Quarterly Commentary: It’s All About Trade: Talk? Or War?Submitted by Integras Partners on February 1st, 2019
On April 1st the S&P 500 Index® was successfully retesting its February 11th low of 2,532 and began its recovery process. Although trade talks slowed the rebound, investors discounted the potential threat to the world economy. US markets traded higher, and in mid-June were within just 2.8% of retaking the January highs. Trade rhetoric ramped up the last two weeks of June; causing widespread concern that threats may, in fact, become something more ominous and markets retreated.
How all this plays out is anyone’s guess. Many investors are taking profits in top performing assets and awaiting some trade dispute clarity before making their next move. Foreign stocks (particularly in emerging markets) have been rocked much more than the U.S. as threats to their export-dominant economies continue to rise. As such, outflows from foreign assets spiked and moved back to domestic assets. Small caps and technology have been the greatest beneficiaries.
We agree that foreign trade deals negotiated in the past need a refresh – particularly with respect to China. Past talks of revisiting these agreements were tentative in an economy too weak to absorb the impact.
With a stable and growing economy, now is certainly the time to challenge the status quo. The uncertainty surrounding the success of tactics being employed has increased market volatility.
Equity (stock) markets fear talks escalating into a trade war – which no one can win!
Positive performance has concentrated primarily in the technology and consumer discretionary sectors. (Both sectors been over-weighted in our strategies). Conversely, interest-sensitive assets; bonds, utilities, and consumer staples, e.g. continue to underperform as the Federal Reserve gradually raises interest rates to ward off future inflation, which could reach 3% by year-end.
Despite these uncertainties, U.S. equities were generally positive in the second quarter. The S&P 500 finished up 4.3% while the Russell 2000 index of small-cap companies was up 8.3%. Smaller companies are favored now as their customers are predominantly domestic and less affected by trade noise. Foreign markets suffered as the developed market EAFE Index fell 1.6% while emerging markets plunged 9.7%. U.S. bond markets were relatively unchanged yet remain in the red by 2% for all of 2018.
As always, a glass-half-full is also half empty
Economic indicators, which slowed a bit from a torrid pace are still very strong. Employment, housing, manufacturing, and most all other economic indicators remain robust. Second quarter GDP growth should come in around +4%; double the strength of the pre-election economy. Earnings growth should remain on pace with the first quarter, consumer and business confidence indexes remain high and leading economic indicators reflect future strengthening on the horizon. This is already priced into the markets. As we warned you, stock and bond values have become more volatile, firstly due to Fed rate hikes. With money markets yields approaching 2% there is a zero-volatility alternative to bonds. Secondly are potential trade disruptions. A true trade war would negatively impact economic growth, dampen corporate earnings and subsequently stock prices. So, portfolio managers now have two headwinds to navigate that didn’t exist a year ago.
Growing Divergence Between Growth and Value
Throughout the past several years we have commented on the increasing divergence in performance between Growth stocks and Value stocks (think Nvidia vs. Coca-Cola). The disparity of these investing styles has reached levels last seen during the dot-com era. Growth has outperformed value by a stunning 30% over just the past 18 months and by 50% over the past 4 years. While current circumstances are very different, we are increasingly concerned that the ultimate mean reversion – which WILL occur – could follow a similar path as the 2000-2001 reversal. The paradox is that if we reduce growth now in favor of value we would likely meaningfully underperform short term. So, we remain overallocated to growth and adding diversification with certain sector overweights. These overweight growth and sector allocations (66% of the total stock weightings) have to date allowed our domestic equity holdings to outperform the S&P 500.
Why We Still Believe in International Markets
The primary headwind faced in the second quarter was the sudden resurgence of the Dollar vs. foreign currencies. While a nebulous subject to most people, a stronger dollar impairs foreign investments.
We believe the trajectory for the dollar is lower, especially as our fiscal deficit grows, requiring more bonds to finance it. Secondly, some recent strength came vs. exceptional weakness from several emerging market countries; primarily Turkey, Venezuela, Mexico, and Brazil. Further strength resulted from concern over trade and China. Since China has few imports from the U.S. to place tariffs on, they could devalue their currency as a trade tactic, creating further dollar strength. Our outlook for foreign assets remains positive even if there is a weak period – again, so long as trade noises remain talk and not war. If we see continued underperformance we may well reverse course in these allocations.
As we march into the latter phase of this market cycle it pays to keep an eye on catalysts with the potential to accelerate the timeline of recession and its accompanying bear market.
We believe we are at least a year from a recession as things stand today. Historically some of the largest gains come at the very end of a bull market cycle. The table is set for that scenario to repeat itself if the above storm clouds dissipate over the next several months. We expect they will and remain invested with both eyes on the fundamentals that would cause us to change course.