Investment Update

Broad equity markets posted positive returns in the second calendar quarter, rebounding from the modest declines of Q1. While the news flow regarding continued economic growth and strong corporate earnings was generally positive, the market struggled for direction amidst longer-term uncertainties regarding the duration of the current economic cycle. As we discussed in our note last quarter, this is consistent with a market in transition, as the outlook for better growth also signals the latter stage of an economic cycle that now exceeds nine years.

Stocks continued to trade within a range defined by the market highs in late January and the correction lows of mid-February. We’ll discuss below some of the factors that could contribute to the market breaking out of this range in either direction.

KEY STORYLINES FOR THE SECOND QUARTER

Corporate earnings excel in the first quarter as expected, but provide little traction for broad based gains in stocks.

By all accounts, the year-over-year earnings growth of 23% had been anticipated by investors, recognizing that the impact of tax reform had already helped drive share prices higher last year. Some see the current earnings cycle as “peak earnings”, implying an inevitable deceleration in the year-over-year earnings growth rate, once the windfall of tax reform is embedded in next year’s comparisons. Looking back, however, previous earnings cycles have shown that moving past the peak in earnings growth rates does not necessarily precipitate lower stock prices over the following 12 and 24 months.

Analyst expectations remain relatively optimistic beyond the benefits of tax reform, with consensus earnings growth forecasts coming in around 10% for 2019. This would clearly be supportive of higher stock prices. On the other hand, investors will be looking at potential pressure on corporate profit margins coming from wage increases and tighter monetary conditions as the Fed unwinds years of stimulus that undeniably boosted stock prices.

Markets are paying more attention to trade war concerns.

For the most part, the markets have held up reasonably well as the Administration has laid out its objectives regarding trade. Current market levels at close to all-time highs imply that an all-out trade war with China is an unlikely outcome. However, the rhetoric around trade policy has ramped up in recent months and is causing increased angst among investors.

While the initial targets of trade tariffs (steel and aluminum) were relatively small pieces of the broad economy, the targets are expanding as is the potential retaliatory impact. The uncertainty caused by trade tensions has a dampening effect on the animal spirits still riding the crest of tax reform and deregulation. Individual companies most affected by recent threats have become more public in how they may respond, with recent attention on imported automobiles. Even without implementation, extended uncertainty could put future capital expenditures at risk and compel management to communicate more conservatively with regard to guidance on future earnings.

Improving the reciprocal nature of existing trade agreements could be game changing. Affecting a paradigm regarding trade agreements with China (and others) was always going to be a risky undertaking. For now, it is not surprising for investors to focus on what is most visible and that is potential for significant disruption. Until this effort runs its course, odds are this gets messier before it gets better.

Investors return to the comfort of tech stocks.

Our note last quarter addressed a developing pushback against tech stocks in the face of new privacy and regulatory concerns. While these issues remain fluid and relevant, investors once again took solace in the shares of tech stocks this past quarter for the stability of their earnings growth, high levels of cash on hand, and as refuge from trade tensions and slowing momentum in the global economy. Tech stocks continued to drive the outperformance of Growth strategies over Value in the quarter. The performance dispersion of this scale, especially over the past two years is unusual and would suggest a momentum that is also feeding on itself. (See chart below). The last extreme similar to this was the Tech Bubble, and while not an apples-to-apples comparison, it is a fair reminder of what can happen when consensus leans heavily in one direction.

Growth’s outperformance since the Financial Crisis has been consistent with an environment that has been well suited for Growth strategies – slow economic growth, limited volatility, and Fed policy that encouraged risk taking. We also know from history that these environmental factors are cyclical, just like the performance trends of Value and Growth investing. The current cycle of Growth outperformance is the longest on record. Prior to this, Value has held a slight advantage over Growth over most long-term time frames (going back to 1927).

Having exposure to both styles is the best way to assure that portfolio performance is not dependent on making calls on the timing of styles. Normal behavioral instincts are to favor what is currently working. Value disciplines will be inclined to lean the other way. We can certainly see Growth strategies continuing to outperform through the end of the economic cycle, but our bias would be to maintain the appropriate hedge on the Value side. Experience guides us to expect an adjustment in prices when the spread between what is cheap and what is expensive moves to historical extremes.

A new development this cycle, as market volatility has picked up, is seeing investors attribute defensive-like characteristics to mega-cap tech stocks. This is similar to the way they used to seek out the stocks of Consumer Staples companies, since most food, beverage, and household product companies typically held up better in an economic downturn. Today, these companies are struggling to grow their revenues in the face of evolving dietary habits and lifestyle changes. Consumer Staples stocks have been among the worst performers for the year.

It is not irrational for investors to expect the revenues and profits of Apple, Facebook, Google, and Microsoft to be less vulnerable in an economic downturn. But there may also be a price where this assurance becomes too expensive. In the meantime, Value investors finally get a shot at owning beaten up Consumer Staple companies, heretofore selling at price/earnings multiples too expensive for their tastes.

Outlook

The subdued results for the year seem logical considering the strong returns last year and the transitional environment we referenced earlier. The Fed has bumped interest rates twice this year and tells us they expect to do this twice more before year-end and maybe three times next year. Short-term yields have risen accordingly. Longer-term yields have edged higher, but appear less convinced that the Fed will have justification to be that aggressive.

This flattening of the yield curve (when short-term bond yields rise more than longer-term yields) is often a precursor to recession. The recent slowdown in Europe and China has helped keep pressure on our bond yields. Our independent macro work has not picked up any corroborating signals in other data that a recession is imminent. In our recent market update, we indicated that domestic economic activity should stay reasonably strong in the second half and be supportive of higher stock prices. Employment trends are strong, oil prices have spiked, and inflation hit the Fed’s 2% target for the first time since 2012. Bonds (and stocks) may very well be set up for a surprise if there are signs of a sustainable pick-up in inflation.

A key difference in the environment is the respective upside and downside when an economic cycle is seen as approaching peak levels. The upside can be constrained by how much investors are willing to pay for future earnings when the cycle is mature, even when those earnings are strong. Risk, likewise, takes on greater consequences when the cycle is extended.

As such, we should expect volatility to stay elevated in the second half. The cover story of this week’s Barron’s makes a case that the economy and bull market will run until 2020. In the meantime, investors and strategists will scrutinize every relevant and irrelevant data point for clues as to whether the underlying assumptions are changing. Regardless of when the cycle ends and another begins, our focus leads us to be a little more cautious in our security selection (higher quality, more domestic exposure) and affirming the appropriate asset allocation for clients to manage through the cycle.