The stock market started the third quarter with a whirlwind of activity and gains, yet ended with a whimper. The strength in July appears to have come with the report that real GDP grew over 4% in the second quarter, which was then accompanied by strong year-to-year earnings comparisons. In contrast, the whimper in September revolved around trade war brinksmanship (on the part of the U.S.) and hyper-partisan bickering as the mid-term elections drew nearer. Both the S&P 500 and Russell value benchmarks recorded returns modestly above 0% for September, yet total returns for the quarter as a whole were quite strong, with the Russell 1000 Value gaining 5.7%.
The stock market has benefitted from last December's tax reform legislation and the reduction in regulatory burdens. Without the trade battles negatively impacting investor expectations, the gains might have been even greater. After the U.S. and Mexico came to agreement on updates to NAFTA in late August, it made sense that both the U.S. and Canada would come to an agreement. The risk of failure was too high for both countries to contemplate, in our view, regardless of the rhetoric between them and the threats made by the U.S. Yet it was once again left as a cliff-hanger up until the last day of the quarter, Sunday, September 30th. The stock and bond markets had already closed for the quarter on the 28th with no real confidence a deal would be struck. When the deal was finally struck the stock market responded with a meaningful gain on the first day of the new quarter.
Without overcoming the obstacles to agreement on USMCA (United States Mexico and Canada Agreement), the opposite would likely have taken place given a pessimistic view about the Trump Administration's ability to successfully negotiate deals anywhere! The U.S. dodged a bullet on this one. The relief rally may last a week or two, however, before investors worry about the even bigger problem of reaching agreement with China. At least now we know the President and his team of Navarro, Lighthizer, and Ross are willing to make trade deals with specific terms.
But that doesn't change an important component of uncertainty regarding the outlook. With P/E ratios on the overall stock market fair value at best, future stock returns should be lower and track closer towards earnings growth. This leaves the market quite vulnerable to mid-term election surprises that might negatively impact future GDP and corporate profit growth forecasts. The betting markets themselves place a high probability of the Democrats taking back control of the House from Republicans, but not the Senate. Since this appears to be a general expectation, if it is the actual result, investors could conceivably yawn… divided government isn't so bad and could be a good check on executive power. Yet as of now, neither of the other two election outcomes—the Democrats take back both houses of Congress or the Republicans retain both houses—is being discounted by the market. Such outcomes could create wild, at least temporary, market volatility.
Furthermore, long-term (30-year maturity) Treasury bond yields had risen to 3.25% at the end of the quarter. On a year-to-date basis, much of this increase was due to rising real interest rates that have accompanied strong economic growth. Rising real rates neither hurt economic growth nor hinder the stock market's advance. So far, long-term (10-year) inflation expectations have drifted upward to only around a 2.2% annual rate, but year-to-year headline CPI inflation is running at 2.8-2.9% annual rate. If headline inflation reports stay high due to rising energy prices and other inflation pressures, it could be one source of pressure on stock P/E ratios (down) and bond market yields (up).
Another effect of the higher yields has been relative strength of the dollar versus most other currencies. This has had a deleterious effect on large multinationals with significant overseas business and has been particularly acute for ADR's.
"Value" as an investment style has under-performed "growth" as a style much of the post Great Recession recovery period. But we once again see a significant divergence in valuations of these stocks, with growth stocks valuations skyrocketing (think FANG stocks and IPOs) while value languishes. With total debt rising relative to the size of the economy and with much higher valuations, positioning the portfolio with an eye towards caution is warranted. We remain on the lookout for the signs of trouble as well as take advantage of the opportunities we see.