Lower For Longer?

Capital Market Comment
December 4, 2019
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer

As the market has made new highs, the uncertainties that have plagued investors and have been the focus of the financial media continue to remain ensconced in the daily dialogue.

China trade tensions, Hong Kong, Brexit, impeachment, European stagnation, the upcoming election cycle, and the pace of economic activity in the U.S. is the daily menu.

Several things have changed since early October which appear to have impacted the investment landscape. First, the Federal Reserve has followed through with a third rate cut at the end of October. Moreover, since the monetary authorities have failed to attain the 2% inflation target for nearly a decade, the central bank has given numerous indications that it will be looking at its inflation target of 2% differently.

As we discussed in our October 21st commentary, the structural issues of inflation as it relates to technology, the symmetrical objective, and the feedback mechanism to the economy are the subject of intense research at the Fed.

Although early next year the results of the internal research effort will be released, there have been indications that its findings will support the need to allow monetary policy to remain accommodative longer in order to achieve an inflationary target that is truly symmetrical (having inflation exceed 2% so that the average over time makes up for the underachievement). The implication of these changes suggests that the risk of short-term rates going up next year is extremely low. Furthermore, with 2020 being an election year and the low profile the Central Bank tends to seek during such a period, the need for policy adjustments (even if inflation runs about 2%) can easily be delayed until 2021 and beyond.

Secondly, although manufacturing and agriculture appear to exhibit recessionary conditions, the overall economy continues to expand as evidenced by employment growth. Nonfarm payroll employment has increased on average over 150,000 a month in 2019 with the participation rate continuing to rise. Employment drives consumption and consumption accounts for more than 70% of the economy. These gains have reduced the concerns of impending recession.

Third, the ebb and flow in the trade negotiations have had a positive bias. The market has taken some comfort in that the escalation of trade tensions may have lessened. However, the passage of the Hong Kong legislation and the potential reinstatement of steel tariffs against Argentina and Brazil shows how tenuous the general trade landscape is. The uncertainty it generates has an adverse impact, which is far greater than the economic consequences of the action. The December 15th deadline for the next round of tariff increases against China is particularly important. A delay or rollback would provide a sense of relief and refocus attention on underlying economic and financial fundamentals. However, President Trump’s recent comment suggesting a possible delay until after the election highlights the tenuous nature of the trade negotiations.

In our judgement, the trade saga will persist for some time with no clear resolution. What will matter to the markets is the extent of escalation or de-escalation of the conflict. Despite the current market levels, the fundamental investment landscape appears to STILL be positioned with an upward bias.

The 10-year Treasury rate is still below the yield on the S&P 500, real (inflation adjusted) short-term interest rates are negative and likely to become more so if the Fed hits its inflation target. These conditions are constructive for the economy and the market.

The 3rd quarter earnings season is essentially over, and the results were better than expected. The recession mentality played into those expectations, and they were generally not fulfilled. GDP in Q3 was at an annual rate of 2%, and Q4 is shaping up to achieve 1.5% – 2%. Moreover, corporate profits (with IVA and CCA adjustments) troughed in Q1 and rose in Q2 and Q3. Corporate cash flow (with the same adjustments) followed a similar pattern but hit a low in Q4 2018. This directional change provides a higher floor under the equity market. Earning of the S&P 500 are projected to rise 4-5% next year, reflecting continued caution. However, Real GDP in the 2% range and an uptick in inflation may generate a better profit picture.

As we look to next year, we should not lose sight of the low level of interest rates and the likelihood they will remain low, thus supporting higher p/e ratios than was the case in other cycles. Additionally, the negative rates on 10-year bonds in Germany and Japan serve to hold U.S. rates down. It is amazing that the 10-year rate in Greece is lower than the U.S. 10-year rate. Most importantly, international flows weigh heavily on the rate structure.

 

 

 

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 don@mcapitaladv.com
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or claude@mcapitaladv.com

Mastrapasqua Asset Management, Inc. does business as M Capital Advisors.

104 Woodmont Boulevard, Suite 320
Nashville, TN 37205
615.244.8400

200 Concord Plaza, Suite 500
San Antonio, TX 78216
210.353.0500

© 2019 Mastrapasqua Asset Management, Inc. All rights reserved.
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.