As we pass 2019’s midpoint and pause to observe markets, we’re reminded of an old proverb that dates to classical times. In Histories of Alexander the Great, Curtius Rufus wrote, “Altissima quaeque flumina minimo sono labi,” or “The deepest rivers flow with the least sound.” Indeed, placid exteriors often mask risks hidden within. Many have expanded upon this lesson over the years—from Shakespeare to Aesop to prolific songwriters—reinforcing caution that seemingly calm waters may hold the greatest risks.
We feel this proverb describes the capital markets today. U.S. stocks are off to their best first-half start in more than 20 years, with large-cap stocks (as measured by the S&P 500 Index) up 18.5 percent through the end of June. International stocks lag—but not by much. International developed market stocks rose 14 percent (as measured by the MSCI EAFE Index), and emerging market stocks (as measured by the MSCI Emerging Markets Index) rose almost 11 percent.
We continue to see strong returns from core domestic bonds as well, with the Bloomberg Barclays U.S. Aggregate Bond Index up more than 6 percent year to date, propelled by a potent combination of declining Treasury yields and tightening credit spreads.
All appears calm on the surface. But risks may lurk below, and we see reasons for caution. In this edition of Investment Strategy, we explore a number of policy and fundamental risks lurking in the apparent calm as we head into the second half of the year.
China Trade Negotiations
Among the greatest perils for the second half of 2019 is a swirling mix of policy uncertainty. Policy factors are notoriously difficult for markets to interpret—and therefore contribute to price volatility—because they often represent binary decisions reached behind closed doors by unpredictable groups of human beings.
Following the 2016 election, the new administration quickly lit a fire under the domestic economy through tax cuts and fiscal stimulus. This boosted after-tax corporate earnings and stimulated business investment. Since then, however, the administration has thrown some water on the fire in the form of trade policy uncertainty.
We were hoping to have more clarity on trade and tariff negotiations with China by this summer, but trade negotiations continue to linger unresolved, leaving business executives in limbo. Recent client conversations illustrate the tangible business impact of this uncertainty. As manufacturers prepare for the holiday shopping season, do they shift production from China to Vietnam—or somewhere else? Should they pull production forward? How will profit margins be affected?
Within the globally interconnected supply chain, this uncertainty represents friction that slows decision-making and erodes confidence.
The perils of an extended China trade spat could offset some of the other positives we see within the economy, including the U.S. consumer’s continued strength and the potential for more accommodative monetary policy. Certainly, resolution could boost market confidence, but it could also break the other way. And the longer these tense trade negotiations persist, the more likely they are to directly impact consumers, posing risks to our consumer-dominated economy.
The Federal Reserve
The level of interest rates is of pivotal importance to economic activity. As recently as December 2018, the Federal Reserve was raising rates and shrinking its securities portfolio. Abruptly, in late December and continuing through today, we have heard increasing talk of cutting rates, and the pace of balance sheet reduction was reduced in May.
Securities markets have priced in at least one—and maybe two—rate cuts during the second half of the year, with the first as early as late July. This creates a bad-news-is-good-news environment for stock prices if softening economic data appears to increase the likelihood of a rate cut. The peril of this situation, of course, is that at some point, bad news could truly become bad news, a condition that will not be clear until after the fact.
The promise of a more accommodative Fed has fueled the strong rebound in stock prices; we see evidence of this beneath the surface of stock returns over the past 18 months. When interest rates and bond yields fall, yield-hungry investors seek bond proxies in stock sectors such as utilities and real estate. It’s rare to see these sectors rally alongside the more growth-leaning sectors—such as technology and consumer discretionary—but that’s exactly what has occurred since the beginning of 2018, as shown in Figure One.
Figure One: S&P Index Sector Returns (1.1.2018–6.30.2019)
Source: CAPTRUST Research
Meanwhile, more cyclical sectors with the most direct linkages into the state of the fundamental economy—such as industrials, financials, materials, and energy—have lagged.
Elections and Political Uncertainty
Even if the two policy factors above break in our favor—we reach a trade deal with China, and the Fed applies the right stimulus at the right time—we could still be entering a season of heightened policy uncertainty and risk heading into next year’s elections. The 2020 election cycle will be a significant driver of market sentiment due to uncertainty around future policy, regulation, and the path of tax rates. Although still very early in the election season, polls are very close, making it difficult to forecast the tax and regulatory environment of 2021 and beyond. Markets and investors must digest a wide range of possibilities.
