News and Commentary

2019 Third-Quarter Outlook by Joseph Karl, CFA

The U.S.’s current economic expansion surpassed the 10-year mark in June to become the longest in the nation’s history. Economic indicators during the first half of this year tempered fears of an imminent recession and helped stocks recover from their late-2018 levels. Despite our belief that there is room for further economic growth, we are mindful that many of the same concerns and uncertainties from previous quarters continue to exist today. This creates a challenging environment to predict future market conditions and requires investors to work with their advisors to view current economic and market data in the context of their unique portfolio strategies that align with their equally diverse individual financial goals and objectives.

ECONOMY

Given the length of the current expansion, we are, on some levels, in uncharted territory. Making decisions requires a narrow focus on the things that can help the economy continue to grow and an effort to identify the potential risks that may hinder that growth going forward. Following are four factors we believe to be most relevant in this analysis.

Duration vs. Actual Growth

The economic expansion is long in terms of its duration, but it has been relatively weak in terms of actual growth. Historically speaking, cumulative real GDP growth during the past 11 economic expansions has outperformed the current post-recession expansion, as indicated in the chart below. In the current cycle, wages, residential investment and capital expenditures still have room to strengthen further.

Figure 1. JP Morgan Guide to the Markets

Additionally, while this period represents the longest expansion in U.S. history, it is far from unprecedented globally. For example, the last time Australia was in a recession was in 1994, and China has not had a recession in more than 40 years. Consequently, the U.S. economy may have more room to run given its moderate growth, and length alone should not prompt conservative action.

Federal Reserve

As expected, the Fed cut interest rates a quarter of a point on July 31, 2019, and ended its quantitative tightening program. Putting this information into context, we must consider that the Fed raised rates four times in 2018 before reversing course in January 2019, when it floated the idea that rate cuts could be possible if the data warranted it. Although the Fed did not take any measurable action at that time, you can see from the chart below (indicated by the red line) that the Fed’s comments alone significantly calmed markets and eased broader financial conditions as illustrated by the Chicago Fed National Financial Conditions Index (indicated by the blue line).

Figure 2 St. Louis Federal Reserve

In June, Federal Reserve Chairman Powell stated that “an ounce of prevention is worth a pound of cure” and subsequently cut rates in late July, clearly indicating that the Fed is trying to extend the current economic expansion. To understand why the Fed would make such a dramatic policy pivot, consider the following:

  1. 1.Historically, in response to previous recessions, the Fed lowered interest rates by an average of 5.5 percent. With interest rates currently at only 2.25 percent, and assuming we are constrained at the lower end at zero, the Fed has less than half of its ability to accommodate. If the Fed can extend the expansion and allow the economy to strengthen further, it would be in a better position to push interest rates higher and provide more accommodations in the next downturn.
  2. S. government debt as a percentage of GDP currently stands at 78 percent. Not only is this twice the average of the past 50 years, the Congressional Budget Office projects debt-to-GDP to continue to grow and reach 93 percent in 2029.1 The easiest way to reduce this debt is with a strong economy that increases government revenue (via taxes) and reduces our dependence on debt.
  3. It typically is not desirable to have an overly accommodative monetary policy that lets the economy run too hot, because it can lead to higher inflation. However, deflation is even less desirable given that it is so difficult to reverse once it sets in, as exemplified by Japan. Since the financial crisis, inflation has consistently undershot the Fed’s 2 percent target, prompting various Fed officials to make comments eluding to a modest inflation overshoot and revisiting their framework earlier this year.

Trade

Following the Fed’s July rate cut, President Trump wasted no time announcing new tariffs of 10 percent on the remaining $300 billion in Chinese exports effective September 1, 2019. China subsequently allowed its currency to depreciate below ¥7.00 vs. the U.S. dollar, prompting the U.S. to label China a currency manipulator, which created concerns of a currency war and caused markets to sell off.

The chart below shows the U.S./China exchange rate (red line) and a trade-weighted U.S. dollar index versus a broad basket of currencies (yellow line). From this data, we can infer the following:

  1. For both sets of data, the higher the line, the stronger the U.S. dollar is relative to the yuan and to other currencies. Today the dollar is rather strong. Additional strengthening makes U.S. goods and services more expensive and therefore less competitive for consumers and businesses located outside of the U.S.
  2. In recent years, the Chinese/U.S. foreign exchange rate and trade-weighted U.S. dollar index have moved in sync with one another, implying that the Yuan/Dollar relationship has implications outside of those two currencies.
  3. While the move above ¥7.00 is the weakest the yuan has been since 2008, the yuan was pegged to the dollar at ¥8.27 from 1997 to 2005, roughly 18 percent weaker than today. 2

 

Figure 3 St. Louis Federal Reserve

Breaking the ¥7.00 level was a somewhat-psychological barrier for markets as it had not exceeded that level in over a decade. However, the movement was a natural reaction to the new tariffs. In other words, it would have been difficult for China (which still manages the value of its currency to a broad basket of currencies) to maintain a rate below ¥7.00, therefore allowing market forces to push it weaker. China could allow the yuan to depreciate further as a tool in the trade war, but doing so would likely create additional challenges to its government, such as capital flight, which could be difficult to manage and may create more problems that it may solve. If China is intent of challenging the U.S. as the world’s economic leader, it is not going to get there by weakening its currency and creating concerns over its stability.

