The 10-Year-Old Bull and Pre-Teen Tantrums

April 26, 2019

“There was a three-year chunk as a teen where I should have been tranquilized and put in a cage.” —Melissa McCarthy1

  • The economy and expansion have shifted over the past 12 months to late-cycle volatility.
  • Our base case remains that the expansion is not over, but the risk of a recession has increased.
  • Investors should follow a risk-management game plan, rebalancing back to target equity allocations on strength and employing some protection in portfolio allocations.
  • Opportunities can be found among shunned areas such as less-growth-oriented value plays and international markets.

Presumably, everyone can remember a time when they either lived with or as a teenager. Currently, my household is filled with three young adults spanning the middle- and high-school years. I am easily proud of my children and their vast accomplishments. At the same time, I notice these years seem to come with a bit more emotion and, let’s say, household volatility.

Our aging bull market has matured to a unique point in its lifespan—where teenage-like emotions take hold and volatility appears more prevalent. In Exhibit 1, note the relative smoothness of the line in the years between 2009 and 2017. While there were more minor zigs and zags as difficulties came and went, the line becomes noticeably more jagged at the start of 2018. This more recent volatility, analogous to the emotional swings of a pre-teen, represents increased investor emotion associated with the transition to a different state of maturity. The economic expansion is now in its later stage, 10 years and counting, and the economy is at, near or a little ahead of reaching its full potential. As a result, the risk of a recession is becoming more pronounced and investor concern of this risk is likely the root cause of rising volatility levels.

In fact, the volatility that began in 2018 can be dissected into four categories of event-driven market outbursts, as color-coded in Exhibit 2. Early in 2018, statements and actions by the President’s administration raised concern about Trade Tensions. As the year progressed, these concerns faded, giving way to more pressing concerns about the trajectory of Monetary Policy. Toward the end of the year, additional concerns about Debt and Deficits were raised as a result of the threat of a government shutdown, and investor concern of a potential Earnings Recession. We think it is important to understand these outbursts in the context of the late-stage economic expansion and address each in the following sections.

#1 Trade Tensions

“As history has repeatedly proven, one trade tariff begets another, then another...” —Mark McKinnon2

“Everybody talks about tariffs as the first thing. Tariffs are the last thing. Tariffs are part of the negotiation.” —Wilbur Ross, U.S. Secretary of Commerce

In early 2018, fears of an escalating trade war began to percolate over the impact of new tariffs imposed on steel; ratcheting tariffs on Chinese goods imported to the U.S.; and retributive tariffs on U.S. goods imported to China. Initial back-of-the-envelope calculations estimated the economic impact of the tariffs to be ~0.3 percent of GDP. Recent U.S. customs duties data shows an increase of nearly $3 billion per month as shown in Exhibit 3. When annualized, this equates to approximately 0.2 percent of U.S. GDP, tracking closely to earlier projections.

There is a wide disparity of opinion on the trade issue. On one side is a fairly academic and well-researched body of economists that see open and free trade as a general positive. In theory, free trade enables each geographic region to specialize in areas of production that come naturally or with efficiency. On the other side are those who believe trade agreements are unfavorable for a particular business or industry. Further, some note that free trade is premised upon fair trade, but that not all global trading partners seem to operate by the same rules.

Years of rapid trade expansion has driven both economic and business growth, but with it has come a myriad of trade agreements struck by multiple international ambassadors, representatives, members of Congress and administrations. It is conceivable that some agreements may be unbalanced, favoring one nation over another. While difficult for many to envision amidst the discomfort of the current escalating high-tariff environment, this leaves room for negotiation and reconciliation. If more-fair trade policy were created, the resulting reduction in tariffs would be liberating to U.S. businesses in the long run.

#2 Monetary Policy

“We’re a long way from neutral…probably.” —Federal Reserve Chairman Jerome Powell, October 3, 2018

“I feel, and our committee feels, that our interest rate policy is … roughly neutral.”—Federal Reserve Chairman Jerome Powell, March 10, 2019

The second and perhaps loudest market outburst of 2018 came in reaction to communications surrounding monetary policy. In October 2018, Federal Reserve Chairman Jerome Powell stated that interest rates were still “a long way from neutral,” implying the likelihood of more interest rate hikes, which surprised investors. In reality, the Fed had already been hiking interest rates for nearly two and a half years and the level of interest rates was actually much closer to the Federal Open Market Committee’s estimate of the long-term interest rate (Exhibit 4).

Then, in his December 2018 speech, Powell suggested that the shrinking of the Federal Reserve’s balance sheet was essentially on “autopilot,” suggesting the ongoing pace would remain relatively unvarying for the foreseeable future. This unnerved those investors who worry the Fed is not amply concerned with the economic and market impacts of its actions. Interestingly, neither statement differed significantly from remarks made by former Fed Chair Janet Yellen. The difference was in the timing. Yellen’s remarks came during the middle of an expansion and at the start of a Fed tightening cycle. The market’s lack of receptiveness at the time was emblematic of the late-stage expansion.

