels; the S&P 500 just points away from 3,000. The bond market has already priced in a series of rate cuts and equities rallied as a result.
Asset allocation decisions are often driven by a comparison between the yield on long term ‘BBB’ rated corporate bonds and the earnings yield on stocks (Earnings per Share/Price). Historically, these yields have been very close to one another; currently they have diverged significantly as bond yields have fallen. The current S&P 500 earnings yield of 5.8% looks attractive relative to the 4.3% yield on the Moodys ‘Baa’ Corporate Bond Index. As fund flows typically drive price movement, a shift in allocation from bonds to stocks as a result of this valuation difference could drive the stock market higher.
In Powell’s semi-annual testimony to Congress he discussed potentially changing the current framework for analyzing and implementing the Federal Reserve’s monetary policy. Since the early 1980’s when hyper-inflation drove interest rates to record levels, the Fed has had an intense focus on controlling inflation. Particularly, when the labor market is near full employment, the Fed has increased rates to control inflation with limited concern for growth. The current conditions seem a bit different as the Fed struggles with a lack of inflation despite low interest rates. This has led Powell and his team to question whether their focus on preventing higher inflation should shift to an emphasis on driving growth while allowing for some higher inflation. An additional dynamic they face is the Global interest rate environment. Europe in particular, has negative interest rates and a slowing economy. Today, amazingly, there is a worldwide total of $13 trillion worth of bonds that carry a negative interest rate. For example, in Germany, interest rates on government bonds are almost entirely negative with the 10 year bond yielding -0.35%. We are surprised that this has persisted for the majority of 2019 as investors are willing to receive a negative return on their bonds.
Negative Debt Surpasses $13 Trillion
With low interest rates around the world, we too wonder why growth and inflation are so elusive. Given the extremely accommodative monetary policy throughout this cycle, it makes one wonder if lowering interest rates will have a positive effect or will simply lower the returns for ‘savers’, driving incremental investment into growth assets. The degree of this shift will be important to watch as it has the potential to inflate asset prices, much like in the housing bubble.
A number of very large private companies were lined up to go public earlier in the year. Uber, Slack, and Zoom were the companies most were focused on, but a few smaller niche players stole the show. Beyond Meat, the maker of veggie burgers and other imitation meat items, soared 163% in the first day of trading and subsequently rose another 1.5 times to end the quarter with a 540% return and a ~$10B market cap. A significant contrast to Uber which priced at $45 per share and has only briefly traded above that level. Regardless of stock performance, the offering was successful and subsequent IPOs were met with a warm reception. We are monitoring the private equity and venture capital markets as they attract increasingly large amounts of capital and company valuations continue to rise.
The completion of the Uber offering and the strong performance from many of the smaller IPOs will likely give confidence to private investors that the IPO ‘exit’ is still a viable path and drive investor confidence in that market. While we don’t typically participate in the IPO market, due to liquidity concerns and unclear valuations, among other factors, we monitor the market as a key indicator of how capital markets are functioning. It is also a key indicator of the risk appetite of investors. We view the current environment as constructive with each offering being analyzed and clearly few are being given a free pass.
The first quarter earnings reports came in slightly above expectations, rising 2.5% over 2018, avoiding the year over year decline that many analysts were expecting. The quarter was strong for most of the companies in our client portfolios as our growth stocks continued to dramatically outpace the cyclical value stocks that we have avoided. Many of the growth themes in the portfolios delivered strong results despite macro headwinds and trade headlines. Cyclical companies and those levered to China struggled. Several gave tepid guidance due to growth concerns and uncertainty surrounding the impact of tariffs on their supply chains.
Bainco has long believed in investing in companies that play into long term growth themes; seeking businesses with consistent earnings due to unique positioning or barriers to entry. The current environment has continued to reward such holdings with strong returns as their earnings have continued to deliver. We have been diligent about trimming some positions to reflect valuations that are richer than we would like; but generally quality growth companies are trading at a premium limiting the list of suitable alternatives. We continue to be diligent, looking for the best companies at reasonable valuations. At this time we remain comfortable being a bit below our mid-point in equity ranges and are using some covered call writing to protect positions which have gotten a bit expensive.
