Quarterly Commentary

2Q 2019

With summer in full swing and so much going on in the world, it is easy to lose sight of the fact that US equities just had their best first six months since 1997. May was the only negative month - escalating US-China trade tensions contributed to a 6% retreat – and that was quickly erased in June as supportive central bank comments fueled a rush to invest in assets of all sorts. US treasuries, high grade bonds, junk bonds, oil, gold and just about everything else generated positive returns along with stocks, an unusual display of correlation among major asset classes.

Investors are cheering the Fed’s recent shift to easing from tightening in the face of deteriorating economic signals. We are holding on to our confetti. It will be months before the scope and efficacy of the Fed’s actions are known. We are concerned that corporate earnings will soften in the meantime, which might put some of this year’s gains at risk. 

Trade tensions rising
Tariffs and trade restrictions have come to dominate the financial news – it seems every day brings a new development. What were previously potential negatives are now real. $200 billion of goods from China, representing 1% of US GDP, are currently subject to a 25% tariff, implying a 0.25% drag on US GDP. However, the impact is potentially more significant than this simple math would suggest. Policy uncertainty is taking a toll on business sentiment. US companies are being forced to reconsider the global supply chain model that has delivered healthy margins for many of them. Spending on factories, equipment and other capital goods slowed in the first quarter as trade fears intensified. There is a growing realization that conditions are not likely to return to the previous status quo, but it’s unclear what exactly the future of global trade will look like.

Economy slowing, corporate profits to follow?
Since the beginning of 2018, the forward-looking ISM New Orders Index of manufacturing activity has fallen from 67 to 50, just a whisker away from the threshold signaling an impending contraction. Unsurprisingly, respondents voiced concern about increasing trade friction with China and Mexico and its impact on the global economy. While typically correlated, it is noteworthy that the ISM New Orders Index and stocks have de-coupled this year.

Many factors contribute to the deteriorating economic picture. The combined effects of Fed balance-sheet reduction and conventional rate hikes over the past several years had the effect of tightening monetary conditions faster than was warranted given the escalation of trade tensions. We believe the Fed’s change of heart recognizes the overshoot - it is not driven by a wish to push stock prices higher nor do we think Fed Chairman Powell is trying to help the president get re-elected. Rather, true to its mission, the Fed is looking at the economic data – and not liking what it sees.

Last year’s tax cuts and increased government spending provided a one-time boost to corporate profits. With no such help this year, it is entirely possible that corporate earnings will not grow at all. Indeed, recent consensus estimates are calling for a 3% year-over-year drop in second quarter earnings that are now making headlines. This earnings recession is projected to persist into the third quarter. All eyes will be on management guidance and commentary around sensitivity to trade and other macroeconomic variables as the earnings reports roll in over the coming weeks.

Looking ahead
This year’s surge has pushed the S&P 500 to all-time highs at a time when world economies are slowing, and corporate profit growth is under pressure. It is impossible to predict how US trade negotiations will turn out. We are worried that both growth and investor sentiment are vulnerable.

Lower interest rates may help, but not immediately. In fact, it takes as much as 18 months for changes in monetary policy to be reflected in the economy. Moreover, no one can say how far the interest rate cuts will go. Bond markets are anticipating cuts of as much as 1% over the next year. The Fed may not deliver on those expectations.

We are not throwing in the towel – just getting more cautious. Lower interest rates today could be contributing to a brighter outlook by the end of 2020. But for now, our portfolio decision-making is emphasizing resiliency and a healthy dose of skepticism around the “Fed-to-the-rescue” scenario.