Vigilare Wealth Management Q3 2018 Commentary
U.S. markets rebounded strongly in the 3rd quarter with much broader participation than through the first half of the year. Other asset classes did not fare as well. Through the end of the 3rd quarter the international markets (ex. USA) were down 3% including dividends, while the U.S. bond market index was down 1.7%. Ironically, Morningstar reported that investors have poured billions into international markets and bonds this year while at the same time withdrawing billions from the U.S. markets. Our affinity towards a U.S. equity focus and our fear of rising rates has really helped avoid overexposure in some of these poor performing asset classes this year. What do we anticipate for the remainder of the year and beyond?
The economy continues to do extremely well. According to the Federal Reserve, U.S. household wealth just surpassed the $100 trillion mark for the first time ever. Second quarter GDP clocked in at over 4%, and the 3.7% unemployment rate is at the lowest level since the Korean and Vietnam wars (arguably even better since the wars skewed the data lower). Personal incomes grew by more than 10% over the last 3 years after being stagnant since the turn of the century. A tight labor market usually benefits Main Street more than Wall Street, but still we view this data as a tailwind to the markets and an argument supporting positive economic momentum.
Earnings for S&P 500 companies are up 24% in the 2nd quarter and are expected to grow at a brisk pace through the end of the year. Some market strategists argue that the reduction in the corporate tax rate from 35% to 21% is temporarily “juicing” up these earnings numbers. This may be the case to some extent. What we found encouraging is that the revenues/sales for S&P companies was up over 9% in the last quarter. A combination of top line growth along with improving margins is a sign of a robust economy. We will pay close attention to CEO commentary this quarter regarding higher input and wage costs and for a hint that global trade and tariff talks may start to adversely impact future results.
While the U.S economy is growing robustly, the same cannot be said about other global economies. European economic data is softening, as is China and other emerging markets. This is to some degree due to ongoing trade and tariff disputes. The administration has formalized trade deals with North American partners and it appears progress is being made on European, South Korean, and Japanese fronts. More troubling, China and the U.S. have hardened their positions with respect to trade and appear to not be close to reaching a deal. China may continue to have a hard line until after our mid-term elections when they feel they might have more leverage. An economic cold war between the U.S. and China would have a material negative impact on the global markets. Complex global supply chains would have to be readjusted and the reshuffling of winners and losers could also flare up geopolitical hostilities. At minimum this would be inflationary for companies and consumers around the world. Our view at this time is that both parties stand more to lose than to gain by not making a deal (especially China) and that both countries will reach an agreement before year end. If the tensions appear to escalate we will manage risks accordingly. Pay close attention to Apple being a target in future trade talks. If this occurs, then it is clear that China and the U.S. have upped the stakes.
History favors the equity markets for the periods after mid-term elections. This has been the most favorable time for the markets throughout entire presidential cycle. In fact, the market has been higher a year after a mid-term virtually every time. If only it were that easy. We can comfortably say we live in different times and interpret all historical precedent with a grain of salt. Still, we would like to share some historical data to provide a little context. If we look at executive/legislative branch party compositions post WWII there are some patterns that emerge (again, grain of salt). The most favorable market-return political party composition by a solid margin has been one with a Democrat President and a Republican Congress (E.G. Bill Clinton 90s). A Republican President with a split Congress has also performed well (E.G. Reagan 80s). The poorest market historically has occurred during a Republican president with a Democrat Congress (E.G. Nixon and H.W. Bush).
Fast forward to today as we approach what will be an extremely tumultuous mid-term election cycle. In the House, the Democrats need a net gain of 23 seats to take the 218 majority. The estimates range from a net gain of 15 to 50 seats for the Democrats. Pundits handicap the odds of Democrats retaking the House at 70%. The Senate is more evenly split at 51 Republican and 49 Democrat; however, the Republicans are defending 9 seats while the Democrats are defending 26 seats. It is projected that there will be some close races for Republicans in states like Arizona and Florida, and even in traditional Republican strongholds like Texas. Still, pundits handicap the odds of Republicans holding the Senate around 60-70%. Although next to impossible to predict which outcome will prevail, we at Vigilare have been tirelessly debating, scrutinizing and trying to understand what the investment implications (short term and longer term) will be under each potential scenario. As we meet with each of you individually we can discuss in more detail.
