After some relatively minor volatility over the course of the summer, stocks are once again at all-time highs. That’s the good news. The bad news is that there really hasn’t been much progress with regard to the issues critical to prolonging the market rally, which include: 1) resolutions to the trade negotiations with China, Europe and Canada/Mexico ; 2) a firming in global growth prospects; and 3) an end to the downward corporate earnings revisions that have been ongoing for more than a year.
In fact, some might claim that a couple of new “black swan” risks have emerged. The first is that Congress is now fully engaged in an impeachment inquiry relating to President Trump’s discussions with the president of Ukraine. The second is that the balance of power in Syria, and indeed the Middle East at large, may be shifting as the Trump administration has decided to pull troops out of the region. While I have neither the expertise nor inclination to opine on the impeachment proceedings or Middle East policy, I will say that the polarization resulting from Donald Trump’s election three years ago has intensified and is unlikely to recede anytime soon. At the very least, the ever-increasing vitriol from both sides of the aisle is going to make it very difficult to get anything done in Washington. A somewhat less likely outcome is that Trump’s presidency, and what many perceive as his business- and market-friendly policies, might come to an end.
This is not a trivial issue. The global economy may be at a critical turning point right now as manufacturing and trade continue to recede. Central banks across the globe already have the pedal to the metal, and interest rates in some regions are now at levels nobody thought possible. Yet even at near-zero borrowing costs, businesses remain reluctant to invest given the economic and policy uncertainties. The Tax Cuts and Jobs Act (TCJA), among other factors, certainly helped the US avoid the kind of economic downturn we now see in Europe and other places. But the stimulative effects of the TCJA were largely fleeting, and businesses still seem more inclined to return capital to shareholders than anything else. At many points during the 10-year economic recovery, the US consumer has been the lone stalwart. But now it’s easy to imagine a scenario whereby sharp decreases in business sentiment trickle down to the consumer as well. Will the US labor market stay as robust if there is no resolution to the trade issues and/or economies outside the US fail to recover in a timely fashion? Will price increases resulting from tariffs begin to more fully offset the benefits of the tax cuts? Will weak corporate earnings force management teams to tighten belts even more? Will consumer confidence and the propensity to spend finally be impacted by goings-on in Washington, DC? Suffice it to say, a lot is riding on the US consumer.
My worry is that a gridlocked government will not be able to implement the policies necessary to avoid a more pronounced economic downturn. There is more room for interest rates to fall, but the Fed has nowhere near the firepower it usually has going into a recession. A large-scale infrastructure bill could prove a nice shot in the arm for the economy while also boosting labor productivity (which has been weak since the end of the Financial Crisis). However, such fiscal stimulus could be limited by the fact that federal budget deficits are already running at $1 trillion annually as a result of the TCJA. Moreover, it may not be realistic to think that Congress will be able to compromise on a large-scale anything for the foreseeable future.
The economic outlook has become cloudy, earnings expectations continue to fall, stimulus may be in short supply, and yet stock prices remain firm. It sure seems like a good time to dial back the risk. As always, though, we think it makes most sense to remain fully invested. The short-term path of least resistance appears to be inching upwards. While we are at all-time highs, values for the markets as a whole are high but not overly stretched (on a price-to-earnings basis). Put another way, we aren’t in bubble territory. There are many high-quality and defensive companies out there that have not fully participated in the FANG-driven bull market. It sure seems like a good time to own more of the former and less of the latter. Finding stocks that do have “room to run” while still providing relative security if the markets begin to sour isn’t easy – but for the diligent investor, there is value to be found.