Second Quarter, 2019

The Glass: Half Full and Half Empty — Some have called this the most hated bull market in history. The S&P 500 Index finished the first half of 2019 at 2,942, only slightly lower than its all-time closing high of 2,954 reached on June, 20, 2019. S&P 500 six-month return, inclusive of dividends, is an impressive 18.5%, the best first half since 1996. Further, the economic expansion that began in July of 2009 turns ten this month making it the longest on record. 

Despite these positives, investors have been withdrawing money from U.S. stocks and putting money into bonds. In 2019, investors have withdrawn, on average, $12.5 billion per month from equities and put $25 billion per month into bonds. In fact, the largest purchasers of equities since 2009 have been companies repurchasing their own shares. Almost $5 trillion of corporate share repurchases have occurred since 2009, including $800 billion in 2018 alone. Survey measures of investor sentiment are decidedly cautious. Counterintuitively, this gives us comfort. Equity markets tend to do better when sentiment is negative. The lack of equity market exuberance minimizes valuation excesses that lead to financial imbalances and, eventually, major corrections.

Looking at the data somewhat differently leads to a very different view. The closing level of the S&P 500 on June 30, 2019, is only 4% higher than the level on January 30, 2018, 17 months ago. It is hard to classify a 7% total return (inclusive of dividends) over almost a year and a half as particularly robust. In fact, this is roughly 60% of the average return earned during a typical expansion. From this perspective, the market has been trapped in a broad trading range with bouts of volatility.

U.S Macroeconomic Backdrop

U.S. economic growth is slowing after a relatively strong 2018, which was fueled, at least in part, by tax cuts and fiscal stimulus. We think U.S. economic growth will revert to its 2.0% trend or slightly lower, without a recession in the near to intermediate term. To be sure, risks of recession have risen. However, we believe accommodative monetary policy and the lack of obvious market imbalances will help us avert negative GDP growth, at least for the balance of 2019.

Here are some recent macroeconomic and market moving developments that we find relevant:


  • Declining yields globally should spur investment
  • Survey of small business job openings remains in record high territory
  • U.S. unemployment claims remain close to a 50-year low
  • U.S. consumer comfort is close to a high for the expansion
  • Inflation remains low globally
  • Potential for more fiscal and monetary stimulus in China and Europe

  • U.S. Manufacturing Purchasing Managers Index has declined sharply
  • U.S railcar loadings have hooked down
  • U.S. two year yields have plunged – U.S. yield curve inversion
  • U.S. payroll employment in May was flat
  • NIPA* profits and the GDP share of residential investment and autos appear to have peaked several years ago
  • Forward earnings estimates seem overly optimistic
 *NIPA is the National Income and Product Accounts. This figure represents corporate profits after tax adjusted for inventory valuations and capital consumption.

Strong U.S. equity market returns (S&P 500 returned 13.65% for the first quarter) have been fueled by a rebound in multiples, as earnings estimates have been declining. On a U.S. dollar basis, several foreign markets have risen even more than the U.S., notably China, Italy and Canada. Most major markets are up between 5% and 15% and no major market was in the red for the first quarter.

Notably, most of the negative factors listed are leading indicators and the majority of the positive factors are lagging or coincident indicators. The yield curve tends to be one of the earliest leading indicators, so it is not uncommon for it to appear “non-confirmed” by other factors, particularly employment statistics. Other indicators that tend to peak well before a business cycle ends, such as a fall in NIPA profits and residential investment and automobile purchases as a share of GDP, are reinforcing the yield curve as an indicator of a faltering economy, maybe as early as 2020. 

But timing is everything in investing. Since equity bull markets can be highly charged in their final stages, becoming too defensive too early can hurt. Although risks have certainly risen and we have begun to position portfolios for an inevitable turn, we think it is still too early to turn fully defensive. Three factors contribute to this conclusion. 

1. The Federal Open Market Committee (FOMC): At the most recent FOMC meeting in mid-June, Chairman Powell indicated that the Fed is prepared to lower interest rates given slowing economic growth and low levels of inflation. Generally speaking, policy actions, like lowering interest rates, that weaken the U.S. dollar relative to other currencies and lowers the short end of the yield curve are good for equity markets. The all-time high in the stock market reached in the past few weeks is almost assuredly a reaction to the FOMC’s June pronouncement. 

2. Lack of Financial Imbalances: This has been an unusual recovery in many ways. Although it has lasted longer than any expansion in history, the rate of growth has been unusually low. One reason for this is that U.S. households have not been borrowing and spending the way they did throughout the pre-crisis postwar era. Consumer credit growth peaked eight years ago and has been declining ever since. There are no signs that consumers have an appetite to re-lever. The typical late-cycle pattern of economic overheating from debt-fueled consumption is completely absent. 

