Years ago, I thought it might be a new and exciting challenge to participate in a sprint triathlon here in Colorado. After all, the Centennial State is filled with active adventure-seekers, so I wanted in on some of the action. As I stood on the banks of a frigid lake donned in a form-fitting wetsuit at 7 a.m. on the morning of the event, I began to have second thoughts. A steady wind made the lake very choppy. In fact, the one lasting memory I have of the triathlon – aside from the breath-stealing gut punch from when I first entered the 51-degree water – was realizing how difficult it was to navigate once I began my swim. Arms and legs - including my own - flailed around me, and the choppy water made it nearly impossible to spot the marker-buoys that outlined the swim course. After several minutes, I found myself gradually drifting off course which added precious minutes to my overall time.
It’s easy to feel a similar level of disorientation when thinking about the global economy and financial markets today. There is plenty of chop to contend with, whether it be concerns about a trade war, escalations with Iran, Federal Reserve policy, an inverted yield curve, negative interest rates, Brexit, and so forth. As I found during the triathlon, it can be helpful to lift your head above water, take a few deep breaths and reorient yourself from time to time, which is what this quarterly update is intended to do. In this report, we will focus on 3 key topics that Destiny Capital’s Investment Committee is paying close attention to the US/China trade tensions, Federal Reserve policy, and current market conditions.
United States / China Trade Tensions
Last quarter, our primary concerns were focused on the trade tensions between the United States and China. These concerns have not diminished despite the recent ‘pause’ that was communicated after a meeting between U.S. President Donald Trump and Chinese President Xi Jinping at the G-20 Summit in Osaka, Japan. In fact, the concerns about a global slowdown that were outlined in our Q2 report have started to materialize when analyzing some recent key statistics. Nearly across the board, global manufacturing PMIs (Purchasing Managers Index – see a detailed definition at the end of this report) have approached-or-entered contractionary ranges. As a reference point, manufacturing PMIs below 50 are considered negative, PMIs at-or-slightly above 50 are considered ‘meh’ (a technical term), and PMIs well above 50 is considered good. In February of 2019, the manufacturing PMI number in the United States was holding strong at 53. By June of 2019, it had dropped to 50.6. We continue to see a similar pullback in manufacturing-heavy countries & regions like Taiwan, Korea, Mexico, Canada and much of the Eurozone. As we stated in our report last quarter, we feared that a global economic slowdown wouldn’t necessarily result from the tariffs themselves, but because of the uncertainty caused by the tariffs.
As a result, world trade has lost momentum and, in April of 2019, world trade volume fell sharply to .4% year-over-year versus a long-term average of 5%. According to WTO (World Trade Organization) Director-General Roberto Azevedo, “Trade cannot play its full role in driving growth when we see such high levels of uncertainty. It is increasingly urgent that we resolve tensions and focus on charting a positive path forward for global trade.”
Given the unpredictability of the trade dispute, it’s difficult to say if-or-when a resolution will be reached. The Chinese are digging in their heels and appear ready to play the long game. In the short term, the markets responded favorably to the recent ‘pause’ that resulted from the G-20 Summit. At the very least, the current administration and their Chinese counterparts have bought themselves a little more time to work toward a resolution. In the meantime, the world is watching and global markets are reacting which, in recent weeks, has shifted focus to our next topic – The Federal Reserve.
The Federal Reserve
The mandate of the Federal Reserve is to support three specific goals: maximum stable employment, stable prices, and moderate long-term interest rates. With an unemployment rate of 3.7%, a positive jobs report in June, and inflation relatively in-check, you might be thinking, “what’s with all the talk about a rate cut?” Well, the Federal Open Market Committee participants are looking at some of the same global data that we outlined above. As Fed Chairman Jerome Powell said in June, “Crosscurrents have reemerged, with apparent progress on trade turning to greater uncertainty with incoming data raising renewed concerns about the strength of the global economy.”
Clearly, the Fed is concerned about a slowdown in the global economy, and they’ve indicated that they will “act as appropriate to maintain the current expansion.” Still, the $20,000 question is – what will the Fed do?
