In case you were able to forget, the second quarter reminded us that we are no strangers to volatility in the markets. We’ve seen the main indexes whipsaw intraweek and even intraday over the last three months, with the S&P 500 Index ultimately finishing the second quarter up 3.43% and up 2.65% year to date, making up for the first quarter’s losses. Headlines surrounding geopolitical turmoil, political agendas, central bank policy, international trade disruptions, and corporate developments, scandals, and acquisitions have driven the markets on an almost daily basis. All the while, fundamentals have remained strong and corporate earnings have continued to offer credence to a highly valued stock market, despite nervousness about the inevitable and unpredictable return of the bear.
Economic growth in the US, as measured by gross domestic product, was slower at the beginning of the year than previously reported. GDP expanded at a seasonally and inflation-adjusted annual rate of 2% in the first quarter, slightly weaker than estimates of 2.2%. But economists believe growth has increased in the second quarter (consensus is around 4%) and will continue throughout the third and fourth quarters, as well, thanks in part to continued low unemployment numbers, solid job gains, and wage growth. And the Federal Reserve Bank has seemed to echo this sentiment, expressing continued optimism at the Federal Open Market Committee’s (FOMC) May and June meetings. The Committee noted that both overall inflation and inflation excluding the more volatile food and energy prices have moved close to its stated objective of 2% after six years of failing to meet such a target. Therefore, the Committee felt comfortable raising its benchmark interest rate range in June (for the second time this year) to 1.75-2%. The FOMC expects that further federal funds rate hikes (one to two more are projected this year) “will be consistent with sustained expansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective over the medium term,” as stated in the Fed’s June press release. And although some officials have expressed concern over an overheating economy, Fed Chairman Powell, on behalf of the Committee, recognizes the risks to the economic outlook and believes, overall, they “appear roughly balanced.”
One of the more notable headlines of late has been regarding a war of international tariff levying, started by President Trump as a retaliatory measure against China for its track record of intellectual property theft. The possibility that such trade tensions could be significantly damaging has become more real as China and other US allies have responded in kind. Chinese officials have responded by proposing to target certain American exports including farm products, cars, and crude oil by July. Meanwhile, in Europe, the EU fired back at President Trump’s steel and aluminum tariffs by leveling tariffs on such American products as bourbon and Harley Davidson motorcycles. As we have said often, trade wars are never good, and while in no sense is it a guaranteed outcome, it is very important to consider the possibility of a full-blown trade war which would have real financial consequences on a global level. We have spent a lot of time thinking (and will continue to do so) about what companies would be most materially impaired so that we can be prepared to act quickly and wisely. Generally speaking, in the event of a trade war, hardware-based tech companies, exportbased industrials, cyclically-sensitive names (essentially, companies that sell discretionary goods or services that consumers can afford to buy more of in a booming economy but tend to cut back on during a recession), and commodities are likely to be materially affected. On a higher level, trade restrictions would certainly damage consumer confidence and could even ignite stagflation (a dangerous, albeit rare, economic environment in which growth is stunted due to rising prices caused by artificial shortages). Since we value the protection of our clients’ assets as our primary responsibility, and this is especially true during down markets, we are prepared to sell stocks where and when appropriate while also doing our best to mitigate potential tax implications. However, our primary goal will always be to protect our clients’ assets first and foremost.
We’ve mentioned for the past couple of quarters that the question on most clients’ (and investors’) minds seems to be about when the next recession will happen. We are currently experiencing the second-longest bull run in our country’s history, which began in 2009. So from a historical perspective, we know we are well overdue for a cyclical shift. Given our current environment, there are a number of things that could act as a catalyst including the Fed’s actions in response to an overheating economy (or an economy that has experienced a long period of growth that leads to inflation as a result, making the growth unsustainable). Another factor could certainly be the escalating trade tensions discussed above. What is interesting about recessions, though, especially late cycle ones, is that they are often the result of an unforeseen or even random shock or surprise. That makes them very hard to predict beyond the basic understanding that when the stock market has been moving higher and higher, it’s more susceptible to toppling over. We are doing our best to monitor those factors and events that could likely be catalysts, although attempting to make any hardline predictions or drastic decisions at this point is imprudent.
Our Portfolio Positioning
Over the last six months we have been deliberately but prudently lowering our stock portfolios’ beta, which is a measure of risk or volatility of a portfolio compared to the market as a whole. As we’ve mentioned in recent newsletters, we’ve done so through sector overweighting and underweighting as well as individual stock picking. In that sense, we are already slightly defensively positioned against the market, and we feel good about our positioning with what we know to be true at this time. It’s important to note that such positioning was not a response to current trade issues, but rather, current trade issue speculation is further validating our cautious outlook. As we’ve discussed, the equity markets are highly valued and in many cases are supported by unusually high levels of corporate earnings growth. Beyond that, we know that our economy (and much of the rest of the globe) continues to fire on all cylinders, and we see limited signs of stress in our financial system. However, despite these factors, we also believe we are in the later stages of this market cycle, and we are therefore leery of the current market environment. It is therefore our belief that we can and should and will balance these beliefs as well as we can without materially changing our positioning until we see it as necessary and prudent. We are making no absolute decisions or overtly defensive actions at this time (we are simply cushioned against a typical level of volatility), but we are postured to act quickly in the event of a trade war or other definitive scenario if we feel it’s in our clients’ best interest.