Newspaper with "Investments" headline, and "Where to invest your money?" subheading October 1, 2019

TCM 3rd Quarter 2019 Market Outlook and Strategy Update

Newspaper with "Investments" headline, and "Where to invest your money?" subheading

Stephen M. Mills, CIMA® Managing Partner, Portfolio Manager

Brad Bays, CIMA® Partner, Portfolio Manager

Highlights: ? The U.S. economy is slowing but remains durable in its 11th year of expansion. ? Trade tensions with China continue to increase threatening both U.S. and global economic growth. ? The Federal Reserve has reversed course and is now lowering its benchmark Fed Funds rate. ? In light of recent concerns, investors may want to consider a more defensive investment posture.

U.S. Economy

The U.S. economy has decelerated this year from the pace of growth in 2018 but continues to show durability and strength. The U.S. Commerce Department recently reported that in its final estimate, U.S. Gross Domestic Product (GDP) rose 2.0% in the second quarter of 2019, a drop from the 3.1% pace in the first quarter.1 Overall for the first six months of 2019, the economy grew at a 2.6% rate.1 The economic expansion is now the longest in U.S. history which begs the question, when will it end? Although the expansion is historical in its time span, it is also historic in its weakness. This may be due to the scars left on investors and business people from the 2008-09 financial crisis that sent the economy into one the worst recessions in our nation’s history and led to the collapse of some of our largest financial institutions. Since the financial crisis, both investors and business people have been very reserved about putting capital to work in the markets and economy. But like the story of the tortoise and the hare, slow and steady often wins the race.

One positive that we see in this economic expansion is there appears to be no major bubbles like we have seen in the past that preceded a recession. The 2001-02 recession was preceded by the tech bubble which collapsed and played a significant role to help drag down the economy. The 2008-09 recession was largely caused by a real estate bubble that ultimately collapsed. We don’t see any such bubbles today that could burst and damage the economy. Instead, we feel that the economy could continue to grow moderately for several quarters. We believe it will take some kind of economic or geopolitical shock to derail growth.

Our biggest concern at the moment is the yearlong trade war with China. Little real progress has been made to resolve the dispute and tensions continue to mount. This has negatively impacted business sentiment as the prospect of rising tariffs has caused many business owners and major corporations to delay capital spending plans. Although consumer sentiment about the prospects for the economy still remains positive, the implementation of additional tariffs may influence consumers to begin curtailing spending because of higher prices on imported goods. Since consumer spending accounts for two-thirds of U.S. GDP, any slowing of in that area could have a material impact on economic growth.

Thus far, the impact of global trade tensions has had a larger negative affect on export driven countries like Germany, South Korea, and Taiwan. In fact, recent indicators suggest that Germany may be heading into a recession. Global growth is now more interconnected than at any time in modern history and more vulnerable to regional economic weakness. The U.S. has been able to avoid any major economic weakness but if the rest of the world continues to struggle, eventually our economy may suffer as well.

This potential economic weakness overseas is one of the reasons the U.S. Federal Reserve (Fed) reversed its interest rate policy and began lowering rates this past summer. After nine rate increases from December 2015 to December 2018, the Fed lowered Fed Funds Rate by .25% in both their July and September meetings this year. Chairman Powell indicated in his post meeting policy comments that these cuts were largely a preemptive measure in case trade tensions continued to weigh on U.S. economic growth.2 In a post meeting interview, Fed Vice Chairman Richard Clarida characterized the U.S. economy as the “star pupil” in the world for its economic performance.2 He called the U.S. economy “resilient” although he said that the Fed is not taking it for granted.2 Although several members feel overall economic growth may slow in the near term, the general consensus of the Federal Open Markets Committee was optimistic on the U.S. economy. We see the Fed’s recent interest rate cuts as positive for the economy in the short-term. Many economists and strategists believe that the Fed may cut one more time this year and then pause to assess the situation.

Equity Markets

Despite the uncertainty about the trade war with China and weakening economic growth overseas, the U.S. stock market has rewarded investors who stayed the course after a very difficult fourth quarter in 2018. As the end of September, the S&P 500 Index has climbed 19% for 2019 while the Dow Jones Industrial Average has advanced 15.6% for the year. The strong performance in stocks is in spite of the slowdown in the U.S. economy in the second quarter of this year. Contrary to popular belief, the economy does not have to grow at a fast clip for the stock market to do well. In fact, history has shown that a more moderate pace of economic growth is better for stocks.3 Case in point, GDP growth has been below its long-term average pace of 3.2% since the 2008-09 recession yet the S&P 500 Index has more than quadrupled in value since its low hit in March, 2009.3&4

Overall, the equity markets have been very strong this year as you can see in Chart 1 below which shows the performance of the S&P 500 Index. Stocks made a strong recovery from the fourth quarter 2018 decline through April of 2019. However, since the end of April, stocks have been very volatile primarily due to the ongoing trade war with China. The dip in the market in both May and August was directly related to negative news on the trade front. Sentiment seems to ebb and flow depending on if the trade news is positive or negative. We don’t know when this trade war will end. However, we feel the longer the trade war goes the more negative will be its effects on the economy. We are already starting to see business sentiment weaken in light of new tariffs placed on China as business people are reluctant to commit capital for fear of even higher tariffs in the future. The impact has been felt mainly in overseas markets thus far. But the more the Trump administration ratchets up Chinese tariffs, the greater the impact on the U.S. economy as both businesses and consumers potentially cut spending due to the higher cost of goods.

