Today, politics again is center stage. The drumbeat for impeachment is getting louder with a whistleblower complaint detailing White House officials’ efforts to conceal evidence on the Presidents’ conversations with Ukrainian officials. Markets have changed little on this news and, as we have expressed earlier this week, what investors should be focused on is the economy, especially at this point in the business cycle. The reason is the impact of tariffs is creeping into business activity. Tariff threats escalated in August and the impact of duties effective September 1st will start showing up in economic data. Within this stock market, tariffs are the fundamental driver of activity. Cooling tariffs would mean global manufacturing has less headwinds. Escalating rhetoric and additional duties has the opposite effect. This is why the performance of specific areas of the U.S. stock market (described value stocks for this discussion) are high correlated with changes in trade activity, Chinese economic data, and even the change in the Chinese currency.
While value stocks had rebounded somewhat in 2019, growth/momentum stocks have established market leadership this year which has been the case since after post-election 2016. Over the last 9 months, the Fed has effectively been easing monetary policy and lowering rates benefiting growth/momentum stocks as it allows for higher valuations. Further, many growth/momentum stocks are secular growers and consumer oriented. The recent slowing of business investment and the declining outlook for manufacturing activity doesn’t impact them as much it does with value stocks.
What we see is investors discounting a much higher probability of a recession value-oriented areas and almost no recession in others. This trend has been exacerbated now that effects of tariffs are an ongoing reality. Despite many months of tweets, meetings and false summits, the market has finally accepted that tariffs are structurally in place for the foreseeable future. Leading economic indicators, like the Purchasing Managers Index which looks into new orders for manufacturing companies, have finally broken below 50, meaning orders are declining. Capital Economics, an economic forecasting firm, now expects GDP growth to slow from 2.3% this year to 1.4% in 2020. While the consumer stays strong (this morning the core PCE print was still positive +0.1%) the future outlook on export oriented and cyclical parts of the economy (industrial, energy, banks) are looking more negative especially with the S&P 500 selling close to record highs. As a result, the gap in relative performance between value and growth/momentum is close to the most extreme since 2015, which sets up a very interesting case.
The discussion of when you should own growth and when should you own value is a hot topic. (We strive to own quality companies at reasonable prices, below our analysis of intrinsic value, which covers both value and growth.) Looking back in March of 2016, once there were indications that a recession wasn’t imminent, value significantly outperformed growth. Today, the market could be similarly positioned. The domestic economy is still OK despite areas of concern. Unemployment claims are still close to a five-decade low. There is no indication from the jobs front that we are approaching a recession. Pending housing sales recently showed signs of increasing. The Conference Board Consumer Confidence Index remains elevated at 125. Yesterday, Richmond Fed chief Thomas Barkin commented, “[Rate cuts] don’t mean a recession is imminent, nor that we are in a prolonged period of easing.” In the near term, a recession is unlikely, but still many value sectors stock valuations imply a shallow recession of sorts. If there is any change in the trade situation, not full resolution but merely a cooling off which would allow global monetary policy loosening to have an effect, cyclicals could outperform and value will have its day in the sun as valuations revert closer to their historical averages.
Stephen Saunders 610-260-2218