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Market Update for September 18th, 2019

Thoughts ahead of this week’s Federal Reserve meeting:

  • Investors expect that the Federal Reserve will ease 25 basis points. This time there is very little expectation that a stock rally will follow.  There might be one if the Fed unexpectedly eases by 50 basis points, but the recent economic results and the oil spike follow the attack on Saudi oil fields probably take that off the table.
  • The strong sell-off in the bond market over the past week was the result of investors running too far with the narrative of the U.S. following the rest of the developed world into negative rate territory. This is still a possibility, but I don’t believe it’s a probability.  In any event, the temporary (maybe?) thaw in U.S.-China relations led investors to be less sure of recession than they had been throughout August.  The result was a rapid reversal of the summer’s big bond trade (long duration/short credit) and stock trade (long defensive/short cyclical) …
  • … which serves to underscore the point I made back in July. Diversification is one of those things that you need the most when you don’t think you need it.  Stick to your discipline.
  • Gold is at this moment almost completely a recession play. If the economy tilts toward recession, the central bank is obligated to do everything possible to prevent it.  Most (if not all) of these measures are at least partially designed to weaken the currency.  Gold will rise the most in the currency of the country/region in which the central banks are most intent on debasing the currency.  On the other hand, if a country’s economy improves and investors believe central banks have scope to behave more prudently, gold will come under pressure.  We saw that last week in the U.S..
  • I would not buy the spike in energy prices as a result of the Houthi drone strike. Oil crisis risk had probably been underpriced, and obviously that has been corrected.  I see the spike in oil prices as a short-term reaction and see little reason at this point for energy prices to be stronger in the intermediate-to-long run.  I believe the economics for the energy sector will only improve when several companies fail, allowing production to be cut and prices to rise.  Low interest rates and yield starved investors mean marginally profitable companies can still access credit at reasonable rates, which hurts everyone’s bottom line.
  • I believe the market has over-reacted in terms of pricing recession risk out of equity prices and pricing inflation risk back into bonds. It is true that the economic reports released over the past two weeks have generally been stronger than they were in August, but I believe the U.S. economy still has more pockets of weakness than strength.
  • Even if the U.S. and China truly make nice (they won’t) the Chinese economy is slowing uncomfortably even in the face of PBOC stimulus. I believe the Chinese currency is going to weaken due to it’s economic (non)performance, and the U.S. is going to regard the falling yuan as proof of manipulation (which will only make the trade situation tougher).
  • One of the reasons we recently chose to lighten up equity exposure is the market’s resilience, ironically. When the bull market is in its infancy, investors panic at the first sign of weakness (see April to July, 2010).  As the bull gets long in the tooth, however, investors become so confident of the market’s strength that they don’t lighten up even as the backdrop continues to deteriorate.  A wholesaler recently remarked to me that this is the bull market everybody hates (arguing that because investors weren’t euphoric yet stocks still had a ways to go on the upside).  I told him that investors may not be feeling like they did in 1999 but that’s not what their portfolios are saying.  I’m not trying to time the market; I just don’t see much potential upside from here from P/E or profit margin expansion while the market’s vulnerability to economic and political/geo-political shocks seems unusually high.

 

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