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July 2019 Investment Commentary
Both stocks and bonds produced solid gains over the second quarter, building on the previous quarter’s strong returns and benefitting client portfolios. Stocks were bumpy – the ACWI world stock index’s 3.6% quarterly return comprised a monthly sequence of +3.4%, -5.9%, and +6.6% -- tracking the state of U.S.-China trade dialogue, whose two protagonists make up 40% of the world economy. A May 5th tweet by President Donald Trump, which ended an anticipated deal and led to additional tariffs, acted as a key hinge point. Spirits then improved in June on more level-headed dialogue and the approach of the month-end G20 meeting, featuring an expected, and indeed realized, Trump/Xi Jinping détente.
|Second Quarter||Year to Date||Five Years (ann.)|
|Developed International Stocks||3.7||14.0||2.3|
|Global Hedge Funds||1.6||4.2||-0.1|
The other key driver in the quarter was the growing anticipation of central bank policy ease, and this pushed bond interest rates sharply down, and prices up, both here and abroad. The ease is seen as a necessary response to economic storm clouds tied to trade and global supply chain upheaval. Closely watched purchasing manager indices (PMIs) in June signaled manufacturing contraction in many key economies, including China, Japan, Germany, the UK, Russia, South Korea, and Italy, and moderating growth in the U.S., its weakest reading since October 2016. With central banks publicly recognizing these trends, rates dropped across regions. The U.S. 10-year Treasury rate dropped from 2.41% to 2.01% over the three months, while corresponding rates in both Germany and Japan moved deeper into negative territory, from -.07% to -.32% and from -.09% to -.16%, respectively.
The latest U.S.-China cease fire, achieved at the June 29th G20 meeting in Osaka (an earlier truce having been hammered out at the previous G20 in Buenos Aires seven months earlier, lasting until May), likely headed off a greater economic threat. The still relatively healthy consumer sector was spared a large dose of pain. After increasing the existing 10% tariffs to 25% in May on $250 billion of the roughly $550 billion in goods we import annually, we were ready to start 25% tariffs on the remaining $300 billion. While the first lot largely consists of intermediate and capital goods, typically bought by companies, the larger, second lot spans a variety of consumer items, bought by shoppers. This includes some 4,000 product categories within housewares, clothing, smartphones and other technology, toys, sporting goods, and drugstore essentials. Retailers, with traditionally low margins, presumably would have passed along much of the cost of goods sold increase, directly hitting pocketbooks.
So far in 2019, U.S. economic performance has been moderate but solid, in line with previous years. The first quarter GDP’s 3.1% growth rate was the best opening quarter since 2015. More muted growth is expected in the second quarter, closer to 2.0%, as the first quarter’s high net exports and inventory investment are expected to naturally reverse. Full year growth is expected to come in within the same 2.0-2.5% range that has characterized the recovery that began on July 1st, 2009. The ten years since tie the longest expansion on record (March 1991 to March 2001), but in respects other than length, this recovery has been sub-standard. U.S. GDP grew roughly 28% over the period, compared to 42% in the 1990s expansion, and 38% and 52%, respectively, over shorter recoveries in the 1980s and 1960s.
Why is this? Theories abound, but among many factors, we’ve seen underinvestment in the public sector, with infrastructure and other spending curtailed by Congressional inaction, and the private sector as well. Corporate capital expenditure has been below average for most of the period, measured either as a percent of revenue or in terms of year to year growth. According to Credit Suisse, growth was stuck in and around zero from 2013 through 2017, then briefly moved higher in 2018 in response to the late 2017 corporate tax cut, and since then has retreated. And by most accounts, even with the tax cuts there has been a predisposition to return money to shareholders via dividends and share buybacks rather than invest in capital equipment. Last year saw more than $800 billion in stock repurchases, the most in a single year.
The better news regarding the dull recovery is a lack of excess, making a hard downturn gravitationally a bit less likely. On several measures, consumers, who account for two-thirds of economic output, have acted conservatively. The credit binge that brought us down in 2008 has not reappeared. Household debt payments as a percent of disposable income stood at only 9.9% in the second quarter, the lowest in at least 40 years and well under the 13.2% high late in 2007. Similarly, residential investment, and motor vehicle and parts consumption, expressed as a percent of GDP, both have stayed well under their 50-year averages throughout the recovery. Barring an extreme event, then, our economy could muddle around a recession for some time. (Australia is not the U.S., but its recovery has reached the 28-year mark.)