In addition to consumer credit demand remaining subdued and consumption moving in line with income growth, the corporate sector seems inclined to return cash to shareholders rather than undertake major capital spending initiatives. Every post- WWII recession was preceded by either high inflation or rapid private debt growth and neither is present today. 

3. There is Just No Alternative to Equities Right Now: This is our least favorite reason, but we would be remiss not to include it. With U.S. 10-year bond yields now yielding only 2.01%, the equity risk premium, or the excess return that equity investors demand for taking on the relatively higher risk of stocks versus bonds, is greater than 300 basis points, more than one standard deviation above its long term mean. The average forward 12-month return when the equity risk premium is at these levels is 12.4%, considerably higher than the average long-term return. 

Further, 47% of stocks in the S&P 500 now have dividend yields higher than the U.S. 10-year Treasury yield. When bond yields are this low, equities tend to do relatively well. 



Source: Strategas Research Partners


So, when will we know it is time to reduce risk exposures and place more emphasis on traditionally defensive sectors? We are watching jobless claims. Compared to the yield curve, which is a very long leading indicator, jobless claims are an early, but timelier datapoint. This statistic tends to bottom well before a recession begins. When claims break above a 20% year-over-year increase, a recession is usually about a quarter away. If we start to see upward movement in jobless claims, we would reposition portfolios. 

Global Macroeconomic Backdrop

The global backdrop is more complicated. After a globally synchronized upturn in 2017, the first since the global financial crisis, 2018 was marked by a divergence in momentum. The U.S., fueled by tax cuts and fiscal stimulus, powered ahead, while China was slowed by monetary tightening. It is telling that the rest of the world followed China’s trajectory, the world’s second largest standalone economy, and not the U.S. economy. 

The slowdown in China was due to the lagged impact of tight monetary policy and slowing domestic credit growth over the past two years. While tariffs on imports to the U.S. were somewhat of a drag on growth, policymakers’ efforts to redirect credit creation from the shadow banking system to the regulated banking system had a larger negative impact on economic activity. China has the dry powder to stimulate growth that can offset the combination of still-muted economic momentum and any larger shock to the export sector. 

There are two schools of thought on China’s current strategy. The first is that China will aggressively stimulate because a booming economy would give it more leverage in trade negotiations with the U.S. If this is correct, higher aggregate Chinese demand will likely lead to increased demand for materials and goods imports. China’s imports are Europe’s, Japan’s and emerging Asia’s exports. If China bottoms and turns higher, we anticipate that its trading partners will too. 

The other school of thought is that China knows that it is the marginal driver of global economic growth. Therefore, it may not be in China’s interest to stimulate aggressively at this stage of the trade war, as slowing global growth and weak equity markets may help pressure the U.S. Thirty to forty percent of revenue generated by S&P 500 constituents comes from abroad. If this is the prevailing thinking, Chinese officials will still likely roll out some additional economic measures in coming months, but those measures will be largely incremental. 


Portfolio Positioning

In either China stimulus scenario, but of course more so if China decides to stimulate aggressively, U.S. equity market outperformance relative to other markets should narrow or reverse going forward. As mentioned, the fiscal thrust from the U.S. stimulus package is nearly spent and it is not just the FOMC in the U.S. poised to lower interest rates, Central banks around the world are moving to stimulate their economies. Mario Draghi of the European Union recently discussed more stimulus due to weak inflation. The Central Bank of China indicated that rate cuts and other stimuli will likely occur. Similar moves are likely or have recently occurred in Japan, Brazil, India, Australia, Russia and Indonesia. 

Growth stocks have consistently outperformed value stocks since 2006. That is by far the longest run on record; in fact, it is double the second-longest growth secular bull market from 1993 to 2000. One reason growth has outperformed is that the market has largely arbitraged away any advantage of buying value stocks. An explosion of computer-based algorithmic trading makes it hard to outperform based solely on calculable anomalies. In addition, the relatively slow pace of economic growth during this expansion has favored growth over value. When economic growth is sluggish, investors seek the few companies that can grow anyway. 

Within the U.S., we think growth stocks generating strong free cash flow margins will remain the market leaders for now. Their margins will merit a premium in a setting of modest economic growth. Our portfolios are tilted toward growth and defensive stability. We are underweight cyclicals such as financials and energy. We are modestly overweight U.S. and European equities, neutral Japan and underweight emerging markets. About 10 to 15% of our portfolios are in smaller capitalization thematic companies where we believe the longer term skew is significantly positive. Investment in these companies is not without risk of loss, but we believe they have the potential to triple or quadruple over the next few years, generating outsize proportions of portfolio alpha. 


