Strategy Updates

Fed Pivots, Trade War Ensues and Earnings Loom

Over the past 18 months, global investors have experienced a number of crosscurrents which created quite a bit of drama, yet yielded little upside in global stock markets. For those less invested during this strange period, there has been little missed opportunity. During the past year and a half I have witnessed stock indexes attempt new highs not once, but three times, without success.

I find this current fourth attempt of interest, since it is in the face of impending earnings results, well-documented slowing economic growth, trade wars and an inverted yield curve – all of which has caused the Federal Reserve to finally agree that we may have veered off “the yellow brick road” as they now consider lowering interest rates. If and when the Fed reduces rates, will it be too late given the well-publicized weakness in so many economic indicators? And what should investors anticipate for the second half of this year?

In many of my previous Strategy Updates, I have emphasized the importance of data: economic and corporate profit growth is essential for meaningful stock market returns. However, a third prong – policy – has played an increasingly important role in financial markets as evidenced by trade wars and the Federal Reserve. Has our path to generating great long-term returns changed? Should we say, “Goodbye yellow brick road?” I think not.

Trade wars pose a significant risk to global financial markets as companies are forced to rethink supply chains, which impacts margins and ultimately profitability. With earnings season right around the corner, there are already a few companies like Broadcom and FedEx reporting poor quality earnings with explicit citation of geopolitical uncertainties – namely the trade war! It will be interesting to see if these reports are the “canary in the coal mine.” We continue to believe that this trade war must be resolved in order for this market to resume a longer-term uptrend.

Jerome Powell and his colleagues at the Fed have pivoted their policy from just short six months ago, which has led investors to price-in rate cuts by year’s end. The purpose of lowering interest rates is to stimulate an anemic economy and inflation rate while attempting to counteract the inverted yield curve, which has historically preceded recessions. However, the idea of cutting interest rates so soon and so aggressively suggests that the US economy and moreover global economies are not on firm ground – a view we have had for some time now.

We certainly do not want to “fight the Fed” if they do decide on a more accommodative policy path like European counterpart, Mario Draghi. However, simply flooding the stock market with additional capital is a bandage on a ten-year wound, which has never fully healed post-2008. The Fed’s lack of tools – specifically the inability to cut rates further from an already low level – leaves the global economy particularly vulnerable as we go forward. This is why I stand prepared to thoughtfully add stock exposure if the Fed acts as the markets want, yet keep on hand risk management tools, such as stop-loss orders and sector management if simply lowering rates does not get this economy back on track.

While both global economic growth and earnings quality have decreased over the past few quarters, they are still positive (particularly in certain sectors), which bodes well for businesses with consistent revenue models – think goods and services you cannot live without! These are the types of companies we want in your portfolio. The better than expected index performance in defensive sectors such as utilities, consumer staples, and healthcare this year has validated my thesis.

A lower interest rate environment would also offer more interesting opportunities in the public real estate market (REITs) and select business models. I am cautiously optimistic that the backdrop of low inflation, an accommodative Fed and resilient economic and earnings data will get this market back on track. I expect several corrections along the way as policymakers and companies alike navigate this new landscape and we should stand prepared to thoughtfully add exposure to sectors and companies performing well in this environment. Should trade talks continue to break down, the Fed acts too late, or corporate profits and economies deteriorate further, be well prepared to weather the storm.

When there are periods of conflicting asset prices and data, I tend to err on the side of caution, as protecting capital in bear markets allows you to better reach your long-term goals of retirement, spending policy guidelines, or next-generation legacy. In that spirit, continue to look for further evidence of better earnings quality, economic growth, and trade resolution before becoming significantly more invested with your portfolio. I think such a period may come sooner than most investors think.

I hope you find this update helpful.

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Long-term investment success often requires short-term periods of patience, restraint and being value-conscious. In today’s fast-paced, short-term performance, the digitally-driven world this can be a challenging combination. However, the discipline to step away from short-term “noise” and carefully examine the “forest” as opposed to the “trees” can result in significantly better long-term returns. This can often mean going against the crowd in the face of a falling or rising market.

Years ago I learned that short-term movements in equity markets are driven by psychology, but long-term trends are driven by economic and corporate profit growth. This comes to mind during the past few months as I witnessed the dichotomy of sharply rising stock prices in the face of declining economic growth and corporate profits. Investors need to ask at this point which of the two – the recent direction of stock prices (up) or corporate profits (down) – has greater longevity? And, how will this play out over the next few months and the balance of the year?

In just a few weeks, stock prices appear to have lost their momentum. In fact, for most of March, global stock indexes were in the red. At the same time, economic statistics and corporate profit reports have continued to deteriorate. Perhaps the long-term fundamentals are beginning to trump short-term psychology? I believe that this may be the case. The bond market, which has historically been the best predictor of such things, appears to agree.

This is evidenced by the bond market’s recent yield curve inversion – short-term yields higher than long-term yields. This unusual phenomenon often precedes weaker economic data and profits. A bit more time, along with earnings and economic data in April, should bring the disparity between stock prices and underlying fundamentals back in line.

We faced the beginning of a bear market in the fourth quarter of 2018 with most indexes down 20% and many sectors down much more. Though we don’t predict Armageddon for the global economy or stock market, we also do not believe that a real bull market can begin again without at least a normal correction or perhaps something worse. We may be on the precipice of such a move given that the market has lost its momentum and we are heading into what is likely to be a dismal period of earnings reports and economic statistics from the first quarter when the US Government was shut down. For that reason, we continue to be a bit more defensive than your normal, fully invested portfolio.

I suggest you continue to search for and take advantage of isolated opportunities in companies that represent great value regardless of the market’s direction. These are difficult to find and, given the overall market environment, the pace of adding significant exposure has been slow.

It is always difficult to predict with accuracy the direction of stock prices, but one simple rule holds true: When the economy and corporate profits are rising, stocks do great! That has just not been the case over the past 4 months, which poses a risk to investors. As a reminder to anyone who has experienced a normal bear market, stocks typically fall before the bad news about profits as happened in October – and then have sporadic, often significant, advances as we’ve seen recently – only to decline again into poor earnings reports.

Though global stocks historically decline approximately 40% during an average bear market, I am not predicting such an outcome. In fact, be ready to become more growth-oriented as soon as stock prices and earnings growth are more aligned – most likely when stock prices are lower and most of the bad news about profit growth has been digested. I wouldn’t be surprised to see this come to fruition in the next few months.

After decades of managing money, I have experienced a number of these short-term periods of being less invested and they have proven to be a bit trying in the middle, but valuable in the end. None of those past periods lasted more than months and I don’t expect this period to be an exception.

The Sustainable Endowment was written for executives and board members of small- to mid-size U.S.-based nonprofits, charities, or foundations. Running a nonprofit requires specialized knowledge and skills, especially regarding foundation management and investing your endowment so it remains sustainable for years to come.

This book walks you through the basics and best practices of what you need to know to be successful.

Order your copy today on Amazon