Third Quarter, 2019

Market Summary and Near Term Outlook — The S&P 500 generated a total return of 1.70% in the third quarter, ending the quarter at 2,977, only 49 points below its all-time closing high of 3,026. Year-to-date, the index has generated a return in excess of 20%. The MSCI ACWI index of global stocks was basically flat for the quarter, generating a total return of 0.1% for the quarter and 16.7% year-to-date. Falling global interest rates and generally easing financial conditions contributed to the modest third-quarter gains.

Despite strong returns this year, U.S. equity markets remain stuck in a relatively narrow 20% trading range that has prevailed for almost two years. Volatility has increased, but the long running tug-of-war between bulls and bears has yet to be resolved.

Our base case is that barring a significant change in the U.S.-China trade dispute, U.S. equity markets will remain relatively range bound through at least early 2020. Although global economic growth has slowed due to manufacturing declines in almost every major economy, central banks around the world have been quick to respond by lowering interest rates. The combination of slow economic growth and proactive intervention has yielded weak corporate earnings coupled with relatively high earnings multiples.

This is not the first time global economic growth has slowed during this ten-year bull market. Slowdowns of roughly similar magnitudes occurred in 2012 and 2015/2016. However, in those instances, massive stimulus by China’s government jump-started global economic activity. We do not think China will act as aggressively this time. There may be some China stimulus which could stem declines in global growth and, perhaps, drive modest acceleration in certain geographies, but we think it will fall far short of the growth seen in 2015/2016, in particular.

Given the already very low levels of interest rates around the world, it is far from certain that further interest rate declines can meaningfully stimulate economic activity. Lower rates may only put a floor under equity valuations by forcing savers out of bonds and into equities. More easing by central banks may be good for Wall Street, but not necessarily for Main Street. Interest rate movements are keeping equity markets in a contained range and equity market movements are doing the same for interest rates. We don’t think this cycle ends quite yet.

What Breaks the Cycle?

Looking out a bit further, there are reasons for concern. During the third quarter:

  • real residential investment in the U.S. declined year over year;
  • the U.S. ISM manufacturing index, an indicator of U.S. economic activity, fell below 50, an indication that manufacturing levels are contracting, rather than just growing more slowly;
  • and, the U.S. yield curve remained inverted for the entire quarter. As measured by U.S. 10-year Treasury Bonds versus the effective Fed Funds Rate, the U.S. yield curve has been inverted for 19 weeks.

Since the mid-1950s, with one exception, every time these three warning signals coincided, a recession has followed within two years. The one exception was 1966; although the U.S. economy didn’t fall into recession in the late ’60s, economic growth slowed sharply and the S&P 500 fell more than 20%.

The fact that these long leading signals are occurring at a time when valuations on bonds, equities and real estate are all relatively fully priced, skews the risk/reward trade-off negatively to the downside.


Getting Defensive

Slowing U.S. and global growth coupled with relatively high valuations has given us the impetus to position portfolios more defensively. We have increased exposure in more defensive sectors such as Consumer Staples, Healthcare, Utilities and REITS. We have also begun to add a small position in gold. We very rarely buy gold since it does not generate a return, but it is a store of value if both equity and bond prices decline. We are underweight traditionally cyclical sectors, Energy, Financials, Materials and Industrials. We are more defensively positioned today than at any point in the last five years.


What Could Take the Market Higher From Here?

There are several potential drivers of a near-term market rise.

  • Investors are already bearish and, counterintuitively, that’s bullish for equity markets. U.S. mutual fund investors have sold $116 billion of equities year-to-date and bought $594 billion of bonds and money market funds. Despite rising risks, investor sentiment is arguably more negative than current economic data warrants. An American Association of Individual Investors survey recently found the lowest five-week average of bulls since November 2016, right before the market soared.
  • While equity markets are expensive in absolute terms, equities are still attractive relative to bonds. Stocks tend to outperform other asset classes when the dividend yield of the S&P 500 is higher than the yield on 10-year U.S. Treasury bonds. That is the case today.
  • China stimulus could be greater than we expect. Many U.S. firms depend on China for growth. Sales by U.S. firms in China are more than twice as large as U.S. exports to China. Regions like Europe and Southeast Asia are even more levered to China. Stronger China growth could indeed be a “shot heard around the world.”


Welcome to a Slow Growth World – A Longer Term Perspective

Although China has the financial flexibility to engineer just about any outcome in the short term, we expect China GDP growth to slow considerably over the longer term. After decades of rapid growth, its economic growth has been slowing for several years, weighed down by rising debt levels, slowing working-age population growth, and diminishing returns from infrastructure spending. With no other country or trend large enough to compensate for a sustained slowdown in China, we expect global growth, particularly in areas where China spent heavily, such as industrials and commodities, to be slow for the next five to ten years.

Other factors are also likely to contribute to slow global growth long term.

Birth rates have dropped below replacement levels in almost all developed economies. In many countries, populations are declining, especially the working-age segment, which deprives economic growth of its main driver, human capital. In the U.S., strong population growth contributed substantially to real GDP growth of 4.0% per year, on average, in the 1950s, and 4.3% in the 1960s. It doesn’t appear the U.S. will even approach 3.0% in the decade to come. In Japan and Europe, where population growth is negative or very low, consensus estimates of economic growth are even lower, ranging from 0.5% to 2.0%.