The re-escalation of trade tensions is an indication that a comprehensive long-term deal is unlikely in the near future. Given the continuous start-and-stop nature of negotiations up to this point, it is difficult to speculate when and if a deal may be reached. Further, it is clear that neither the U.S. nor China wants to be perceived negatively, and both are viewing the negotiations through their own lens and taking calculated actions intended to motivate the other country’s behavior. While the Trump administration may be motivated to get a deal done before the 2020 election campaign heats up, it is more likely that negotiations between the two nations will continue for years and possibly even decades.

Predicting how long the trade disputes will last is a challenging endeavor, and it is something we have and will continue to monitor closely. With that said, we do believe that both the U.S. and China want to get a deal done. Although each country may take actions to influence the other’s behavior, both governments will be cautious to make sure that they do not cross the proverbial line in the sand that can lead to a negative outcome. Both sides understand they are walking a fine line. Overstepping that line could lead to equally negative consequences for their respective countries, ultimately weakening their negotiating leverage in the trade war they want to win and impacting the entire global economy along the way.

 Employment and Consumer Spending

Because consumer spending accounts for roughly 70 percent of our economy, it is a critical factor to consider when trying to measure economic growth. Current data is rather strong with unemployment at a 50-year low, wages growing at a modest pace, higher savings rates and consumer confidence remaining at elevated levels. We believe that this data combined with an accommodative Fed and a strong labor market are enough to propel the economy forward. However, given the length of the expansion, we will continue to monitor for signs of weaknesses and take defensive actions as needed.

EQUITIES

After falling almost 20 percent in the fourth quarter of 2018, the market, as measured by the S&P 500, fully recovered and even recorded additional gains to reach all-time highs in 2019. Through the end of July, the index settled up 20.24 percent year to date, and up 7.99 percent over the prior 12 months.3 Since the lows of March 2009, the S&P 500 is up 439.5 percent.4 Given recent volatility and an already long economic expansion, it is natural for investors to ask “how much upside could be left?”

To put things in perspective, consider the following:

  1. From 1950 to 2018, stocks have averaged 11.1 percent per year, exceeding the returns on bonds by 5.3 per year over that same time period.4
  2. Markets can rally for an extended period of time. For example, for the 18 years between 1982 and 2000, the S&P 500 increased 18.81 per year. For the 10 years since the March 2009 lows, the S&P 500 has risen 16.79 percent per year.3
  3. Corrections, which are defined as market declines greater than -10 percent but less than -20 percent, are quite common. For example, between 1982 and 2000, there were a total of eight corrections and one bear market (in 1987). 5
  4. Bear markets, defined as market declines of 20 percent or more, are the events investors should try to avoid, since they tend to be more severe and take longer to recover from than corrections. More often than not, bear markets are associated with recessions, which is why so much attention is paid to current and expected economic conditions.

To help us gauge where returns could be headed in the near-term, we must consider some additional factors outlined below.

Let’s start with dividends, which are currently 2.05 percent for the S&P 500. It is fair to assume that dividends will remain at 2.0 percent, which is extremely close to the 25-year average.3 Next, we can look at earnings growth, which is projected to be 2.7 percent for 2019, with an expected increase to 10.6 percent in 2020.6 The current forward P/E is 16.74, as compared to 16.19 for the past 25 years. If we assume that the forward P/E moves back to normal, there would be a decline of -3.2 percent. Taking all of this data together, the expected rate of return for stocks is approximately 1.5 percent.

2.0% Dividends + 2.7% Earnings Growth – 3.2% Valuation = 1.5% Rate of Return

While this is an oversimplified analysis, it allows us to form a baseline from which we can consider different scenarios that could change expected rate of return.

Scenario 1: Assume modest economic growth resumes, recession concerns ease, valuations remain at current levels, bond yields remain low, and the recent drag on corporate earnings from a strong dollar and weak international sales abates. If we further assume analyst estimates for 2020 earnings growth is correct at 10.6 percent, with no change in valuation, we would expect stocks to yield returns of approximately 12.6 percent. (2.0% + 10.6% + 0.0% = 12.6%)

Scenario 2: Assume that we do, in fact, have a recession. If we look at bear markets going back to 1835, the average decline is 35 percent with an average of more than 4.5 years to fully recover.7

Next, we can assign what we believe are appropriate probabilities to each scenario.

