October 15, 2019
By Sarah Swan
“The consumer’s back might be getting a little sore from carrying an economy that is normally able to rely more heavily on manufacturing and production.”
Inter- and intraday volatility was a far too common occurrence this quarter—the market swung in both directions on an almost daily basis, but the swings were fortunately relatively range-bound. Quarter-end was an accurate portrayal of this range-bound volatility, with the S&P 500 Index settling out at +1.7%. Despite mostly the same headwinds that have been making headlines this year and rattling the markets, the economy still appears strong enough to continue to stave off recession. The lack of economic and political certainty surrounding many of the issues at play (trade war, Brexit, Fed action, US election, to name a few) continues to damper performance in an environment already prone to fear. Investor and business sentiment has therefore swayed between cautiously optimistic and simply speculative, depending on the day.
The Trade War Continues
While the history of the trade war between the United States and China is all too familiar—a real life example of the classic Prisoner’s Dilemma, a game theory concept in which two parties act in self-serving, non-cooperative ways (imposing retaliatory tariffs on one another), even though it is actually in their best interest to cooperate (reach a compromise)—the future of it is much less charted territory. Not only is there no historical precedent for these protectionist policies, but quantifying how they might impact business and the economy at large is very difficult as well. Federal Reserve economists’ research had implied a more than 1% blow to US economic output through the start of 2020. But theoretically, that negative impact grows every day that some sort of resolution isn’t reached. However, any willingness to meet and negotiate towards a compromise is a bright light, and the most recent meeting between President Trump and China’s economic envoy seemed promising. While a “phase one agreement” of sorts to limit tariffs and buy more American agriculture is apparently in the works, there are still bigger issues left unaddressed and a large, comprehensive deal is still needed. So, while the markets appreciate progress, many investors are of the mindset that they’ll believe it when they see it—negotiation isn’t a resolution, but it is something. The way this plays out will be critically important in either combatting or fueling the global economic slowdown it has in part caused.
According to Federal Reserve communications, uncertainty surrounding Brexit and US-China trade relations are the two most prominent “crosscurrents” causing the global economic slowdown. Remember that in June, the Fed chose to signal a rate cut but did not actually cut rates because the central bank hoped for a trade deal to come out of the negotiations taking place a week after the June meeting. Therefore, the Fed may find itself in another sticky spot this time around. The market is anticipating, overwhelmingly so, another federal funds rate cut at the end of October (in addition to the one widely anticipated for December)—if the Fed is feeling more optimistic in its outlook, though, it may not cut rates this month after all, and we have a feeling that move won’t land with such positivity among investors who want to have their optimism cake and eat their Fed accommodation, too. The Fed is trying to do what it can to sustain this decade-long period of growth, and it is being careful not to get ahead of itself, despite the market’s propensity to have expectations about what the central bank should and will do.
A Beacon of Hope
The consumer’s back might be getting a little sore from carrying an economy that is normally able to rely more heavily on manufacturing and production. The latest reading of the ISM Manufacturing Index, a survey of over 300 large companies, dropped below 50 to 47.8 with weakness in orders, business activity, and employment, the three most critical components. For reference, this time last year it was around 60. The Non-Manufacturing Index held higher ground at 52.6, but it was also down from the previous month in the second largest monthly decline since the Recession. In the current environment, economic growth depends heavily on consumers working and spending money. The unemployment rate hit a 50-year low in September, and the economy added 136,000 jobs. The jobless rate also hit its record low of 3.5%, not seen since December of 1969. Remember that the economy doesn’t need to be firing on all cylinders to continue to trudge along. Growth can be slow without being recessionary, and for as long as the strain is somewhat contained to the manufacturing sector, the consumer continues to be resilient, and the financial system doesn’t seem stressed, there is reason to stay optimistic. Of course, we will keep a close eye on this, because although the strain seen in manufacturing and hinted at in the service sector hasn’t trickled down to the labor market yet, it could start to at any time, and this would have a significant (negative) impact on our economic outlook.
Our Q4 Game Plan
We continue to look for opportunistic deployment of the extra cash we’ve accumulated in our slightly defensive positioning. The current environment of uncertainty has its challenges, but it has also presented some chances to get into names that we’ve liked for a long time that have been unfeasible from a valuation standpoint. The markets are shifting to be more defensive in nature, and at the same time we’ve been positioning ourselves more on the value side. Base on other cycles historically, this is probably not the time to buy into those growth stocks that have lived up to their name throughout this decade-long bull run—those companies are typically priced high, with higher P/E ratios, and are more susceptible to slow growth or fears of recession. The same can probably be ascertained from the many IPO flops you’ve been hearing about in the news—the likes of WeWork (dead on arrival), Uber, Peloton, and Lyft. While some of these IPOs could have simply been priced wrong before being brought to market, and some weren’t actually profitable companies, what they all have in common is that they fit into the theme of negative market sentiment. Therefore, we‘ve been focusing on companies that we feel are undervalued and positioned more safely against economic turmoil.
We foresee continued choppiness throughout Q4, especially over the coming weeks as S&P 500 companies report earnings. Q3 earnings expectations have come down, but perhaps not enough—we wouldn’t be surprised by some increased volatility in the market as some companies report what are likely to be disappointing numbers. We believe expectations for the quarter and next year could stand to come down even further, and it’s possible a bottom or correction could help right the course of market sentiment. But again, we anticipate using this earnings season to pick up some good value. When those big growth names get pounded during volatile market swings, it can provide a nice opportunity for us to move into other names at attractive entry points.