Capital Market Comment
October 21, 2019
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
Much debate surrounding the economic outlook has emerged over the last several months. The media has managed to make the probability of recession a daily news feed. A number of high-profile investors and forecasters have weighed in on the likelihood of a 2020-2021 business downturn. Recently, Moody’s Analytics believes there is an “awfully high risk” of a global recession in the next 12-18 months. The International Monetary Fund has lowered its growth rate again for world economic growth to 3.0% in 2019, citing the trade conflicts. The behavior of the yield curve has added to the debate. The movement into inversion then flattening, then positive, then back again has been an element of confusion.
At the same time, overall U.S. economic activity continues to rise at a moderate pace with nonfarm payrolls increasing at a 156,000 average over the last three months. However, evidence of weakness in manufacturing has emerged and business confidence and spending has taken a cautious tone.
The trade conflict’s impact on world economic activity, as evidenced in the decelerating growth path (less than 6%) in China, declining exports in Germany, and generally weak growth in the European community, has policy makers resorting to the tool that they used aggressively since the financial meltdown: monetary policy. However, fiscal policy would be a viable tool, certainly in the current interest rate environment. But the political resolve, particularly in Europe, does not yet exist. Germany, the country best positioned to embark upon a stimulative fiscal policy, is mired in the historical burden of the hyperinflation of the 1920’s and the inflation pressures of the 1970’s and 1980’s. Consequently, monetary policy is the only expedient and viable choice. Virtually every major country has lowered its interest rates and some, multiple times this year.
The European Central Bank has become particularly aggressive, lowering a key lending rate by 10 basis points to -0.50% and extending the bond buying program indefinitely. They have also renewed the TLTRO (Targeted Long-Term Refinancing Operations). In an environment in which 15+ trillion dollars of government debt obligations have “negative” interest rates, monetary policy is being challenged.
The Federal Reserve has reversed course and began easing monetary conditions. Two rate declines have occurred this year and a third one is anticipated at the end of October. There has been a growing recognition at the Fed and elsewhere that there are structural issues with inflation. The technology revolution may well be a deflationary force. Consequently, the Fed’s failure to hit its inflation target requires more aggressive action and a more enduring easing strategy to achieve a symmetrical 2% inflation target. The research by the staff of the Federal Reserve is suggesting the need to rethink the feedback mechanism and linkages between inflation and employment. From the market’s perspective, the changes underway provide a supportive backdrop:
- Short-term interest rates are moving down and generating “negative” real rates – a positive for the economy and the stock market.
- Monetary growth (MZM & M2) has been accelerating in recent months and rising well above the inflation rate, thereby generating “real” monetary growth. With a lag, the benefits should be apparent by mid-2020.
- The S&P 500 yield of 1.90%, higher than the U.S. 10-year Government Bond of 1.75%, bodes well for equity prices. Historically, such a setting has generated positive returns in the next 12 months.
- An earnings yield of 6%, over 400 basis points above the 10-year Treasury, is also a bullish condition.
- Within the market, much discussion has surfaced surrounding growth versus value. However, the distinction is often less clear and adjusting positions to reflect what appears to be a shift is an exercise in futility. Maintaining one’s discipline and investing in secular themes should generate the most promising results.
As we go through the current period of slowing economic growth, the forces appear to be in place to reenergize the economy in 2020. However, the external factors of Brexit and trade conflicts remain and can be disruptive. There are indications that a de-escalation of trade tension is taking place, and a Brexit breakthrough may be at hand. Yet, a derailment can occur at any time. As we enter earnings season with expectations low, investor sentiment quite cautious, an emerging seasonally strong period, and valuations constructive, the bias to the upside appears in place.
If you have a question or need further information, please contact:
Don Keeney, CFA, CFP, Principal & Portfolio Manager in Nashville at 615-866-0882, or firstname.lastname@example.org
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com
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The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.