 

Scenario Expected Return Probability Weighted Average Return
Base Case 1.5% 50% -2.47%
Scenario 1 12.6% 30%
Scenario 2 -35.0% 20%

 

As the exercise above illustrates, we remain optimistic and place higher probabilities on the scenarios with positive returns. However, the return profile of the bearish market overcomes both of those, and pushes the weighted average expected return into negative territory.

Viewing these possibilities through this lens also shows why it is critical to consider this information within the context of one’s own investment goals and objectives. For clients that are close to or currently relying on their portfolios for cash flow, we recommend exercising caution at this time, given that portfolios relied upon for cash flow are more sensitive to market declines.

On balance, we continue to believe that stocks still have some room to run and can continue to produce attractive returns above alternatives, such as bonds and cash. However, with uncertainties over trade and an already long economic expansion, there is likely to be bouts of volatility. Further, outside of a significant pick-up in economic growth, the best returns are likely behind us. Given these dynamics as well as the return profile mentioned above, we have made several defensive moves within our discretionary portfolios.

Fixed Income

The 10-year treasury started the year at 2.66 percent after reaching a temporary high of 3.25 percent temporarily last fall. Currently, bond yields have moved much lower with the 10-year treasury currently at 1.77 percent. Historically, longer term bond have offered protection against recessions and stock market volatility as money flows into longer term bonds. However, in today’s low interest rate environment, with parts of the yield curve inverted and more than $12.5 trillion in global bonds with negative yields, fixed income remains a challenging place to deploy capital.

Even still, fixed income remains a critical component of a well-diversified portfolio. It offers price stability and cash-flow production that can provide a ballast to a portfolio’s more growth-oriented portions. Given the uncertainty of precisely how long the economic expansion will last, we continue to believe that the best way to position your fixed-income exposure at this time is to 1) keep a slightly underweight exposure to duration, 2) maintain a reduced exposure to maturities in 2021-2026 and 3) increase credit quality.

CONCLUSION

The U.S. continues to be in the midst of its longest expansion in history. In these unchartered waters, gauging future growth will only get more challenging. This, combined with uncertainties over trade, has prompted us to make additional defensive moves in our discretionary portfolios. However, given the strong labor market and rather patient and accommodative Fed, we continue to believe that the positives outweigh the negatives, and the current expansion has further room to run.

 

About the Author: Joseph Karl, CFA, is Chief Investment Strategist with Provenance Wealth Advisors (PWA), an Independent Registered Investment Advisor affiliated with Berkowitz Pollack Brant Advisors + CPAs, and a registered representative with Raymond James Financial Services. For more information, call (954) 712-8888 or email info@provwealth.com.

 

Provenance Wealth Advisors, 515 E. Las Olas Blvd., Ft. Lauderdale, FL 33301 (954) 712-8888.

 

Joseph Karl, CFA, is a registered representative of and offers securities through Raymond James Financial Services, Inc., Member FINRA/SIPC. Raymond James is not affiliated with and does not endorse the opinions or services of Berkowitz Pollack Brant Advisors + CPAs. PWA is not a registered broker/dealer and is independent of Raymond James Financial Services. Investment Advisory Services offered through Raymond James Financial Services Advisors, Inc., and Provenance Wealth Advisors.

 

This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Any opinions are those of the advisors of PWA and not necessarily those of Raymond James. You should discuss any legal matters with the appropriate professional. Prior to making an investment decision, please consult with your financial advisor about your individual situation.

 

The information contained in this report does not purport to be a complete description of the securities, markets, or developments referred to in this material. The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investments mentioned may not be suitable for all investors.

 

The S&P 500 is an unmanaged index of 500 widely held stocks that is generally considered representative of the U.S. stock market. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Every investor’s situation is unique and you should consider your investment goals, risk tolerance and time horizon before making any investment. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is an inverse relationship between interest rate movements and fixed income prices. Generally, when interest rates rise, fixed income prices fall and when interest rates fall, fixed income prices generally rise. Past performance may not be indicative of future results. While we are familiar with the tax provisions of the issues presented herein, as Financial Advisors of RJFS, we are not qualified to render advice on tax or legal matters. You should discuss tax or legal matters with the appropriate professional. The above hypothetical examples are for illustration purposes only. Actual results will vary. Future performance cannot be guaranteed and investment yields will fluctuate with market conditions. Diversification does not ensure a profit or guarantee against a loss.

 

Sources:

 

  1. The Budget and Economic Outlook: 2019 to 2029, Congressional Budget Office
  2. China’s Evolving Exchange Rate Regime, IMF Working Paper, Sonali Das, March 2019
  3. Morningstar Direct https://www.morningstar.com/
  4. JP Morning Guide to the Markets, 3Q 2019, as of June 30, 2019
  5. “Market Briefing: S&P 500 Bull & Bear Markets & Corrections” Yardeni Research August 5th, 2019.
  6. FactSet, Earnings Insight, August 2nd 2019 https://www.factset.com
  7. “Bear Necessities, an update” Goldman Sachs November 9th, 2018

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