April 16, 2019 Letter to Clients

While on a walk recently with my wife, Jodie, the kids and our two very energetic dogs I recalled an article I had read in which an analogy was drawn between walking a dog and the relationship of the economy and the stock market. As there is much discussion surrounding what lies ahead for the U.S. and global economies in 2019 and beyond, I thought it may be beneficial to discuss that relationship and why economic data and prices on Wall Street may reflect one another but behave drastically different at times.  

It’s not uncommon to view the economy and stock market as one and the same. When the economy is booming, the stock market must be as well, right? Not necessarily. While the two are connected they don’t always look or behave the same even when heading in the same direction. All too often on my walks, the dogs pull in different directions chasing squirrels, digging holes and playfully greeting everyone along the way despite my every attempt to keep them focused on our path. Passersby comment on and interact with them more so than they do with me, as I’m not as entertaining, with my moderate pace, normal steps and attention on the road. The economy steadily trudges along as I do on my walks whereas the dogs, like the stock market, react quickly to their environment ripping to and fro, based on the latest noise and information.

We saw this occur in the last quarter of 2018 when the markets dropped considerably despite strong economic data. Healthy consumer spending and record corporate earnings were unable to boost or sustain market prices as worries that plagued the markets throughout the year such as Brexit, a trade war, rising interest rates and the government shutdown all came to a head in December. I recognize that period was concerning for our clients, and I would like to take the opportunity to thank you for remaining disciplined and patient. Investors who remained invested through last year’s downturn have been rewarded by the refreshing market rebound this past quarter.

Slowing, but Still Growing

Although their optimism has dimmed somewhat from last October, U.S. consumers remain optimistic thanks in part to low unemployment and wage growth acceleration. We are currently near full employment and at our lowest levels of unemployment in decades with the number of job openings exceeding the number of those employed according to the U.S. Department of Labor. Consumer borrowing also continues to grow overall, albeit at a more moderate pace. There are, however, signs of a slowing U.S. economy. Despite tame inflation, U.S. consumer spending was short of projections in January. In addition, with the number of workers on the sidelines shrinking in recent months, labor market tightness has increased causing low productivity growth.

Analysts previously expected S&P 500 earnings to decline for the first quarter this year, however, banks such as J.P. Morgan and Wells Fargo unofficially kicked off earnings season on Friday posting profits and revenues that topped expectations. Of the companies that have reported earnings so far, 84% are beating expectations. If companies continue to beat estimates, this will set the tone for the remainder of the year as an improvement in earnings typically translates into higher stock prices and vice versa.

The Fed and the Inverted Yield Curve

The Federal Reserve’s most recent announcement on March 20th to leave rates unchanged was a welcomed reversal to their previous expectations of two policy-rate increases this year. This dovish approach followed the expectation for slower economic growth in 2019 and the Fed becoming more data dependent. Economists have also noted that the Fed’s policy pivot played a role in improving financial conditions last quarter. I do not anticipate further rate hikes from the Fed this year. If the Fed were to take any action, I do see the potential for a rate cut of no more than 25 basis points.

With the U.S. Treasury yield curve inverting in March for the first time since 2007, many investors took notice as it was prominent in the news being that historically an inverted yield curve has been an indicator of a pending economic recession. To better understand the significance of the recent inversion, it is first important to understand the relationship between short and long-term interest rates of fixed income securities issued by the U.S. Treasury represented by the yield curve.

Typically, short-term interest rates are lower than long-term rates, therefore a yield curve inversion occurs when short-term rates rise above long-term rates. In the past, rapidly tightening monetary policy to fight inflation caused short-term rates to rise well above inflation, making money more expensive. Market sentiment in return suggested that the long-term outlook was poor. The March inversion, however, was unlike past yield curve inversions as it was driven by falling long-term yields rather than rising short-term yields. While we often look to history to predict the future, this past inversion suggests a less predictable relationship with economic growth.

Trade and a Messy Brexit      

With the global trade tensions remaining unresolved, the global economy is facing a slowdown. The International Monetary Fund, which analyses economic developments at the global level, indicated in its most recent outlook that the U.S. and China trade talks represent a critical ongoing risk to the global economy. The trade war between the two countries has disrupted supply chains and whipsawed markets over the last nine months, but recent announcements of progress towards a trade deal have lifted stocks slightly in hopes of an agreement covering technology, non-tariff measures, and agriculture among other items. An essential element of the deal would include China’s promise to purchase hundreds of billions of dollars of American goods to reduce the United States’ record trade deficit with China. Any real resolution would strengthen the stock market as uncertainty over the trade war would lessen. However, major questions remain over monitoring and enforcement procedures for whatever trade pact is made and whether tariffs would be part of any such enforcement.

On the Brexit front, three years after the United Kingdom voted to leave the European Union, negotiations over the withdrawal agreement are still ongoing. The recent decision to extend the deadline for the U.K.’s exit from the EU to October 31, 2019, means further uncertainty for businesses, trade and economic weakness in the U.K. and the rest of Europe. While the full impact to the global economy is yet to be seen, the uncertainty surrounding the deal remains a depressant for economic growth in the U.K. and the rest of Europe in the near-term. Even if a deal is reached by the new deadline, there are negotiations that will still need to take place throughout the transitionary period regarding trade and economic arrangements.

In Closing

Unless more significant signs of a deterioration in global economic and financial conditions arise, we still expect the markets to enjoy solid performance this year with continued bouts of volatility. In the next few months, I expect to see a near-term correction with the markets rebounding and subsequently trading sideways for a period if traditional seasonal patterns hold. With rising employment and rising wages, and tame inflation coupled with consumer and business confidence, the markets are poised to deliver a positive overall 2019 return.

We invite you to contact our office should you wish to discuss your portfolio or other financial matters. We appreciate your ongoing trust and confidence in our firm and as always, we will strive to deliver exceptional service you can count upon.

Best Wishes,

Steve LePage

These are the opinions of Steven LePage and not necessarily those of Cambridge, are for informational purposes only, and should not be construed or acted upon as individualized investment advice. Past performance is no guarantee of future results. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.