October 2019
By: Pat Guinet, CIMA®
2019 Third Quarter Market Recap
Financial markets were choppy in the third quarter, buffeted by some familiar themes: on-again/off-again U.S.-China trade war headlines, weak global growth, recession fears, and central bank monetary policy.
For the full quarter, both major asset classes produced solid gains: larger-cap U.S. stocks (Vanguard 500 Index) were up 1.7% and core bonds gained 2.4% (Vanguard Total Bond Market Index).
Despite a rebound in September, foreign stocks posted negative returns for the quarter. Developed international stocks were down 0.9%, European stocks were down 1.8%, and emerging-market (EM) stocks lost 4.1% (the Vanguard FTSE Developed Markets ETF, the Vanguard FTSE Europe ETF, and the Vanguard FTSE Emerging Markets ETF, respectively).
In fixed-income markets, the benchmark 10-year Treasury yield dropped to below 1.5% in early September as the trade war and recession fears reached new heights of concern.
Because our portfolios are diversified beyond U.S. stocks and core bonds, the overall market trends in the third quarter were a drag on our relative performance. However, performance was aided in September when interest rates moved higher, catalyzed by an apparent détente (at least for the time being) in the U.S.-China trade war.
A Brief Macro Update: Trade Policy vs. Monetary Policy Tug of War
Global economic growth remains weak and consensus expectations are for further slowing. For example, during the third quarter, both the Organization for Economic Co-operation and Development and the International Monetary Fund cut their projections for 2019 and 2020 global gross domestic product (GDP) growth (again), citing the negative impact of the U.S.-China trade war on manufacturing, exports, and business investment spending.
On the other hand, while measures of global manufacturing activity remain in contractionary territory, services (non-manufacturing) activity, which represents upwards of 70%-plus of the global economy (and more than 80% of U.S. GDP), still looks solid.
As we all know, there are hundreds of economic data points that can be selectively marshaled to support almost any macro view. (That’s what keeps all those Wall Street economists employed!) Suffice it to say, the data is “mixed.” But one might not be far off the mark boiling things down to a tug of war between the contractionary effects from U.S. trade policy and accommodative/expansionary global monetary policy. Expansionary fiscal policy (lowering of interest rates and quantitative easing) may soon enter the picture in Europe and China, if not also the United States.
The BCA Research view that both China and U.S. President Donald Trump have an incentive to make a trade deal before the U.S. election, lead them to expect global growth to rebound in 2020 and, with it, strong performance from foreign and cyclical stocks. A weaker dollar would likely accompany a rebound in global growth, which would further loosen financial conditions, enabling a positive feedback loop between the financial markets and the economy. A weaker dollar would also boost foreign stock market returns for U.S. dollar-based investors.
In response to the weak global economic environment and the impact of trade policy on U.S. business sentiment and capital expenditure, the Fed followed its late July interest rate cut with another 25-basis-point (bp) cut in mid-September, bringing the federal funds rate down to a range of 1.75% to 2.00%. Also, earlier in the month, the European Central Bank (ECB) cut its policy rate 10 bps, to negative 0.5% and announced it would launch a new open-ended asset purchase plan (i.e., quantitative easing) at a rate of €20 billion per month starting in November. Departing ECB President Mario Draghi also implored eurozone governments to undertake fiscal stimulus to boost the region’s growth, signaling monetary policy may be reaching its effective limit.
What does the second Fed rate cut mean for the stock market in the near term (next 12 months)? Not surprisingly, the answer depends on whether the economy is heading into a recession. What we know for certain, though, is Fed rate cuts do not necessarily prevent a recession from happening. The last three recessions—in 1990, 2000, and 2008—all occurred despite the Fed cutting rates prior to the recessions’ start. Bear markets coincided with each of those recessions.
Looking further at monetary policy, Ned Davis Research analyzed Fed rate cuts going back to 1921. They concluded that when the Fed cut rates twice and the U.S. economy avoided a recession over the next year, the stock market gained an average of 18% in that year. This has happened seven times in the past. However, in the three instances (1990, 2000, and 2008) when two Fed rate cuts were closely followed by a recession, the stock market dropped 11% on average over that year.
