In a pattern similar to 2018, the stock market has entered the final quarter with stellar performance through the first three. In fact, the S&P 500 posted its best nine month performance since 1997. However, on a trailing twelve month basis (i.e., since 9/30/18), the stock market’s total return was only 4.25%. The modest return includes the sharp, albeit brief, market correction at the end of last year. In our December 31, 2018 letter, we noted the following factors behind the correction: “a hawkish posture by the Federal Reserve; ongoing trade tensions; weakening economic growth in parts of Europe and emerging markets; collapse in crude oil prices; Brexit negotiations in the UK; faltering housing starts data in the US; and concerns over the state of China’s economy.” We also noted that the most significant factor remained “trade uncertainty and the relative contribution of China’s economic activity to global growth.”
It is arguable that most of the factors that contributed to the December 2018 market correction remain. The ongoing Brexit negotiations suggest a process that is no closer to resolution, notwithstanding the ominous deadline at the end of October. Parts of Europe, particularly Germany, appear to be in recession, posting data that are only slightly above levels last realized during the Great Financial Crisis. Yet, we would submit that one highly significant factor is different – i.e., the policy stance of the Federal Reserve.
In the US, there is considerable debate about both the efficacy and necessity of the Fed’s approach. The Fed’s shift in policy appears to reflect concern about recessionary signals emanating from the bond market. With interest rates near historic lows, it seems a foregone conclusion that bond investors anticipate an economic contraction in the near future. The Fed is among 16 central banks that recently provided monetary accommodation. With $16 trillion in global sovereign debt offering negative yields, it is reasonable to question, however, whether lowering policy rates further will prove effective. Stock investors disagree with a recessionary outlook and focus, instead, on a stable domestic economy with sub-4% unemployment. These conflicting views are unsustainable. In other words, the outlook for both markets will eventually converge in an adjustment process involving rising bond yields or contracting stock market valuations.
Resolution of trade uncertainties should remove a headwind for economies and financial markets. We acknowledge lingering political motivations could prolong negotiations. However, the trade war does appear to be having a pronounced negative impact on China’s economy. While the US economy has remained relatively insulated, we are quite concerned about the breadth of tariffs that become effective on December 15th. We also believe that the impeachment inquiry could, ironically, prove to be a catalyst for an accelerated resolution. For a sustained rally, however, the markets will likely be dissatisfied with incremental or temporary trade agreements. The corporate sector requires policy clarity to re-engage in expansionary practices.
We expect the Fourth Quarter will exhibit periods of heightened market volatility, associated primarily with geo-political uncertainties. Those uncertainties are likely to intensify in 2020. We would caution investors, however, against assuming worst case outcomes. Liquidity provided by central banks, fiscal stimulus implemented recently by several economies, and a generally stable global banking system offer a good foundation upon which to allocate capital. We would further caution investors against reacting to each piece of incremental information that is likely to surface as the impeachment process unfolds. Gradually, the markets will begin to price in the “most probable” outcome as more and more “unknown unknowns” are identified. We recommend a defensive posture that emphasizes diversification, but we are not yet prepared to recommend an excessively cautious orientation. Specific portfolio adjustments depend, of course, on each client’s objectives. Please contact the office if you would like to schedule an appointment.