U.S. equities have struggled to break out of a narrow trading range in recent weeks. Despite strong year-to-date returns, U.S. equities are only slightly above the level reached before last fall’s selloff.
The “stop-go” pattern of trading in recent weeks is an indication of investor uncertainty about several key issues. Slowing global growth, particularly in manufacturing, amplifies fears that the longest economic expansion in U.S. history is nearing an end. Bullish investors think that Chinese reflation, a pause in trade tensions and dovish central banks will be enough to keep the expansion going; bearish investors are skeptical about the likelihood of a trade deal and the willingness of the Federal Reserve to extend mid-cycle rate reductions into next year. Within equities, long-suffering value investors are hoping that the recent strength of value stocks represents a turning point in market leadership.
The fog of uncertainty may not clear anytime soon, given the likelihood that the coming months may offer only partial resolution of the major issues influencing equity markets:
1. A “grand bargain” between China and the U.S. is unlikely.
An economy in recession is not a recipe for re-election, which provides powerful motivation for President Donald Trump to de-escalate tensions with China before the 2020 vote. However, a temporary cease-fire or partial trade agreement is much more likely an outcome than the comprehensive deal that investors and corporate CEOs are hoping for. Frustration with China is seemingly one of the few issues in which Democratic and Republican voters are in agreement.
Trump runs the risk of being portrayed as being “soft on China” by Democratic opponents if he enters into a comprehensive deal with China. China’s president, Xi Jinping, faces his own set of constraints. Nationalist sentiment is high in China, and Xi is not likely to make concessions in the trade negotiations that alter its state-led economic model and the Communist Party’s control of the organs of the Chinese state.
2. Chinese economic stimulus is likely to fall short of investor expectations.
Chinese economic stimulus provided an important boost to global growth following the global financial crisis. Today China is prioritizing financial stabilization over reflation, with fiscal stimulus and easing of monetary policy relatively restrained in comparison to prior efforts.
Xi is concerned that another round of excessive debt creation would add to economic imbalances and hinder efforts to build a more sustainable economic model for China. Consequently, China’s leadership is willing to accept slower economic growth in order to slow the growth in leverage.
Trump’s trade policies and attacks on China provide a convenient scapegoat for a slowing economy, with nationalist sentiment keeping dissent in check on the mainland. Although Chinese stimulus should provide some spillover benefits to the rest of the world, the boost to global growth will probably far less meaningful than was the case in 2009 or 2016.
3. The Fed may also disappoint investors.
The Fed and European Central Bank are setting the tone in a world in which central banks implement expansionary monetary policies. However, the Fed may not provide as much monetary stimulus as is priced into the market today.
Fed Chair Jerome Powell faces a delicate balancing act within the Fed, given three dissents in the most recent vote to cut rates. Kansas City Fed President Esther George and Boston Fed President Eric Rosengren voted to keep rates unchanged, with low unemployment and the rising stock market among the factors motivating their dissent. St. Louis Fed President James Bullard voted against the 25 basis-point rate cut, favoring a deeper 50 basis-point cut. Among 17 Federal Open Market Committee members, seven expect to cut the federal funds rate once more this year and 8 expect a still-lower policy rate in 2018. The median estimate is for no more rate cuts this year.
In addition, equity selloffs in response to negative developments on trade policy are a reminder that monetary policy isn’t a universal cure for what ails the global economy. Trade policy is the primary cause of slow business investment, not the cost of capital. The latest round of tariffs will hurt U.S. consumers harder than any prior trade actions, underlining the diminishing effectiveness of tariffs as a policy instrument. Worst-case outcomes on trade would have a direct bottom-line impact for many companies and impose significant costs on companies forced to reconfigure their supply chains.
4. Value investing isn’t dead, but investors should beware of value traps.
Value investors are hoping that the recent surge in value stocks represents a sustainable turning point after a decade of frustrating relative performance. The speed and magnitude of the rotation from growth to value is a reminder that changes in leadership are unpredictable. “Cheap” stocks may not universally benefit from a rotation to value, as T. Rowe Price estimates that more than 1/3 of S&P 500 companies are facing disruption. That percentage is likely to grow, making a meaningful subset of the value universe cheap for a reason!
Many highly leveraged businesses have been helped by a decade of low interest rates – companies with fragile business models and weak balance sheets will be vulnerable if rates rebound and the economy continues to slow. Growth stocks face their own set of challenges. The disrupters that have driven the outperformance of growth stocks are increasingly vulnerable — to higher rates, increased competition, trade conflict and regulatory scrutiny. For some of the most popular stocks, valuations discount an overly rosy set of expectations for future growth and profit margins.
Ultimately, bulls and bears may both be disappointed. Escalation of the trade war between the U.S. and China is likely to be postponed until after the election, with longer-term strategic conflict between the U.S. and China remaining unresolved. The divided Fed makes it unlikely that investors will be satisfied with Fed policy moves. Consumer spending and the labor market remain relatively strong, providing grounds for optimism that the economic expansion will continue into 2020. However, tepid economic growth may be as good as it gets for the next year.
The combination of tepid growth and geopolitical uncertainty is a recipe for a continuation of the stop-go market of recent months. In a stop-go market, a portfolio balanced between “offense and defense” may be appropriate. A well-diversified portfolio of equities should do well if the economy continues to grow, while high quality bonds should provide a necessary counterweight to equities in the event that economic growth deteriorates further.
Daniel S. Kern is chief investment officer of TFC Financial Management, an independent, fee-only financial advisory firm based in Boston.
Prior to joining TFC, Daniel was president and CIO of Advisor Partners. Previously, Daniel was managing director and portfolio manager for Charles Schwab Investment Management, managing asset allocation funds and serving as CFO of the Laudus Funds.
Daniel is a graduate of Brandeis University and earned his MBA in Finance from the University of California, Berkeley. He is a CFA charterholder and a former president of the CFA Society of San Francisco. He also sits on the Board of Trustees for the Green Century Funds.