In reversing some of the steadier seas seen in the first quarter, the second quarter of 2019 marked a return to a volatile environment more closely resembling the tail end of 2018. Despite a peak-to-trough decline in the S&P 500 in May (by about 7%), little changed in aggregate as markets subsequently recovered and ended the quarter up just under 4%. Energy was the only sector to experience a negative return, down almost 4% on the back of oil prices that were down low single digits for the quarter.
Current Market Environment
The S&P 500 forward earnings multiple ended the second quarter at 16.8x, just above the level at the end of the first quarter. While we ended up essentially right where we began the quarter, May saw a multiple contraction that was half the size of the contraction seen in December 2018 as fears of increased trade wars led to greater volatility. The G20 meetings offered no permanent solution to trade, but the lack of escalation is a relative positive.
On Investors’ Horizons
As the market enters the second half of the year, we believe there are currently three main factors on the horizon for investors. The resolution of these factors (or lack thereof) will likely dictate the direction of the market for the remainder of 2019.
The first factor is trade. While the G20 meetings did not escalate the trade situation between the US and China, the meetings did not solve the problem and trade still has the potential to be a wildcard.
Second, the Federal Reserve’s actions should weigh heavily on the direction of risk assets. 2019 has marked a dramatic shift in tightening expectations. Until the very end of 2018, markets expected more tightening, as measured by the January 2020 fed funds futures. Since then, this tightening trend has done an about-face as the fed funds futures implied increasingly dovish expectations throughout the second quarter. According to this measure, at the end of the second quarter, the market expects 75bps of fed funds rate cuts in 2019. Data this quarter indicates that the US economy has slowed, and foreign economies remain weak. In the US, 2019 earnings estimates have been falling since the beginning of the year as have GDP growth estimates. Leading economic indicators at home and abroad are declining and PMIs are falling. Fed minutes released from the June meeting reveal downside risks had “increased significantly” in the weeks running up to the June meeting and that “additional monetary policy accommodation would be warranted in the near term should these recent developments prove to be sustained and continue to weigh on the economic outlook.” This, combined with lower inflation around the world, increases the likelihood that the Fed will follow through on its dovish tone in the remainder of the year despite some more relatively positive data points from areas like employment and consumer confidence. We currently find ourselves in this present situation. If the Fed does not cut rates as much as the market expects, risk assets that have been bid-up in anticipation of these actions will fall. Cuts at or exceeding market expectations will likely propel markets higher, but whether these cuts will be effective in stimulating future growth would remain uncertain.
The final factor investors are currently weighing is earnings. As previously mentioned, earnings estimates for 2019 have been in decline since the beginning of the year as the trade war continued and an increasing number of negative macro data points surfaced. Additionally, last year’s strong earnings growth will make for tough comparables for the rest of the year. As second quarter reporting season gets underway, the net negative revision number for companies in the S&P 500 is close to -30%, including those that confirmed guidance. While this is more negative than normal, it is still within the historical range. Investors will be paying close attention to earnings growth throughout the remainder of the year. Any positive surprises would help alleviate general growth slowdown concerns and be positive for risk assets.
Threading the Needle
We find ourselves living in an increasingly abnormal market environment where old risks still linger and new risks, in various forms, emerge. Geopolitical risks, such as the unfolding events with Iran, are still very much at play and have the potential to impact markets. Unresolved trade disputes are still impacting trade and investment decisions. While currently more in a steady state, negotiations could turn on a dime, for better or worse. In the face of this, most of the world is dealing with an environment of slowing growth, which, if it continues, will impact the multiples that investors are willing to pay for stocks. On the debt side, advanced economy public debt to GDP is at levels unseen since the WWII era. In the US, corporate debt to GDP is now past prior peaks. Years of low global rates and monetary stimulus have encouraged excess borrowing while not generating nearly the growth or inflation expected. In a defining sign of the backwards market we now find ourselves, negative yielding debt globally is $13T, up 50% from the beginning of the year. Additionally, companies with non-investment grade or junk ratings have also joined the ranks of corporations that have negative yielding debt. As it became clear that the world had trouble handling higher rates, governments around the world are moving closer to politicizing central banks, jeopardizing their independence. President Trump’s recent comments to Fed Chairman Jerome Powell are just one example of this. Could geopolitical risks be solved, trade disputes neutralized, and a later-cycle easing lift growth and the markets? Of course. Is there an equally likely scenario possible of continued slower growth, negative trade news and potential financial issues from over-indebted countries and companies spilling into risk markets? Unfortunately, also yes.
In the face of these varied risks, we continue to adhere to our core investment philosophy and process as we search for under-valued companies with favorable risk-return dynamics. Overall, we remain nimble. We recognize these market risks while still maintaining a view that factors that would lead to risk asset outperformance can change quickly. In this environment, we believe lower valued companies and those with higher dividend yields and lower leverage can help protect the downside while positioned well for a sharper recovery. We have coined our nimble stance ‘threading the needle’. Our stance and portfolio positioning are akin to driving down the center lane of the highway: we are not in the slow and overly defensive right lane nor the fast and entirely risk-on left lane. Rather, in the middle, we can benefit with faster moving left lane traffic and aim to protect the downside if traffic comes to a screeching halt to our right.