Souring Mood

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It was a tumultuous August for financial markets. Stocks sold off from their June highs, dipping over 6% in the middle of the month. Investors grew more concerned as economic data softened, and the White House upped the ante once again in the ongoing trade war.

By the end of the month, global stocks had recovered to finish down 2.4% for August.

The big move was in the bond market as long-term interest rates fell drastically and long-dated yields fell further below short-term yields. The 30-year treasury yield fell below 2% for the first time in history. Long-term government bonds have outpaced stocks for the year, gaining 22.6%.

Interest rates fell across the world as well. There is now over $17 trillion of debt that trades at head-scratching negative yields. These low and negative yields have boosted the appeal of gold, which is up 19.5%.

Expectations for corporate profits have fallen. Second quarter earnings are in for most companies in the S&P 500. The results have been sluggish but better than feared. Expectations for the quarters ahead are more sanguine. A drumbeat of low guidance from management teams has resulted in analysts ratcheting down earnings estimates. Currently, analysts expect earnings contraction of -3.6% for the 3rd quarter.

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Within stocks, defensive sectors have been leading the market as cyclical sectors have struggled to gain traction. Defensive sectors such as utilities and consumer staples are thought to hold up better in a lower growth environment as they are less sensitive to the business cycle.

It is clear the mood of investors appears to be souring on the economy. Low interest rates, reduced expectations for corporate earnings, and low inflation expectations paint a bleak outlook for the economy.

On Recessions

Worries of an impending recession have been heightened for most of this year. As the trade war has waxed and waned, the economic data has slowly weakened. It has started with softer data points like business sentiment, where surveys suggest that business executives are less willing to invest amid the trade uncertainties.

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No doubt the outlook according to asset markets is bleak. However, as for predicting recessions, stocks have a spotty record.

The table shows the performance of the S&P 500 in the six months prior to each of the last nine recessions. In four of the nine, the market gained leading up to the downturn. The reliability of stocks is even worse when factoring in all the false positives along the way. As we have noted before, stocks have forecast nine of the last five recessions.

In another four of nine recessions, stocks gained while the economy contracted. This goes to show that in the short term the stock market is not the economy. Markets will do their best to anticipate what may come, but it’s far from perfect.

Of course, we will eventually have an economic contraction. It could happen in the next two months or next two years. Just don’t count on stocks, or pundits, or anyone to tell you when it will happen.

What We Are Doing

While we have been focused on quality and defensive positions in our portfolios for some time, we do not feel now is the time to race into these areas of the market. High-quality yields are back to historic lows and valuations on defensive sectors are relatively elevated. We continue to hold the course for our clients’ accounts and look to tilt away from pockets of the markets that investors are holding dear.

The sudden fall in global yields reduces the outlook for global bonds. Interest rates have been low and, if the recent history has proven anything, they can go even lower. Still, there are limits to how negative central banks will take interest rates, and thus, limits to how further global bonds can rally. In this context, we are looking to pare interest rate risk where the upside is limited.

What It All Means

Investors have clamored for quality and safety, driving down yields on government bonds and pushing up prices on defensive assets. It’s possible that the economic growth is slowing rather than heading for a sharp contraction.

No doubt the outlook is foggy, and there isn’t much we can do to control that. It always helps to have a roadmap for your investments that is determined by your goals. Knowing that you are on track can help make it easier to get through uncertain times.

Let us know if we can help find the right strategy for you.   

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