After a ten-year expansion in the U.S. and long expansions elsewhere, there is little pent-up demand to drive growth higher. In 2017, there were 259 million registered private and commercial vehicles in the U.S., compared to only 225 million licensed drivers. By contrast, in 1950, the number of licensed drivers, 62 million, far exceeded the number of registered vehicles, 48 million. Ownership penetration of most other consumer durables has similarly limited upside today. Consumers appear willing to spend their income, but are less inclined to borrow to buy things.

On the other hand, government finances have spiraled out–of-control in many countries, constraining the potential for further fiscal stimulus. The U.S., for example, is saddled with unprecedented peacetime deficits. The Congressional Budget Office projects that federal debt held by the public will approach 100% of GDP within ten years. Historically, higher levels of government debt have been associated with slower growth.


Looking at the Future Through the Lens of the Past

With global economic growth likely slow for the next five to ten years, growth stocks should continue to outperform value stocks. Investors tend to favor growth when it’s hard to find. But, more important, the best growth stocks are unlikely to stay the same.

Few companies can sustain terrific earnings and sales growth for more than ten years, and when growth slows, multiples generally contract sharply. A new set of global market leaders emerges every decade or so.

In 1980, six of the world’s ten largest companies by market capitalization were energy firms: Exxon, Standard Oil, Schlumberger, Royal Dutch Shell, Mobil, and Atlantic Richfield.

In 1990, eight of the top ten stocks were Japanese: NTT, Bank of Tokyo, Industrial Bank of Japan, Sumitomo Mitsui, Toyota, Fuji Bank, Dai-ichi Kangyo Bank, UFJ Bank.

In 2000, seven of the top ten were tech or telecom firms: Microsoft, NTT DoCoMo, Cisco, Intel, NTT, Lucent, and Deutsche Telecom.

In 2010, seven of the world’s ten largest stocks by market capitalization were energy or Chinese industrial firms, reflecting expectations of continued rapid growth in China and a commodity supercycle: ExxonMobil, PetroChina, BHP Billiton, Industrial and Commercial Bank of China, Petrobras, China Construction Bank, and Royal Dutch Shell.

Today, the seven largest stocks in the world by market capitalization are all tech giants: Microsoft, Amazon, Apple, Google, Facebook, Alibaba and Tencent. Their sales and earnings growth have attracted huge amounts of capital. Capital flows tend to push down returns. Also, several of these companies face political risks, related to concerns about privacy, extraordinary size and market power.



At Chevy Chase Trust, we are focused on finding the best growth opportunities for the next decade, not the growth leaders of the past decade. We think potential contenders can be found in healthcare, genomics, automation, luxury goods and luxury services.

We believe our themes hold the promise of identifying some of the next decade’s market leaders. Here are thematic bullets that frame much of our current research:

  • U.S. Wealth Migration Mirrors Global Urbanization – Concentration of wealth is characterizing urbanization across the country, reinforced by demographics, changes in city planning and shifts in the housing market. Underpinning this wealth concentration are economies of scale that enhance growth and productivity, spurring new business models in what becomes a virtuous cycle. Urban living has profound implications on consumption and spending patterns.
  • The Advent of Molecular Medicine – Breakthroughs in genomic science are changing the practice of medicine. Genomic sequencing technology, clinical research, data analytics and gene editing are converging to deliver novel treatments and diagnostics that will improve medical outcomes and usher in a new era of healthcare.
  • The End of Moore’s Law Ushers in the Age of Heterogeneous Compute – For nearly 50 years, Moore’s Law broadly benefited the economy by providing exponential improvements in the performance and cost of computing technology. As the physical and economic challenges of further scaling semiconductors continue to mount, researchers are shifting focus from general purpose processors to special purpose technologies tailored to very specific tasks.
  • The End of China’s Emergence – After a multi-decade economic boom, China GDP growth is set to slow considerably. China has been the largest driver of global growth and the largest consumer of many commodities. A significant decline in growth and/or a shift away from infrastructure spending will have a material impact on growth and spending on cyclicals worldwide.
  • Inequality Paradox Leading to Cultural Convergence – Although economic inequality has been on the rise within countries for at least the past four decades, inequality between countries has been falling dramatically since the turn of the century. This shift has greatly expanded the population and distribution of middle and upper income consumers and presents new opportunities for global brands and products in a variety of sectors.
  • Next Generation Automation and Supply Chain Reorganization – Automation that was centered in automobile production in the developed world is now penetrating other industries such as retail, food service and healthcare. This will lead to improved productivity, dramatic shifts in supply chains and growing end markets for technology components and industrial equipment.


Fixed Income Perspective

Fixed Income markets were even more volatile than equity markets during the third quarter. The U.S. ten-year Treasury Bond began the quarter yielding slightly over 2.00%. Due to a breakdown in U.S. – China trade negotiations and a general slowdown in global growth, the yield precipitously dropped to 1.46% in early September, more than a 25% decline. Subsequently, the 10-year yield recovered some, to end the quarter at 1.66%.

Interest rates around the world remain extremely low with approximately $15 trillion in negative yielding debt. It is difficult to predict a path forward for rates in the short term, since movements have been largely tied to inherently unpredictable events.

A small acceleration in global growth from China stimulus could cause rates to rise modestly. This would likely pressure equity market multiples lower, which would depress consumer confidence and spending, forcing rates lower again.

Central bankers are concerned that they do not have enough firepower to stimulate global growth when the next recession hits. The U.S. Federal Reserve typically lowers rates about 400 basis points, or 4.00%, during a recession to stimulate economic growth. That would pose an unprecedented challenge given the current Fed Funds rate of 1.75% to 2.00%.

In a difficult environment for fixed income investors, we identify high-quality, value-add bonds with market or above-market yields.