Chart 1

In addition to the China trade war, investors now have to deal with a possible presidential impeachment process in the U.S. House of Representatives for the next few months. Even if the House votes to impeach President Trump, it requires 2/3rds of the Senate to confirm the impeachment and convict the President on the charges. We see that as highly unlikely to happen. The threat of impeachment is another negative for the markets to deal with and could influence investors to stay on the sidelines until it is resolved. We also don’t believe the impeachment process will have a material impact on the presidential election unless it can be proven that Trump committed a crime. More likely voters will look at it like they did the Russian collusion probe as partisan politics.

Fixed Income Markets

Despite the uncertainty about the trade war with China and weakening economic growth overseas, the U.S. stock market has rewarded investors who stayed the course after a very difficult fourth quarter in 2018. As the end of September, the S&P 500 Index has climbed 19% for 2019 while the Dow Jones Industrial Average has advanced 15.6% for the year. The strong performance in stocks is in spite of the slowdown in the U.S. economy in the second quarter of this year. Contrary to popular belief, the economy does not have to grow at a fast clip for the stock market to do well. In fact, history has shown that a more moderate pace of economic growth is better for stocks.3 Case in point, GDP growth has been below its long-term average pace of 3.2% since the 2008-09 recession yet the S&P 500 Index has more than quadrupled in value since its low hit in March, 2009.3&4

Overall, the equity markets have been very strong this year as you can see in Chart 1 below which shows the performance of the S&P 500 Index. Stocks made a strong recovery from the fourth quarter 2018 decline through April of 2019. However, since the end of April, stocks have been very volatile primarily due to the ongoing trade war with China. The dip in the market in both May and August was directly related to negative news on the trade front. Sentiment seems to ebb and flow depending on if the trade news is positive or negative. We don’t know when this trade war will end. However, we feel the longer the trade war goes the more negative will be its effects on the economy. We are already starting to see business sentiment weaken in light of new tariffs placed on China as business people are reluctant to commit capital for fear of even higher tariffs in the future. The impact has been felt mainly in overseas markets thus far. But the more the Trump administration ratchets up Chinese tariffs, the greater the impact on the U.S. economy as both businesses and consumers potentially cut spending due to the higher cost of goods.

Chart 2

Lower bond yields may be signaling increased risk to global growth. This may in turn continue to push investors into high grade bonds to preserve capital in case the global economy slides into a recession. Although we believe the risks of a global recession in the next year is still very low, it does make sense to be more defensive with a fixed income portfolio. We continue to recommend that investors keep the credit quality of their fixed income portfolio very high by focusing mainly on U.S. government securities and high grade corporate and municipal securities. We continue to underweight lower quality “high yield” bonds. Typically, high yield bonds tend to act more like stocks and can decline in value when the economy weakens significantly. In addition, we also continue to underweight non-U.S. fixed income. Keeping credit quality high in the fixed income component of a portfolio can help reduce overall portfolio volatility in difficult market environments.

Investment Strategy

Overall, although we remain cautiously optimistic about the U.S. economy and financial markets, we believe that a more defensive posture may be appropriate for risk averse investors. The trade war with China, the Democratic investigations and threat of impeachment of the President, and the rise in tensions with Iran could weigh on investor and consumer sentiment for the foreseeable future. This in turn, could impede the equity markets until some resolution to those concerns is reached. Thus, we continue to recommend that for investors with shorter time horizons, it may be appropriate to adopt a more defensive position by increasing portfolio quality and reducing economic sensitivity. We feel that this is a good time to examine your portfolio risk in light of your personal tolerance for volatility and potential income and liquidity needs. We would upgrade the fixed income component as suggested above. We also recommend possibly reducing equity exposure especially if the equity allocation has increased significantly due to the strong equity market this year. However, since we are optimistic longer term for the U.S. economy and financial markets, we recommend those with long-term time horizons maintain equity allocations according to long-term goals.

We will continue to closely monitor the financial markets and keep you informed of any new developments that may impact your portfolio. In the meantime, please call us if you have any questions or concerns.

Footnotes

1 Bureau of Economic Analysis report on U.S. GDP, www.bea.gov, September 26, 2019

2 Bloomberg.com, “Clarida Says Fed Policy Will Take Account of Downside Risks, September 20, 2019

3 Riverfront Investment Group, The Strategic View, September 3, 2019

4 Thompson Charts

5 CNBC, “Amount of global debt with negative yields ballons to $15 trillion,” August 7, 2019

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