Quarterly Commentary: Unknowns Have Investors Walking a TightropeSubmitted by Integras Partners on July 29th, 2019
2019 Second Quarter markets were narrowly focused on trade talks, interest rate speculation and concerns that economic expansion may be very close to stalling; yet stocks prices kept climbing.
Economic and market outlooks now hinge on three big questions: Will diplomatic negotiations end tariffs and foster trade? Can central banks keep economic growth rolling while we wait? Is global growth sustainable even with these actions? The unknowns have investors walking a tightrope, balancing the fear of missing out on stock gains with the darkening clouds of economic weakness on the horizon.
Integras Partners clients can take comfort that we recently installed some protections while participating in market gains. Our retirees can more freely enjoy spending monthly income because it’s insulated from cyclical downturns while allowing the future growth needed to outpace rising expenses. We detail these benefits at the conclusion under Benefits of Time-Horizon Investing.
After an almost miraculous first-quarter rebound from December’s 10% decline, US stocks sustained the uptrend, though a peek under the hood reveals a lack of conviction. As economic data continues to weaken, the Federal Reserve is expected to lower interest rates to counteract the mounting impact of trade tariffs. Markets love lower interest rates, so the prospect of them buoyed both stocks and bonds, ultimately sending the S&P 500 Index to new highs into July. Hardly a broad-based, healthy advance as defensive sectors (Utilities, Staples, Real Estate) and the largest technology names led the way, but we’ll take it.
For the quarter, the S&P 500 Index finished up 4.25%. Bond markets rallied with the broad Barclays Aggregate Bond Index finishing up 2.3%. Established foreign markets lagged the US again, up 3.5% while Emerging Markets finished up less than 1%. So, stocks are relatively expensive, as prices average 18 times forward earnings and nearly 20 times current earnings. We’ve returned to the TINA scenario, where there is no Alterative bonds and cash yields continue to decline.
Equity markets are rising as if a trade deal is near and it would fuel the earnings growth necessary to justify current stock prices. This may prove correct. Bond investors, however, believe that economic growth is slowing, a trade deal is far off, and the stock market has it wrong. Only one will be right!
Stocks and bonds have diverged to their widest point of this expansion. At some point, this divergence will be rectified. There is some justification for higher equity values if the Fed lowers rates as expected next week. Ultimately earnings MUST justify the prices being paid and trade certainty is the key to unlocking that potential.
Investors on the tightrope are balancing slowing economic data (below) and hopes for meaningful improvement with a trade deal. While negotiating a deal is vitally important to both the US and China, the Chinese have the freedom to play the “long game” by waiting for a more amenable administration to take office. President Trump essentially has a year or less to close a deal going into the election.
Should the Fed lower interest rates (a 1/4 % to 1/2 % cut is already priced in), it will provide the short-term stimulus the stock markets desire but will come at a long-term cost. Low-interest rates allowed companies to borrow at a record pace, issuing bonds that financed increase dividends, stock buybacks and execute mergers and acquisitions. All of which have greatly fueled the run-up in equity prices in recent years. As a result, companies hold record amounts of debt, which can continue with low-interest rates. What happens when (not if) earnings deteriorate and cash flows needed to service this debt decline? Will investors cheaply lend more money to sustain this debt? Of course not. And the Fed’s effectiveness will wane again having already lower interest rates. These are all hallmarks of the late-cycle. The late-cycle is when excesses and stresses begin to accumulate, ultimately triggering a recession.
Though likely a year away, the probability of a recession is rising. We reiterate the point that we are very late in the economic cycle (as of May 31, this chart is at 29.6). Equities are reaching new highs primarily on hope while bonds tell us differently. Incoming economic data continues to weaken, so markets are primed for volatility. It is vitally important to be cognizant of risk today.
Markets are Primed for Higher Volatility
History shows that it’s common for stocks to exhibit outsized gains during the final stages of a market cycle. So, let’s not abandon them just yet. There are many reasons, including trade and rate accommodation to believe this party will continue, providing further gains. Yet many of the economic indicators we track indicate current and coming weaknesses. (See below). While we may miss some of these final gains, we plan to leave the party early, striving to protect asset values before the music stops. We do so knowing that our clients are likely to emerge from a recession in stronger shape than average investors. Without a crystal ball, we think it’s prudent to reduce risk as we get closer to the cycle’s end.
All Integas Partners clients have a unique blend of proprietary strategies we manage for graduating timeframes. We have been taking most of these increasingly defensive over the past year or two and recently installed protection mechanisms in even our most aggressive strategies. Having captured significant growth over this expansion we aim not to ride the market down when the tide ultimately turns. While our clients are structurally protected with time appropriate investment risk with their customized allocations to them, we have added further protection to the strategies themselves.
Near-term withdrawals come from our Liquid Assets strategy designed for capital preservation. We reserve the next tier of withdrawals in our Income Strategy, targeting attractive income with minimal volatility for four to seven years. Then additional layers increase opportunities for capital appreciation all the way out to money they won’t need for 15+ years, allowing risk assets to weather virtually any storm. Who wants to make lifestyle adjustments due to protracted bear markets? Our process and implementation allow you to sleep at night knowing that you can weather the next storm and emerge with your lifestyle and your dreams intact. We vow to uphold this commitment to the best of our ability.
We are passionate about investing wisely and seek to balance our communications for the layperson. Please reach out if you would like to discuss any of this in more detail. For prospective clients, we provide a complimentary analysis of your investments with our recommendations. From today on, investing gets tougher and the risks get higher. The music hasn’t stopped yet and may not for many months down the road. But when it does, we need to be already sitting safely in a chair.