Ultra-High Frequency Radio Frequency Identification (UHF RFID)

One example of a smaller thematic holding with great potential is a leading participant in the production of ultra-high frequency RFID semiconductors. A lot has been written about the promise and peril of the Fourth Industrial Revolution. If the Third Industrial Revolution saw sweeping change from computing and communication technologies, the Fourth is marked by developing breakthroughs in fields such as robotics, artificial intelligence, nanotechnology, quantum computing and biotechnology. The complexity of these technologies and their emergent nature mean that some individuals and companies will be very big winners and some very big losers. Within this realm, we look for new technology enablers that disrupt business models, enhance productivity, have high barriers to entry and outsized growth potential. UHF RFID is a case in point. 

If you have ever used a corporate ID badge to enter an office building, you have used RFID, a wireless transmission of data over a very short distance. UHF extends the distance of the data transmission 30 to 50 feet, opening up a sea of new potential uses. For example, it enables the purchase of items at a department store without having to scan the items at a cashier. You would simply walk through a door sized scanner and the UHF RFID tags will be read instantaneously and the items charged to your account. This would eliminate a major source of friction in brick and mortar retailing. 

The cost of UHF RFID tags have declined from 15 to 20 cents per tag 15 to 20 years ago to about 1 to 2 cents today. As the industry scales, costs are likely to decline further. Delta Air Lines already includes UHF RFID chips on all luggage tags. Passengers are able to track exactly where their bags are at all times. Other airlines will soon follow suit. Healthcare facilities are tagging beds and other medical equipment so administrators have a real-time view of their rolling inventory. 

UHF RFID chip usage has been growing over 20% per year for over five years now. Retailers such as Macy’s, Zara, Lululemon and Target have begun to mandate that their supply chains tag all pieces of clothing. These companies are initially adopting the technology for inventory management, to know what is on their shelves and in their store rooms at all times. NIKE has said that better inventory management can increase top line sales up to 10% by more timely matching supply to demand. 

We think that within the next five years, retailers will expand beyond supply-chain management and begin to use UHF RFID for instant check out. With apparel being the leader in UHF RFID usage and still only 10% of clothing items currently being tagged, we see room for exponential growth. There are only two main suppliers of UHF RFID technology and barriers to entry are high due to extensive patent protections and technical complexity. We believe future growth will accrue to the current duopoly of leading edge suppliers. 


Interest Rates

U.S. 10-year Treasury Bond yields have declined more than 60 basis points since the start of the year and much more since the November 2018 high of 3.24%. At the end of the first half of 2019, a 10-year Treasury Bond was yielding only 2.01%. 

The yield curve recently inverted, as measured by the spread between the 10-year U.S. Treasury yield and the 3-month U.S. Treasury yield. Sustained inversions have been an early warning sign that monetary policy is too tight and have preceded every recession. There has only been one instance when the yield curve inverted for a sustained period and the economy did not fall into recession. 

Global bonds have also moved significantly lower. Through the past five years, the global long bond yield (as defined by the average of the Euro Area, U.S. and China 7-10 year bond yields) has tried to surpass 2.5% on three occasions – once in 2015 and twice in 2018. Each time it failed to sustain this level (chart below). This indicates that the neutral rate of interest, the rate at which monetary policy is neither stimulative nor restrictive, is likely quite low. 



Source: BCA Research


According to behavioral finance, perception of an investment’s risk is best reflected by its negative asymmetry: the potential largest loss as a multiple of the potential largest gain. When the bond yield gets very low, the proximity to its lower bound (i.e. zero) dramatically reduces the potential for price gain, while exposing almost open-ended potential for a large loss. Negative asymmetry, like bonds are experiencing now, means that bonds are not necessarily perceived as less risky than equities. As a result, equities no longer require a higher expected return as an investment alternative. 

Interestingly, the equities that have performed best when yields declined have not been the most rate sensitive sectors such as housing, autos and financials. This may be because it is hard to find evidence that lower rates are stimulating investment. The largest equity beneficiaries of the decline in rates have been the longest-duration segments of the economy, or growth stocks, because their cash flows extend furthest into the future and rise the most when interest rates decline. This reinforces our view that the rise and fall in interest rates are having a greater impact on the valuations of financial assets than they are on economic growth. 

The relationship described above has been in place for the better part of five years. We do not expect it to change in the near future. Given the relatively large decline in yields year-to-date, we would not be surprised to see some retracement in the short term. However, longer-term, we believe U.S. interest rates will remain below most expectations.