There is peace even in the storm.
- Vincent van Gogh
In November 1876, Vincent van Gogh excitedly wrote to his brother Theo of a brief moment when his persistent battle with depression unexpectedly halted as he strolled along the Thames. He relays to Theo that he was suddenly overcome with a sense of peace as he took in the beauty of the yellow chestnut tree leaves against the dark blue of a clear autumn sky. For that moment, he was able to look past the dogged clouds of his illness and actually see the world around him and embrace the tranquility. For that instance, he was able to clear his head and gather a new perception of the world around him. Like Mr. van Gogh, even the savviest investors can find new perspective when they step back and look again at what is around them; although, as investors, we need to seek both the good and the bad in order to gather proper perspective.
As our melancholy painter discovered, sometimes a moment of clarity surprises us and exposes unexpected realities hidden in plain sight. In the immediate future, investors will face a challenge of an elevated period of disorder, but investors will need to look past the noise for facts to make investment decisions. With pending impeachment proceedings, an election year, and all that is China, the threat of volatility seems to gather on the horizon. However, factors such as corporate earnings results, employment, consumer confidence, and GDP growth are some of the more relevant inputs which will drive investment results.
The Starry Night
When van Gogh painted The Starry Night, he painted it looking back on his time in the sanitarium. Many experts have noted his extraordinary ability to accurately place the stars, which he did from memory. As investors, it is important to accurately assess where we are in order to set the stage for the future.
Looking back over a turbulent quarter, it may surprise some to discover that the S&P 500 managed to eke out a 1.7% return, bringing the year-to-date return for the US stock market up to 20.6%. Although, it is just as likely to surprise observers to realize the market is only up 4.2% over the past 12 months. In between, we also saw a 20% decline and a reversal of Fed policy due to slowing economic growth. Somewhat ironically, concerns of a weaker global economy led to lower interest rates and easier monetary policy, improving the environment for stocks.
This environment is particularly positive for rate-sensitive and debt driven sectors, such as utilities, real estate, and other levered businesses. Real Estate Investment Trusts (REITs), for example, were the top performers for the quarter, and year-to-date returns of 29.7% were only eclipsed by the 31.4% return of Information Technology stocks. Technology stocks, along with other cyclicals, continue to benefit from a strong and seemingly resilient consumer. While quality remains a major factor for stock returns this year (primarily due to many big tech companies low debt levels,) it was replaced as the top driver of performance by cyclical stocks – up nearly 25% year-to-date.
Cyclical stocks are typically thought of as those companies particularly sensitive to changes in macro-economic conditions and are the “opposite” of defensive stocks – incidentally, the worst performing factor thus far in 2019 (+11.9%). This fact seems of note given the recent uptick in recession fears. Historically, defensive names have led stock returns prior to recessions. In fact, in 2007 and 2008, defensive stocks were the second best performers while cyclical stocks, as expected, came in as the worst performers during those years. For now, despite concerns for global growth, the U.S. consumer continues to spend and bolster the economy, and companies with more exposure are performing the best.
Some of van Gogh’s most recognizable works are of landscapes. Many are reminiscent of the beauty Vincent found along the Thames, but even in these works you will often find prominent symbols such as cypress trees or crows representing more ominous undertones. If there is a figurative cypress tree we should watch for, it would be deterioration in consumer confidence. Consumer confidence and spending go hand-in-hand. Tighter purse strings could portend major problems for the economy. While the decline has yet to appear, we are alert for catalysts that might weigh on sentiment; uncertainty emerges as one of the top suspects. Factors such as ongoing trade battles impact the global economy in a variety of tangible ways, and the uncertainty it foments is the more substantial concern.
Rumors around the years-long trade negotiations seemingly shift markets daily. However, true economic weakness could come to pass as opaque conditions force investors and corporate leaders to pause capital deployment. Conversely, tangible movement towards a resolution, even if a partial agreement, would help assuage investor concerns and, maybe more importantly, allow CEOs to make decisions on where and how to commit capital. Corporations can react and navigate a world with higher tariffs, but not knowing the playing field creates fears of strategy missteps.
As to the prospects of getting a deal done, the more uncertainty generated by negotiations, the more likely sentiment declines and weighs on the economy. Along with the pending U.S. election, this puts a great deal of pressure on President Trump to conclude the process. Indeed, according to Ned Davis Research, the incumbent party loses over 80% of the elections if the economy is in recession. With a deal complete, we could see a situation where stocks tied to manufacturing, industrials, or economies with close ties to China doing well. Either way, it appears the outcome could impact the teetering confidence of U.S. consumers. Although it is worth considering even with a positive resolution, the Fed could still emerge as a wild card, potentially negating the party.