This is where it gets interesting – there are 17 participants from the Federal Open Market Committee who provide assessments on appropriate monetary policy. In general, these 17 participants seem to be fairly evenly split when it comes to whether or not to maintain the status quo or to cut the federal funds rate. However, of these 17 participants, only 10 are able to actually vote on FOMC policy. Of these 10 voting members, they’ve communicated the following assessments:
Recommended Action # of FOMC Voting Participants
Raise Fed Funds Rate by 25 basis points (.25%): 1
Keep Fed Funds Rate the same: 2
Reduce Fed Funds Rate by 25 basis points (.25%) 1
Reduce Fed Funds Rate by 50 basis points (.50%) 6
As you can see, 7 out of 10 voting FOMC participants prefer a rate cut of some kind, with 6 of these members recommending near-term rate cuts of up to 50 basis points. Furthermore, based on the fed fund futures market, the financial markets are also anticipating that the Fed will cut rates significantly over the next 12 months.
In normal circumstances, you might’ve expected a positive response from the markets based on the fact that the U.S. economy added 224,000 jobs in June – far above the 165,000 estimate. However, stocks began to sell-off because many market participants thought that the June employment numbers might prohibit the Fed from cutting rates. What’s our take? Given that 7 of the 10 voting FOMC participants prefer to cut rates at some level, we think a rate cut of 25 basis points is still a strong possibility in July. We also believe that the justification for a rate cut may partially shift from a fear of recession to concerns about falling inflation.
Current Market Conditions
This month, the current economic expansion became the longest in U.S. history and, as detailed above, the Fed has communicated that it will take action to maintain the expansion for as long as possible. While the U.S. economy appears to be slowing, it does not seem to be stalling.
Given the length of the current expansion, the question we hear quite often is – will there be a recession? While a general slowdown may be occurring, it is important to note that we aren’t seeing bubbles form in equity valuations or in 4 key cyclical sectors – housing, autos, business spending, and inventories. You’ll likely hear us reference these 4 cyclical sectors often because they represent nearly two-thirds of the variability in U.S. GDP. According to JP Morgan’s Chief Global Strategist, David Kelly, “Expansions don’t die of old age. They are assassinated, and they are usually assassinated by a breakdown in one of these 4 cyclical sectors.”
When it comes to equity valuations, the forward P/E of the S&P 500 is at 16.7x versus a 25-year average of 16.19x. So, while valuations may look slightly expensive relative to historical averages, they are not reaching the lofty levels that we saw, for example, during the tech boom of the late 90’s when the forward P/E of the S&P 500 exceeded 24x.
According to FactSet, in aggregate, industry analysts predict that the S&P 500 will see an 8.3% increase in price over the next twelve months. We take that with a grain of salt, as analysts have historically overestimated the future closing price of the S&P 500. Also, while analysts predict a positive outlook for the markets, that doesn’t mean that we won’t experience a bumpy ride, particularly if the U.S. / China trade tensions continue to escalate. The key to investing during uncertain times is to achieve true diversification among asset classes, which is a major focus of Destiny Capital’s portfolio construction. We build diverse, risk-adjusted portfolios that contain non-correlated assets that react independently of one another. This allows for flexibility and the potential for performance and consistent income in a variety of market environments.
As was stated in our Q2 report, it’s not a good idea to bet against the resiliency and ingenuity of the American economy. For now, we wait for the Fed’s next move, keep a watchful eye on global trade, and continue to search for effective investment opportunities for our clients.
As always, please don’t hesitate to contact your Destiny Capital team with any questions or if you would like additional information.
Global PMI (Purchasing Managers Index): The PMI survey of each country is based on questionnaire responses from a large panel of senior purchasing executives from over 400 companies. Respondents are asked to state whether business conditions for a number of variables have improved, deteriorated or stayed the same relative to the prior month. Manufacturing PMI covers the following – output, backlogs, new orders, new export orders, output prices, input prices, stocks of finished goods, suppliers’ delivery times, the quantity of purchases, employment, and future output.
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