Fortunately, the leadership of the Federal Reserve does not live in a bubble. They are truly data dependent and objective, evaluating both economic data as well as remaining in touch with investors and other market participants so they can understand the markets’ reaction to their policies. As a result, the Fed has since shifted course, communicating now that interest rates are near neutral and projecting a much slower pace of rate hikes, if any. Members are using words like “patient” to define the intended path of rate hikes and further balance sheet reduction, as shown in Exhibit 5.

#3 Debt and Deficits

“Avoid the accumulation of debt…”—George Washington

“A national debt, if it is not excessive, will be to us a national blessing.”—Alexander Hamilton

Government spending is another concern that came into focus toward the end of 2018. Admittedly, the main concern around the end of the year was related to the government shutdown. Fortunately, the shutdown ended not too long after it began. However, related fears concerning the magnitude of government spending and the resulting debt on the government’s balance sheet remain.

Since the financial crisis in 2008–2009, the U.S.’ net government debt has risen from around 40 percent of GDP to nearly 80 percent of GDP (Exhibit 6). It is hard not to worry about the sustainability of this mountain of federal debt. Acknowledging this concern, it is important to note that the cost of paying the interest on this debt has remained relatively low, at around 3 percent of GDP. In short, this level of federal borrowing is reasonably sustainable for as long as interest rates remain low. With the Federal Reserve now targeting a continuation of low interest rates, this window of sustainability appears yet again to have been extended.

While low interest rates make the burden of federal debt more bearable, prudence would suggest the government work toward a more balanced budget. Yet, both 2018 and now 2019 have seen an expansion of government spending and a resulting tailwind to near-term economic growth (Exhibit 7). An accounting of the spending plans detailed in recent legislation and budget agreements point to a reversal of some of this spending in 2020. Of course, 2020 is an election year. Election years, particularly when they involve the re-election of a first-term president, tend to see less reduced government spending or policies that could impede economic growth. So it may not be in 2020, but it appears that budgetary conservatism could become a headwind to economic growth at some point following the election.

#4 Earnings Recession?

“If a business does well, the stock eventually follows.”—Warren Buffett, Berkshire Hathaway Chairman

“What we live and breathe is on the income statement.”—Nelson Peltz, Investor

The last outburst of 2018 persisted into 2019 and concerned the path of corporate profits. After a year of exceptional earnings growth resulting from tax reform and a strong economic backdrop, analysts are expecting a year-over-year decline in Q1 (Exhibit 8) and with Q2 earnings estimates looking quite modest, a technical earnings recession is possible. Earnings recessions are often defined as periods in which overall corporate earnings decline for two quarters in a row. Earnings and earnings growth are primary reasons for owning stocks, so it is understandable this may cause investors angst.

Fortunately, even if there were an earnings recession, not all recessions are equal. Earnings recessions can be divided into two relatively distinct categories: earnings recessions associated with economic recessions, and those that are not. Earnings recessions associated with economic recessions tend to be more severe, with larger declines and longer durations. Earnings recessions that are not associated with economic recessions tend to be more shallow and short-lived. Often, the earnings weakness is concentrated in a minority of sectors or industries and investors can more easily see the light at the end of the tunnel. The trajectory of earnings still bears monitoring but the risk of economic recession should be the primary focus when evaluating the likelihood of material declines and sustained loss.

Strategy: Investment Implications of Our 2019 Themes
In summary, market outbursts over the past 12 to 18 months reflect anxiety about the sustainability of the 10-year bull market. Below, we summarize Glenmede’s viewpoint on each specific category of outburst. While some excesses have accumulated and the risk of recession is more elevated now than at any point in the cycle, recession should still not be the base case.

At the same time, investors should understand that rising markets and lower fixed income yields come with lower future returns. Expectations for longer-term portfolio returns should be balanced accordingly. Investors should also actively re-evaluate and rebalance to target allocations established with their Relationship Managers to reflect goals and spending plans. More recently, rebalancing would have meant purchasing equities on the decline in December and having trimmed equity strength at the beginning of this year.

Investors should also shop among the shunned. Narrow markets do not tend to persist. Investors should attempt to strike a balance between growth and value, favoring value on the margin. We suggest looking abroad where valuations can be more attractive, paying particular attention to Japan and emerging markets in Asia where more favorable circumstances are still not fully reflected in relative valuations.

Lastly, investors should focus on risk management at this stage of the cycle. The first step is to utilize a modest level of portfolio protection as the risks to the expansion and equities become more pronounced. Our base case remains that the expansion will continue, requiring a balance between growth and protection. Reducing equity exposure is one way to achieve moderate protection, but we prefer employing defensive equity strategies. Partly insulated from volatility, defensive strategies should fare better than cash or bonds if the expansion continues. Further risk management steps include reductions in equities, although such actions are not yet warranted.


You may also be interested in: Top 5 Pre-Teen Tantrums from This 10-Year-Old Bull Market
 

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1 Melissa McCarthy is an Emmy-award-winning actress, comedian, writer, producer and fashion designer.

2 Mark McKinnon, an American political and media advisor and executive, has worked for President George W. Bush, Senator John McCain, and Bono. He is also the co-creator, co-executive producer and co-host of Showtime’s The Circus: Inside the Greatest Political Show on Earth and a consultant for HBO’s The Newsroom and Netflix’s House of Cards.