Last week provided a glimmer of bipartisan hope in the form of a tentative budget deal reached by the White House and congressional leaders. Assuming passage by the House and Senate, the deal would reduce policy risk around budget caps and a potential government shutdown. Although federal spending would increase under the announced deal, it would not represent a significant source of fiscal stimulus when viewed relative to the growth of gross domestic product (GDP). We view this agreement as a positive but remain cautious. Implementation details must be worked out by Congress in September.
Politics via Social Media
Underlying all of the uncertainties described above is the evolving way in which policy matters are introduced and negotiated on social media platforms. In the past, policy topics such as monetary policy, trade negotiations, and foreign exchange rates were discussed, negotiated, and often advanced to near resolution behind closed doors, before being widely broadcast. Today, these matters are tweet-debated from the very earliest salvo and are also used as chips to advance other social agendas. The sausage making is being live-streamed, with the potential to affect our appetites. If nothing else, we have greater visibility into the range of uncertainties that exist and the distance between stakeholders (either within or across party lines) on these issues.
Even as the range of policy risks described above receive the bulk of attention from the financial media, a number of fundamental signals point toward potential dangers in the global economy.
The pace of economic growth continues to slow across the globe, and fundamentals have been on a weakening trend for more than a year. Global GDP growth is expected to slow to 3.2 percent in 2019, down from 3.5 percent last year. The growth picture in Europe is particularly weak, and China is estimated to have completed almost 90 separate stimulus efforts over the past year to boost its flagging growth.
An important leading indicator of economic activity is Purchasing Managers’ Index (PMI) survey data, which provides a reading on corporate purchasing trends. It can provide early insights on unfolding market conditions by indicating if business activity, such as spending and hiring, is expanding, contracting, or staying the same. Recent global PMI data shows business conditions deteriorating the most since late 2012, with manufacturing declines seen across Europe and Japan. Within the U.S., the PMI has fallen to its lowest level since 2009.
As shown in Figure Two, when global PMI data peaked and then turned down in early 2018, stock prices initially followed the downward trend into late 2018 before rallying back against the PMI trend in 2019, likely buoyed by expectations of a Fed rate cut.
Figure Two: S&P 500 Equal Weighted Index, Global Manufacturing Purchasing Manager Index
Source: CAPTRUST Research
The level of corporate earnings is a fundamental driver of stock prices because it is a share of those earnings that investors buy with a share of stock. As shown in Figure Three, corporate earnings growth has flattened since the end of 2018, corresponding to the period of higher price volatility we have experienced since then.
Figure Three: Corporate Earnings Growth, 2014-2019
Source: CAPTRUST Research
Stock price returns in 2019 have been driven by valuation expansion—growth in the price-to-earnings ratio—rather than by the growth in earnings, and earnings expectations for the second half of 2019 have softened. Recently, we have seen the majority of earnings revisions to the downside. Whether such revisions are designed to provide room for upside surprise or reflect a true deterioration of outlook remains to be seen. Some of the firms with the largest cuts to outlook are those with the most exposure to China trade, such as semiconductors.
Positioning for Hidden Risks
Despite the range of risks and uncertainties described in this article, we do not believe a major downturn in the economy or asset prices is imminent, or a forgone conclusion. Some of the best market returns can occur at the end of a business cycle, and we aren’t certain we are there yet. We do believe we’re heading into a time of wider dispersion of outcomes, making the case for the importance of a sound portfolio strategy when uncertainties rise.
To that end, there are a few important steps that investors can take in the face of uncertainty:
- Re-examine your tolerance for risk and rebalance portfolios to target. With the run-up in stock prices this year, capturing gains while returning to strategic targets is a prudent step. For investors of all types—from retirement plans and foundation portfolios to individual investment accounts—the best defense against uncertainty is to maintain an asset allocation strategy that is both sound and suitable.
- Remain highly diversified. Diversification is the best way to strengthen portfolios. Even as a small number of traditional asset classes continue to outperform—notably U.S. large-cap growth stocks and corporate bonds—the value of maintaining a well-diversified portfolio across categories, geographies, and investment style is more important than ever.
- Maintain flexibility to act upon opportunities. Think about the nature of market undercurrents to identify ways to improve portfolio efficiency and find areas of relative strength. We continue to develop strategies to take advantage of uncertainties we foresee on the horizon.
Remember, times of heightened uncertainty can lead to great
opportunities for investors who position themselves to take advantage of it.
 Williamson, Chris, “Global Manufacturing PMI Slides to Lowest Since 2012,” IHS Markit