So, based on history we see two widely divergent, if not binary, market outcomes. This again highlights why we believe it is important to incorporate a wide range of scenarios in our portfolio management process. The most effective way to do this is through diversification across multiple asset classes and investment strategies that have different risk exposures and different sources of return. Some investments will be zigging while others are zagging. Of course, this also means that not every position will perform well in every scenario or macroeconomic environment. That’s the definition of portfolio diversification and the essence of risk management under uncertainty.
U.S. Stocks Are Priced as if History Is Irrelevant
At a time when U.S. stocks have continued to outperform, clients sometimes ask why we don’t have more in U.S. stocks. (Interestingly, we rarely get asked why we don’t have less
Markets typically don’t stop rising when they reach fair value. History has shown they overshoot both when they go up and when they go down because of investors’ greed (or fear of missing out) and fear (of losses). To justify a higher weighting to U.S. stocks at present, we’d have to assume history is largely irrelevant.
Breaking Down Equity Return Components
There are only three drivers of equity returns:
When we aggregate the three return components (dividend yield of 2.2%, earnings growth of 3%, valuation or P/E compression of –4.6%), future five-year expected U.S. stock returns are less than one percent, annualized, and this is despite our relatively generous margin and sales-growth assumptions. If we were to stretch on valuation multiples and assume 19x or 20x P/E, returns are a bit above 3%, which is still poor for a risky asset like stocks. In our bear-case scenario, where we give history more weight and assume 6% margins and 4% sales growth (the two determinants of earnings growth), then returns are quite negative over our five-year time horizon.
It is worth remembering low rates do not shield investors from an overvalued equity market. Case in point, the Fed was cutting interest rates significantly in the bear markets of 2000–2002 and 2008–2009 but could not prevent the nearly 50% declines in the stock market.
In addition to U.S. stocks being priced at historically high valuations based on earnings that we believe are above normal and unsustainable, cyclically the news seems just as bad:
What Our Analysis of U.S. Stock Market Return Components Tells Us
On the other hand, there are scenarios where we can see U.S. stocks generating 8% to 10% annual returns over the next five years. For such an outcome, investors would have to assume profit margins stay at all-time highs, sales grow at more than twice the rate they have since 2008, and investors continue to accept the relatively high valuations of today, possibly paying even more during what remains an uninspiring real economic environment with heightened geopolitical and trade tensions. In our view, this outcome has little chance of playing out, at least not over an extended period. But it’s a possibility we don’t exclude from our thinking entirely, especially if the promise of technology (artificial intelligence, robotics, etc.) allows companies to continue to lower their operational costs in the next cycle and beyond. We think it would be hard to achieve though, given the social and political pushback we are already seeing in America and other developed nations in this cycle.
Weighing the scenarios and their likelihood of playing out, we have continued to hold a reduced allocation to U.S. stocks across our clients’ portfolios in favor of more attractive asset classes: non-U.S. stocks, tactical active strategies, income investments, and alternative strategy investments.
Final Thoughts
We believe U.S. stocks are expensive and do not deserve a higher allocation in our client portfolios at present. In the short term, U.S. stocks may continue to outperform as they have for several years. But this would only borrow returns from the future. We also know by stretching our horizon over 10 years and longer, U.S. equity returns should be decent. So, in our balanced portfolios, we continue to have nearly a quarter of our portfolios allocated to U.S. stocks through our use of low-cost index and exchange-traded funds complemented by our tactical strategies.
Our dual investment mandate is to compound our clients’ wealth while being mindful of the risks we take in achieving that goal. We don’t know exactly how the future will unfold. As a result, in our portfolio decisions, we weigh various risks your portfolio may be exposed to. We gauge risk by analyzing a wide range of positive and negative economic and market scenarios, the impact they may have on your portfolio, and the likelihood of them occurring given current fundamentals and how we see them likely evolving.
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