While Jim is away on vacation, other members of the TBA Investment Committee will write the market comment. Today’s comment is from Jim Vogt.
Recent news events are leading the market to price in at least two Fed Rate cuts by the end of this year. It seems like the Federal Reserve made a mistake in December as they wrongly focused on short-term data that was tax induced. This led to rising inflation and a 3% GDP run rate. This caused them to believe raising rates and hinting at further tightening would not impact the economy severely. As the Fed is wont to do, they overstepped, again. The yield curve is screaming at their error. A 2-year Treasury bond now yields 1.89%, well below Fed Funds of 2.50%. This can’t last for an extended period, or a recession becomes likely. Banks tighten lending standards when their ability to borrow at low rates and lend at higher rates is minimized. That is what an inversion does. If there are less loans, there are less fund flows. The cycle is pretty consistent.
Assuming the markets can hold it together today, it will end a four-week losing streak in most major averages. So far, we’ve already regained half of that May drop in just 4 days. Whether this is an oversold bounce in a cyclical bear market or the resumption of the secular bull market is anyone’s guess at the moment. The near-term data is showing weakness. However, investors are already starting to predict, and price in, what is expected to happen economically next year.
The recent slowness is also bringing massive changes to central bank policies abroad. Instead of fighting inflation and raising interest rates like last year, most developed economies are shifting gears and focusing on loosening monetary conditions. If we get a few interest rate cuts, a China/Mexico trade deal and a clean Brexit, we should be looking at a much more favorable landscape where risk taking will increase.
However, those are not guaranteed by any stretch. Further, we are likely to see more economic weakness over the coming months. A lot of enthusiasm from recent earnings reports were built on a second half rebound. The lack of a China deal and the further inversion of the yield curve makes this premise seem less likely. The next few months should clear up the picture.
Taking a step back, the S&P 500 bounced 26% from Christmas Eve thru the end of May. This was preceded by a 20% drop from September. Going back to the end of January 2018, the major indexes are now basically flat. That’s eighteen months of minimal returns but numerous, wild swings. Following the day-to-day news during this time frame could make any investor question the future of their holdings. From Presidential tweets, investigations, to Tariff battles and trade rhetoric, it has been a mine field of disconcerting events.
Although the major averages have ended with minimal total returns for a year and a half, the underlying constituents have provided more action. Stock and sector selection has yielded varying returns.
Looking at the group of companies making new highs, one can notice a theme of Consumer Staples (Coca Cola#, Pepsico#, Kimberly Clark#, Diageo#), REIT’s (Prologis#, Crown Castle International#, Public Storage), Utilities (Nextera Energy#, Southern Corp, Con Ed) and select data providers (IHS Markit#, S&P Global, MSCI). Recently, that theme makes sense. As uncertainty in the global landscape increases and interest rates decline, investors have rotated into companies that possess high dividend yields, predictable revenue and/or consistent earnings above expectations.
Recent economic data has been weakening. GDP estimates for nearly every developed nation are lower in 2019 than last year as you can see below:
Crude oil prices have entered a bear market with a 20% drop since April. Many commodities, the input to anything tied to expansion, are not doing much better. Manufacturing data is dropping, which is a critical leading indicator. Semiconductor inventory levels are at multi-year highs. Private residential construction spending is down nearly 10% YOY even with interest rates collapsing. Earnings estimates continue to come down. Inflation is non-existent which means pricing power is muted. The May jobs report this morning was one of the worst we’ve seen in a while with only 75,000 jobs added, well below the 223,000 average of last year.
This leads the other side of the stock/sector selection coin. The bulk of stocks trading near new annual lows are in the Consumer Discretionary (Nordstrom#, Kohl’s, Signet), Energy (Marathon Oil, National Oilwell) and Materials sector (most steel and copper companies). In an uncertain or declining economy, this makes perfect sense. There is less demand for basic commodities so prices drop. The consumer continues to find ways to spend money more wisely while retailers fight an uphill battle with online leaders. With US oil production increasing 50% over the past couple of years, the excess supply is pressuring prices. The global demand slowdown is not helping either.
Being broadly diversified has helped mitigate the impact of the lagging areas. Placing an emphasis on companies with predictable stories and clean balance sheets has produced slightly more favorable results. As noted in previous letters, identifying themes that have a long runway for growth and finding world class operators in those fields should produce solid returns over the coming years. Trying to find the exact top or bottom in the overall market is an entirely different game.
When the market cycles through a trading range, a prudent investor will allocate funds to stronger companies. If a breakout occurs on the upside, then one can start to add risk to a portfolio, and vice versa. Avoiding the day-to-day news cycles can go a long way in preventing the mistake of altering asset allocations at the wrong time. To use a baseball analogy, we strive to play the middle innings. This helps lower risk while still providing returns one can expect from their equity portfolios.
End result, beware the near-term animal spirits as this summer could yield more volatility. Opportunities will arise. Collect your dividends and let the dust settle. Nibble on proven winners. Build positions in stocks that have 5+ year secular growth stories you can trust.
I’ll keep the Birthday list going…Liam Neeson is 67, Allen Iverson is 44 and Mike Pence is 60.
James Vogt, 610-260-2214