Assuming the trade rhetoric stays cool, investors’ immediate attention will be on whether central banks make good on expected monetary ease. The European Central Bank and Federal Reserve both have openly offered within the last few weeks that their next moves will be in that direction. More recent indications are that the ECB might prefer to watch the PMI and other data into the fall before acting. But encouragement has come with the seemingly market-friendly Christine Lagarde set to succeed Mario Draghi on November 1st, as opposed to a more hawkish choice such as Germany’s Jens Weidmann. Jerome Powell is widely expected to reduce the current 2.25-2.50% policy rate by .25% at the end of this month, which would be the first cut since December 2008, and come right on the heels of four hikes in 2018. The odds lessened a bit with the June jobs report, which showed a strong recovery to 224,000 added, up from May’s disappointing 72,000 increase.
Meanwhile, U.S. stock valuations, on 2019’s rise, will test investors unless we see a resumption of earnings growth to support them. After strong gains of 9.3%, 16.2% and 20.5% in 2016-2018, we may see something closer to zero earnings growth this year; second quarter indications have been soft, with many companies blaming the trade issues. But according to FactSet, a return to double digit growth is expected by the start of 2020. This would imply a lofty but manageable forward price/earnings ratio of 16.8 times, versus respective five and ten year averages of 16.5 and 14.8 times. Obviously, much will depend on economic ground conditions, including the state of play with China, and other major trading partners (to wit Mexico, against whom President Trump briefly threatened tariffs as a border response).
With the approach of fifth generation (5G) mobile telecommunication, and possible big leaps in enterprise software, artificial intelligence, and digital payments, we may in fact be on the doorstep of a true renaissance in capital spending and investment, ending the ten years of relative dormancy. One hedge fund manager, Prince Street, uses the term “digital decolonization” to describe the next phase of competition and opportunity, in which political leaders and entrepreneurs abroad effectively target local markets, in response to both President Trump’s nationalist doctrine and the dominance of the U.S. and Chinese tech giants. But the next months will be key. It is really no surprise that China’s most desired concession in Osaka was our partial relaxation of restrictions on Huawei (allowing some U.S. suppliers to sell to them), as the telecommunications company is seen as a linchpin in the 5G sweepstakes.
Valuations look stretched to us in the bond arena as well. Investors who seek safety in U.S. Treasuries need to be reminded of intra-term market value risk, particularly with 10-year rates down to around 2%, from 3.2% a mere eight months ago. If rates were to retrace that move, holders of 10-year paper would suffer a greater than 10% market value loss, which would be an issue if funds needed to be raised imminently, as opposed to waiting to be made whole at maturity. Longer dated paper would be markedly more vulnerable, and holders of overseas sovereign debt, with rates around or less than zero, also assume greater risk. While we most recently expanded bond allocations to around a full weight, we maintain a preference for our mix of bond managers, who are conservatively positioned and well diversified, and thus have shown a smoother, but still solid, return stream amidst the broader rate volatility.
Other portfolio exposures are held in place as well. Within a modest overall equity underweight, we remain fully allocated to U.S. equities, in both long-only and hedged mandates. While our most recent moves in non-U.S. stocks have been to trim rather than add, we still see value in these markets, which trade at unprecedented discounts to the U.S., including price to book ratios that are less than half (1.6 times in both developed and emerging markets versus 3.3 times in the U.S.). A modest overweight to the hedged group also continues. In all categories, a high standard with regard to manager selection is critically important. Within the equity allocation, we also use passive options selectively to lower portfolio costs.
We wish you the very best for the summer of 2019. We will be back as needed, but in the meantime please feel free to reach out with any questions.
David S. Beckwith, CFA
Managing Director & Chief Investment Officer
This letter may include forward-looking statements. All statements other than statements of historical fact are forward-looking statements (including words such as “believe,” “estimate,” “anticipate,” “may,” “will,” “should,” and “expect”). Although we believe that the expectations reflected in such forward-looking statements are reasonable, we can give no assurance that such expectations will prove to be correct. Various factors could cause actual results or performance to differ materially from those discussed in such forward-looking statements.