Quarterly CommentarySubmitted by Integras Partners on October 21st, 2019
Participating But Defending as Recession Storm Clouds Build
Many investors have forgotten that volatile markets exact an emotional toll. For several years during the current economic expansion, the biggest dips were in the 6% range. December 2018 saw a 10% decline in about three weeks. Market corrections (~10%) can be considered a healthy stabilizer. It's when they’re frequent or more severe that investor and consumer behaviors can swing.
Markets were increasingly volatile during the 3rd quarter. As recession fears mount and trade negotiations have yet to produce results, confidence fell and economic indicators weakened. Markets generally gained ground due to the Federal Reserve providing a boost by lowering interest rates. “Risk-off” assets outperformed again, most notably US Treasury bonds (the ultimate risk-off asset) gained an astonishing 8% during the quarter. The 30-year Treasury Bond yield fell to all-time low of 1.95%.
For the record, the S&P 500 Index® rose 1.7%, foreign stocks (MSCI EAFE index) fell 5% and emerging markets fell 2.1%. Bonds (Barclays US Aggregate Bond Index) gained 2%, largely benefiting from long maturities. Bonds and bond proxies; i.e. consumer staples, real estate & utilities, received a strong interest-rate generated tailwind.
Global rates have never been more supportive of inflation and economic growth, yet neither are responding to them. Inflation is steady at an anemic sub-2%; while global economic growth continues to decline. Central bank efforts around the world continue to lower interest rates which have not produced the desired effect. Global manufacturing is contracting, services activity is slowing, and several recession indicators are flashing red. More accommodative monetary policy is not the answer, though it may extend the expansion. While we continue to wait for direction, domestic stocks have become more volatile but effectively gone nowhere for 18 months, and clouds darkening the investment horizon get closer.
We have discussed in previous issues that the immediate challenge is trade and tariffs. The U.S. and China have agreed in principle to a détente of future tariff escalations and a timeline to reach agreement on many major sticking points. Yet nothing material is at hand and markets have discounted any meaningful improvement soon. Currently, markets are fully priced based on next year’s projected earnings (which continue to be revised lower) and very susceptible to bouts of Twitter-related volatility.
Until and unless business sentiment and business capital spending improve, there is little support for a meaningful move in economic growth or stock markets outside of still lower interest rates. Corporate expansion plans have been put on hold until there is clarity in the path of trade and its impact on supply chains, cost structures, and overall sentiment. For now, the US consumer holds the lever to determine whether we maintain growth or fall into recession.
US consumers are responsible for roughly 70% of U.S. economic activity and perhaps as much as 20% of global activity. As such, it’s imperative that consumers maintain their ability and willingness to spend. Current ability is not in doubt as consumers in aggregate have rarely been in such good financial shape. So, consumer confidence becomes the primary concern. While personal incomes are growing the fastest of this expansion and current optimism is high, future expectation surveys indicate consumers are concerned about financial security lasting much longer. Any pullback in either consumer spending or an increase in layoffs and the strongest leg of the stool will be broken.
We repeat our assertion that we see a binary outcome scenario. Either we get meaningful trade resolution or we fall into recession. It’s as simple as that. This fork in the road is coming but we don’t know how soon.
Expectations range from 12-18 months before profit margins contract, business confidence is broken, companies lay off workers, consumer confidence evaporates along with spending and recession ensues. Should we reach an honest, comprehensive trade agreement that eases tariffs and opens end markets, markets would likely explode upward with a huge rotation away from safety into cyclical growth stocks.
Consequently, we see this as a 50/50 proposition and have positioned our Participate but Defend strategies to capture meaningful upside potential with protection from downside volatility.
This does not rule out equity markets moving up prior to the fork in the road. In fact, we believe there may well be another leg higher for U.S. stocks as an abundance of investment capital looks for a productive home and stock dividends are higher than bond yields. While corporate profits remain positive there should be adequate demand for blue-chip stocks – especially with the skepticism meeting new IPO’s coming to market. Should interest rates fall further, as expected, future earnings would be worth more today, further driving equity prices. These outcomes will ultimately cause pain as the farther the market rallies in the meantime the farther it will fall once a recession begins.
Longer-term there are reasons for both optimism and concern. We assume that the U.S. will eventually reach some agreement China, providing a clearer path for business investment and renewed economic activity. In and of itself it would be a major boost to the world economy. We must also recognize that only so much economic growth is possible over the next two decades because of demographics. The global population is aging, which reduces spending on goods and certain services. With escalating retirement, there are fewer workers producing products and fewer wage earners buying products. The prospects for long-term investment becomes rather sober. Lower revenue growth, tighter margins, lower profits, and lower dividend growth lead to historically lower share price appreciation. Some predict that over the next 10 years we will likely see only 4%-6% average stock market returns as a result. Bond returns will be closer to zero.
Therefore, it is incumbent a sound financial plan be in place and mated with investment strategies that can perform in such a low-return environment. Those accumulating assets for future retirement will simply have to save and invest more. Those entering retirement will have to become comfortable with taking more risks in order to outpace inflation and greater longevity trends. Most importantly, assets must be matched to the intended timelines for consumption.
Integras Partners recognized many years ago that markets are volatile and less predictable over shorter timeframes (the environment of the future) and designed our investment paradigms to guide clients and manage assets with reasonable expectations and measured risk. Our detailed cash flow planning and timeline investment strategies allow clients to rest assured that both long-term growth assets and near-term income streams are structurally protected from random, short-term market movements.
INVEST. NURTURE. ENJOY!