by Brad M. Weafer, CFA Chief Investment Officer
by Long-time readers of our newsletters will notice a consistent theme in our message. It is necessary to focus on economic growth because it underpins corporate profit growth, the key determinant equity returns over long-time periods. Shorter-term, investor sentiment shifts can be an opportunity for those willing to invest with a long-term horizon. The 24-hour news cycle provides a constant barrage of headlines to tempt our emotions to act rashly. The challenge for thoughtful investors is to discern the material from the immaterial. In an age of social media, salacious financial television, and polarizing politics, this challenge is more acute than ever.
During 2019, the market has been resilient with the S&P 500 index returning over 20% year-to-date and reaching all-time highs in late October. This positive result stands in stark contrast to sentiment from institutional investors and clients alike. According to the Bank of America Fund Managers Survey (see Figure 1 below), managers are significantly overweight in the cash and defense sectors.
What are all these investors worried about? There are currently many bricks in the proverbial wall of worry.
We share our thoughts on the most noteworthy:
State of the Economy
Recent economic data points have been decidedly mixed. The U.S. manufacturing Purchasing Managers’ Index (PMI) was reported at 48 in September, the lowest figure since the last recession. Any reading below 50 signals a contraction and this was the second consecutive month below that key level. Another key indicator we follow, the Conference Board’s Leading Economic Index (LEI), while not signaling recession, confirms signs of decelerating growth. We witnessed a similar showdown during 2016, with both data sets implying softness in the economy. While recession fears were stoked during that period, the consumer economy remained strong. We see similar signs today, with new highs in advanced retail sales reached in August. Initial jobless claims also remain subdued, but the trend shows little signs of improvement over the last two years (see Figure 2 below). This is an indication we are in the later stages of an economic cycle. This does not mean a recession is imminent. It does, however, raise the risk of a policy shock, such as an overly restrictive monetary policy or fiscal policies that restrict growth and could push us into a period of economic contraction.
Trade War with China
The ongoing dispute between the world’s two largest economies is generating volatility in markets and uncertainty in the global economy. The U.S. and China have imposed tariffs on billions of dollars of each other’s goods. In early October both countries announced a truce in what is being called a phase 1 deal. It is expected the deal will involve delaying or removing already announced tariffs, agricultural purchases, and intellectual property protections. A reduction in tariffs is an incremental positive for global economic growth and the stock market reacted favorably in turn. We expect more details to emerge as we get closer to an agreement and for stocks to respond to each headline.
Given the complexity of the issues and negotiations it’s difficult to predict what and when the outcomes of the negotiations will be. What we can observe, though, is the negative impact on business confidence. The Conference Board’s index for CEO confidence has worsened dramatically in recent months and is experiencing new lows not seen since the depth of the last recession (see Figure 3 below). In order to grow the economy and profits, businesses need to invest. Considering CEO confidence correlates well with business investment, this is not encouraging. It is too early to tell whether the latest truce will change the direction, but we are watching this data carefully.
2020 Presidential Election
The Democratic primaries are less than 100 days away and the presidential election is already starting to weigh on investors’ minds. Current polling suggests former Vice President Biden and Senator Warren are the front runners for the nomination (see Figure 4 below). To state the obvious, it is much too early to make predictions on the outcome of the primary race or the full election. However, consensus opinion is largely that an Elizabeth Warren or Bernie Sanders agenda, including greater regulation and increased taxes on corporations and the wealthy, would be viewed negatively by equity markets. We are starting to hear more and more fear mongering about this outcome, which reminds us of 2016 with similar sentiment applied to the potential for a Trump victory. In 2016 we got a very different outcome of course, with the benefit of hindsight. We resisted any urge to reduce equity weights in 2016 to the benefit of portfolio returns. While we won’t act rashly against a similar sentiment today, we are always prepared to recommend and lower allocation to equities (relative to long-term targets) if we see policies put in place that we expect will hurt corporate profits or be negative for equity markets. Our process holds true no matter which party is elected next year. In addition, where we see an increased probability for changes in legislation that would harm specific companies or industries, we will reduce or eliminate positions to manage that risk. In fact, this is already happening in portfolios over the course of the last year, with reductions in our managed care and banking exposure, as well as sales of companies operating in the oil and gas industry.
Impeachment
It is becoming more and more likely that the House of Representatives will move to vote to impeach President Trump (see Figure 5 below). An impeachment trial has numerous potential outcomes to consider. Does an impeachment proceeding increase the odds of a trade deal being completed? Given the political incentive in an election year, we would conclude yes. How exactly does an impeachment trial change the odds in the coming election? On the one hand, it may weaken President Trump’s reelection chances, but it could also embolden his base. Does the increased uncertainly and negative attention diminish consumer confidence? We certainly expect further escalations in political turmoil to increase. Instead of trying to predict the outcome, we continue to look for evidence that any political activity is transmitting to the economy. As suggested above, the data continue to support a late cycle view for this expansion.
The Bottom Line
The U.S. economy shows many signs of being in the latter stages of an expansion that began nearly ten years ago. Late cycle economic growth is more vulnerable to recession and at risk from errors of policy (monetary and fiscal). The additional uncertainty raised as a result of trade and politics suggest equity markets could be choppy. Trying to anticipate or time the outcomes of these uncertain world events promises to be a costly and treacherous exercise. With all that in mind, we are encouraging clients to re-balance portfolios back to long-term equity allocation targets to avoid being overweight in risk. A near term recession is not our base case, but risk is growing. Should our view change, we would suggest lower equity allocations. It is impossible to avoid all risk in equity portfolios, but a balanced portfolio including lower risk fixed income and high-quality companies can help moderate the inevitable declines in equity values that occur at times over the course of a long-term investment program.
Market Commentary Disclaimer: This publication is for informational purposes only and should not be considered investment advice or a recommendation of any particular security, strategy or investment product. The information contained herein is the opinion of Boston Financial Management and is subject to change at any time based upon unforeseen events or market conditions.