Investors hoped that the US and China would reach a long term trade deal and simplify the economic landscape. Instead, talks broke down; Huawei, one of China’s largest tech companies, was labeled a national security risk and blacklisted in the US; and President Trump threatened another round of tariffs. In addition, President Trump threatened tariffs on Mexico due to the migrant crisis. For a few days things were looking grim, but then in a positive series of events, a deal with Mexico was reached avoiding any tariffs, followed by a productive meeting between Presidents Trump and Xi at the G20. Although the meeting did not result in a trade deal, President Trump agreed to delay any incremental tariffs and softened his stance on Huawei.
Geopolitics were no less tumultuous. Relations deteriorated between North Korea and Iran with both countries continuing their nuclear ambitions. Tensions skyrocketed as Iran was accused of attacking a Norwegian tanker in the Straits of Hormuz and shooting down an American drone. A significant escalation was narrowly avoided as President Trump called off a late night air strike on Iran, commenting that he wanted to avoid a war. The quarter finished with a surprise visit by President Trump to the demilitarized zone where he became the first US President to enter North Korea and to meet with Kim Jong Un.
Markets moved higher amidst all this news, but in reality nothing was resolved. Iran continues to interfere with shipping channels and has increased their enrichment of Uranium while the trade deal with China seems to still be months from completion. That said, a deal that takes a bit longer to construct will hopefully be more encompassing and address more complex issues. The theft of our technology and limited direct access to Chinese markets for most US companies remains a key hindrance to US companies and benefits the Chinese. A quick trade deal was unlikely to adequately address these issues.
“When the goal is to stimulate growth, the last thing you want is for companies to be indecisive.”
The main concern about the longevity of the dispute relates to the impact on business decision making. The use of tariffs in particular, has caused indecision surrounding incremental capital investment and in some cases, supply chain modification. When the goal is to stimulate growth, the last thing you want is for companies to be indecisive. Business confidence surveys have recently weakened indicating delayed decision making in capital investments. Increased clarity surrounding trade should help to catalyze investment decisions, thereby improving growth.
As we move into the second half of 2019 we see a fairly balanced outlook for US equity markets. We believe progress on the trade front and lower interest rates could drive equities higher. In the same regard, economic weakness in Europe and Asia continues to persist and poses a significant threat to global growth. Growth may be further impacted by trade tensions between the US and its major trading partners. We continue to believe that one should invest in growth, thus favoring the US markets. At the same time, valuations keep us slightly underweight of the mid-point of ranges. We continue to utilize option strategies as a tool to stay more fully invested. If the economy stabilizes and equities continue to perform well, we do not see a significant continuation of the bond rally. As such, we are keeping our bond portfolio duration intermediate, but may shorten it if we see further price appreciation or if we start to see rates move higher.
The next couple quarters will be eventful as we see the impact of the Fed’s previous interest rate hikes fully play out and watch how the market responds to a move back to lower rates. We are mindful that the 2020 election cycle, which has already begun with the Democratic debates, may have a tendency to move markets. Global growth and international relations will continue to be front of mind. We stand ready to make adjustments to portfolios as needed but most importantly continue to believe that being invested is the most prudent course of action at this time. We hope that you have a restful and enjoyable summer with family and friends and look forward to future conversations and interactions with each of you.
This commentary/ article has been published or selected for distribution by Bainco based on current events and/or topics of interest. It contains the current opinions of the authors as of the date of publication. All opinions are subject to change at any time. This material 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.
Material in this publication, including market forecasts and forward-looking statements, is original and/or derived from proprietary and non proprietary sources Bainco deems to be reliable; Bainco does not, however, warrant the completeness, accuracy or timelessness of the information obtained from these sources. The opinions and statements set forth do not consider the investment objectives or financial situation of any particular individual or group of individuals. Readers will need to consider their own circumstances before making an investment decision and are cautioned to consult their own tax and investment professionals with regard to their specific situations.
Past performance is not a guarantee of future results.