Quarterly Commentary

3Q 2019

Even a glorious summer such as the one just ended includes a few squalls. The stock market had a good summer, too – turbulence in August gave way to a September rally and stocks ended the quarter little changed. Away from the markets, turmoil was increasingly apparent in the streets and in the halls of government, here and abroad. As disconcerting as the headlines may be, the underlying worry for investors is the decelerating global economy. This concern was on full display in the bond market during the third quarter, but was less evident in the case of stocks.

Declining interest rates (aka yields) are generally expected to be good for stocks – the lower returns available from bonds make stocks look more appealing. But it matters how and why lower interest rates come to pass. When interest rates fall in anticipation of a slowing economy, the relationship can flip flop – lower rates are accompanied by lower stock prices.

 What moves interest rates? The bellwether short-term interest rate is the Fed Funds rate – the rate that banks charge each other for overnight loans. It is managed by the Federal Reserve, downward to stimulate lending when the economy looks weaker, and upwards to tighten credit when the economy is at risk of overheating. Long-term rates, in contrast, are determined by market forces.

 Rates were moving lower everywhere this summer. In late July, the Fed cut short-term rates by a quarter-point, citing concern that the US might follow the rest of the world into a recession. Soft economic data intensified concerns in August. Investors sought the comparative safety of bonds, sending US and foreign stock indexes down by 5% in just a few weeks.

 In Europe, Germany and its neighbors issued 30-year bonds with negative yields – buyers were locking in losses if they hold the bonds to maturity. This seems crazy – why would anyone want to lend money and pay for the privilege? The primary answer is that the economy in Europe is stagnant. Investors there are afraid to own anything else and institutions can’t simply stash cash under the mattress. We hope this dynamic never comes to pass here! Ten months ago, the US 30-year was yielding 3.4%. By August, it had fallen to 1.9%, an all-time low but still comfortably north of zero.

 Apart from the direction of interest rates, the shape of the yield curve flashed more warning signs in August. The yield on long-term bonds fell below the yield on short-term bonds, a relationship known as an inverted yield curve. This is watched closely by economists everywhere, including those at the Federal Reserve. Indeed, based on the inversion observed at the end of August, a Fed model was pointing to a 38% probability that a recession would materialize within a year’s time.

 To be clear, a yield curve inversion does not cause a recession, it merely reflects investors' pessimism over the path of future interest rates and the economy. It has been a reliable signal – every inversion since 1986 has been followed by a recession. Importantly, however, it hasn’t been predictive regarding the timing, depth or duration of the ensuing recession.

The S&P 500 ended the third quarter a shade higher, hanging on to its impressive recovery from the year-end 2018 sell-off. Information Technology, Real Estate and Utilities have led the way this year. Presumably, investors believe these companies are best suited to chug along in a slow growth, low interest rate environment. We can’t help but question if technology stocks are a good place to hide if trouble is on the horizon.

Certainly not all tech stocks are alike. Some will turn out to be secular growth stories, but most will likely suffer in a recession. Even recurring “software-as-a-service” revenue sold via subscriptions can go down! In general, the sector’s valuation concerns us, and we are seeing signs that other investors may be crossing over to our side of the fence. A number of FANG & friends stocks have lost their momentum and there are worrying developments in the IPO market.

WeWork (which curiously portrays itself as a tech company) buys and leases office space, creates smaller offices and attractive common areas and rents it to individuals and businesses. It was expected to make its market debut in September. Numerous commentators grew skeptical of WeWork’s business plan, corporate governance and the IPO’s proposed valuation. As the IPO approached, buyers backed off leaving WeWork with an uncertain future.

 Like the aura surrounding the S&P 500, particularly its large tech companies, the venture capital unicorns (start-ups valued at over $1 billion by private investors) had done so well for so long that continued success seemed assured. New investors were committing at higher prices because other presumably smart investors had previously bought in. But the “emperor has no clothes moment” appears to have arrived. This year’s most prominent IPOs, former unicorns Uber and Lyft, are now trading well below their initial prices.

The headlines that didn’t seem to matter much over the summer could have more impact in the months to come. The Q4 calendar is full of meetings and votes. The range of possible Brexit outcomes is wide as the self-imposed October 31st deadline nears. Recent developments in Washington are likely to influence tariff negotiations. Increasingly, CEOs are identifying trade restrictions as the reason for disappointing earnings outlooks. The US is not insulated from global economic volatility – surprising trade developments may jolt stock markets in either direction.

The best crystal balls can be wrong, yet the yield curve’s cautionary signal commands our attention because of its widespread acceptance. The potential for self-fulfilling prophecy, where uncertainty induces hiring and investing paralysis, is also of concern. If a recession does eventually materialize, we take the view that the worrying stage may pose more risk to stocks than the actual event. The 2001 and  2008 downturns have conditioned many to believe that recessions could precipitate 50% stock market declines. However, history shows there are many mild recessions, including those much less damaging to stock portfolios.

Faced with economic uncertainty, we seek resilience as we manage client portfolios. In the case of many of our current holdings, we expect that company-specific developments will matter more than overall market direction in the long run. At the same time, we are seeking out new opportunities that may be less risky because their prices already anticipate economic weakness ahead.