Economic growth appears to have peaked in early autumn. Unemployment is now starting to rise, judging by weekly claims. On the positive side, inflation is slowing as well and corporate profits are expected to remain robust in 2019. Markets have absorbed these pieces of information and are reacting to the prospect of further Federal Reserve rate hikes. That said, fundamentals are almost never leading indicators. Stock prices and the yield curve have historically been much better at forecasting downturns. The yield curve is flashing a bright yellow warning sign, having inverted in the middle of the curve. The stock market is now flashing red, with every index on a sell signal as current prices have fallen below their 50 and 200 day moving averages with the former having crossed below the latter, known in the world of money management as the Death Cross. The S&P 500 index was the last of the indices to cross over (which is did last Monday). Based on the above factors, it is Trademark’s belief that we have entered a bear market. We don’t know how long it will last, but we expect this period of elevated downside risk to continue.
It is my personal belief that America’s chaotic pursuit of its trade objectives is the main reason the market is weaker than the fundamentals suggest it should be. This creates a dilemma for investors. The trade situation could be resolved if both the US and China were willing to deal in good faith, so it is somewhat dangerous to be too bearish[i]. On the other hand, this situation could get a lot worse if the planned and delayed tariffs ultimately take effect and the costs begin to be passed on to businesses and consumers (to some extent, this has already happened). Hence the volatility we see day in and day out depending on the latest report/rumor/tweet.
The strongest part of the stock market in recent weeks has been the defensives – utilities, real estate, consumer staples, and health care – but only the latter is doing anything in terms of profit growth. Technology, which has led the market since late 2015-early 2016 correction, appears to have run out of steam and looks over-owned and vulnerable right now. We may struggle until a new narrative and new sector leadership emerges. Utilities and staples, the best performers lately, do not lead a bull market.
I would love to recommend shifting money abroad, since valuations are cheaper and momentum in US stocks has broken down. Unfortunately, I can’t. Valuation is a poor short term indicator and overseas money has been languishing for four of the past five years. Fundamentally the “developed” markets look pretty bad. I would prefer to underweight developed markets even though they are inexpensive, because I don’t see a catalyst (either politically or in liquidity). China is being hurt by the trade conflict, is probably growing at the lowest rate in two decades, and it has a debt problem. Where China goes, so goes (most) emerging markets. That said, I’d still overweight EM vs. DM.
I have been surprised that financial services stocks cannot mount a rally with their forward P/E multiples in the neighborhood of 12x. Given the constraints put upon them after the great financial debacle ten years ago, most financial company balance sheets are in good shape. Perhaps the best way to play financials now is to own preferred stocks through a fund or ETF. Preferred stocks are higher up the capitalization spectrum so they are safer than common stocks and yields are around 5%. With the economy weakening, preferreds shouldn’t be hurt by rising rates (as they were in the first half of 2018).
High quality bonds are having a decent quarter while both medium and low quality bonds are not. You get paid more for taking a little credit risk for long stretches of time until suddenly you don’t. This is such a time. Investors are getting nervous about the high levels of corporate debt in the US, so they are trimming exposure in corporates in favor of treasuries, mortgages, municipals, and to a lesser extent asset-backed bonds. Even international bonds have become less horrible as the dollar is buffeted by political concerns and signs that the economy might have peaked. In the third quarter it paid to trim duration as much as possible, but duration has been your friend lately. I continue to recommend having a little bit of interest rate sensitivity, but still much less than the benchmark. Whatever your duration, you do want quality. High yield corporate bonds have struggled this quarter but issuance has been restrained, so I think that sector is 75% through its down cycle. The risk is in floating rate corporate debt, which was overissued and overbought. Many have very weak covenants as well. You may want to consider a floating rate Treasury fund like USFR.
Other than that, I am optimistic about 2019 being a strong year for emerging market debt. I believe the dollar will contract as the economy slows, the political climate becomes more uncertain, and the soaring deficit becomes more of a concern.
The idea that the economy is peaking is bullish for hard assets to the extent that the dollar would be expected to roll over as well. Neither oil nor gold can do much when the dollar is strong. News flow can provide a short term bounce for either, but until the market perceives that the Fed is done tightening, one should underweight these sectors. We may get a hint of that on Wednesday when the Fed gives its post-meeting guidance. Gold might be the biggest winner at the point when the Fed signals that it is done, so speculative money might consider a small position now.
-Mark Carlton, CFA
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[i] On the morning of the December 11th the Dow opened up 350 points on President Trump’s tweet to “expect a trade announcement very soon”, then fell over 500 points in the next four hours as the markets discovered that there was no substance to the tweet. This follows the pattern established after the summit in Argentina on December 1st when we were told that we had a great deal with Chinese and it turned out to be light on specifics.