Beyond the mid-term election our primary concern is the Fed’s tightening policy and the direction of rates/inflation. The Fed Funds Rate has gone from zero to 2% in a short amount of time. The Fed is projecting raising rates one more time this year and three more times in 2019. Although the economy has been robust of late, raising rates too quickly will stifle growth, especially after our economy has been conditioned to a zero-rate policy for so many years. We have already observed a little softening in housing and autos which can be partly attributed to higher rates. Raising rates also influences the dollar and capital flows which can lead to emerging market volatility and liquidity crises. Global uncertainty and too strong a dollar can also impact U.S. stocks; forty-four percent of the S&P revenues come from overseas. Not to be forgotten is also the impact of unwinding the Quantitative Easing (QE) program. The Fed still has $4.5 trillion of assets on its balance sheet and unwinding their balance sheet will put additional pressures on long term rates.
Longer term we also must consider the implication of what severe deficit spending will have on stock and bond markets. According to the Congressional Budget Office (CBO), national debt is expected to increase from $16 trillion (78% of GDP) to $29 trillion (98% of GDP) over the next decade and this does not factor extra infrastructure spending, war, or recession. Not a problem today, but a condition for which we should not be too Pollyannaish.
The bright side is that we believe the markets can sustain increasing rates for the time being. Historically, equity markets have done well in this phase of a rising rate environment. The stock market really hits a wall when the 10-year treasury approaches 5% and above. Today the 10-year treasury rate is at 3.2% so we believe there is some room to run. This may be good for stocks, but bonds will continue to suffer in a rising rate environment, some more than others. For example, a 1% change in interest rates will cause a 2-year treasury to lose 1.9%, a 10-year treasury to lose 8.1%, and a 30-year treasury to lose a whopping 17%. Our current view is that rates will continue to move higher, therefore we continue to be short-term in our interest rate exposure.
Right now, we would be more concerned if we saw long term rates moving lower and the yield curve starting to invert. An inverted yield curve has preceded seven of the last seven recessions going back to 1969 and preceded the 1929 crash. Nasty bear markets always accompany recessions. The two post WWII bear markets without a recession (1962 Cuban Missile Crisis, 1987 Stock crash) were shallow and short-lived. We are much more concerned about a recession-induced bear market. We will pay close attention to the Fed’s stance on raising rates and watch policy where Fed appears to be raising rates too quickly. If it appears a recession is imminent, our strategy will incorporate being invested in longer term government bonds (a solid hedge in these environments). Although rates have an adverse impact to existing bonds, a higher rate environment gives us more flexibility to earn solid returns in the bond markets (also a nice alternative to dividend stocks). To paraphrase a beloved baseball player/philosopher, the bright side of higher rates is higher rates.
We are currently in the longest bull market in S&P history, just passing the bull market of the 90s, and the third longest if we go back and look at the Dow (1929 and 1961). However, if we look at this bull market from a return perspective, it still lags the 90s bull market considerably (417% vs 320%). Also, one could argue that the 2009 bull market ended in 2011 when the market dipped below 20% intraday and just missed the bear market definition of 20% down by less than half a percent (geek observation). Our view is that given the right circumstances this bull market can continue for some time, or it could end tomorrow. Analogous to a game of baseball, there is no clock or time limit and the game can also go into extra-innings.
Historically, September and October (along with February) are easily the worst performing months of the year and we expect heightened volatility through the mid-term elections. We are at a crossroads, in a way, with the key question being: Are we in a temporary economic “sugar high” or are we still at some sustainable stage of an expansionary economic cycle? Only time will tell. We remain overall optimistic about markets given the momentum in the economy and strong earnings growth, however we do not take these risks lightly and will be monitoring developments closely and if necessary, taking appropriate actions to protect portfolios.
Thank you for your trust.
The Vigilare Wealth Management Team
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