Blue Irises often symbolize faith and hope. If you ever have the opportunity to venture to the Getty Center in Los Angeles, there you will find van Gogh’s Irises. The museum is unique in the use of skylights to illuminate works of art. The museum believes the use of natural light allows the visitors to see the works as they were created, and thus as the artist also saw them; the same picture under different lighting conditions might give the viewer a different perspective.
As markets continue to trek higher, investors need to keep an eye on valuations. However, investors should think of these valuations under varying conditions. The recent period of Fed rate cuts has fueled this year’s rally, but propping up asset prices today may lead to longer-term concerns. With this in mind, earnings continue to drift downward, likely resulting in a third consecutive quarter of declines. Since the Global Financial Crisis, we have had two other earnings recessions, the last seen in 2016. Though four of the last six earnings recessions did not lead to economic recessions, a higher stock market combined with lower earnings means elevated valuations. A sharp dip in earnings could result in a market that today looks reasonably priced, but is actually expensive – see the earnings collapse of 2008. Conversely, while the current environment of lower interest rates supports higher valuations, a rebound in economic growth and higher rates could set the table for a market correction.
Though we have seen issues with both top-line and bottom-line growth, net profit margins have recently improved. Net profit margins, as measured by FactSet, peaked in the third quarter of 2018 at 12.1% and abruptly declined to 10.9% as of the second quarter this year. However, they have rebounded to 11.4% on resilience of the consumer and modest inflation. At this level, margins remain well above 20-year averages. Worry creeps in, though, via the previously mentioned slowing sales numbers. Of the negative contributors to more modest sales numbers, international exposure stands out as the top culprit. Again, where we go from here depends greatly on global monetary, fiscal, and trade policies.
Reduction in international exposure
During the quarter, the Investment Policy Committee changed our outlook on International Equities to Underweight. This move was primarily based on a slowing growth in Europe and Asia, a strong dollar, and an uncertain resolution to the trade war. Simply put, in this environment there is an asymmetry of the risk/reward profile for foreign stocks.
While a few economies, like Russia and Brazil, have rebounded this year, there are few obvious catalysts in place that make foreign equities as a whole more attractive than U.S. markets. The Euro Area continues to face significant headwinds as German manufacturing slows due to reliance on a slowing Chinese economy. Brexit adds to the uncertainty as deadlines approach for a deal or no-deal exit. As these worries persist, many central banks are forced to aggressively seek ways to stimulate their economy; as a result, the dollar does not seem poised to significantly weaken despite rate cuts in the US. With global GDP forecasts continuing to decline, it is reasonable to expect these trends to continue.
Blossoming chestnut branches
One of van Gogh’s last works was a still-life of a springtime chestnut branch. It’s interesting that, even in his final year, he found beauty in the same trees which inspired him nearly 15 years earlier. As we enter into the last quarter of the year, we are met with some of the same beauty van Gogh found that November day nearly 150 years ago, and although we are cautious of the pending winter, we know there is much more below the surface. In the markets, we continue to benefit from positive conditions, and yet we worry about some underlying trends. While we must enjoy the beauty that we see like the leaves of the chestnut trees, we also must not look past the signs of the changing seasons.
In our portfolios we remain committed to mitigating risks where we can. Investors are forced to take risks to meet their goals, but those risks are offset by handy tools such as diversification, portfolio construction, and fundamental analysis. We try to tip the scales of risk with those tools in order to seek the best risk adjusted returns for our clients. As we invest in equities, the constant is safety in quality. While investors will not avoid all volatility, the true risk to investors is permanent loss of capital. Quality stocks are best positioned to offer peace during the storm.
Details you need to make a smart decision
BBVA is the trade name for BBVA USA, Member FDIC, and a member of the BBVA Group. Securities products are NOT deposits, are NOT FDIC insured, are NOT bank guaranteed, may LOSE value and are NOT insured by any federal government agency.
This material contains forward looking statements and projections. There are no guarantees that these results will be achieved.
Investing involves risk including the potential loss of principal. There is no guarantee that a diversified portfolio will outperform a non-diversified portfolio in any given market environment. No investment strategy, such as asset allocation, can guarantee a profit or protect against loss in periods of declining values. Past performance is no guarantee of future results. Please note that individual situations can vary. Therefore, the information presented here should only be relied upon when coordinated with individual professional advice.
Indexes are unmanaged and investors are not able to invest directly into any index.
International investing involves special risks not present with U.S. investments due to factors such as increased volatility, currency fluctuation, and differences in auditing and other financial standards. These risks can be accentuated in emerging markets.
Investments in stocks of small companies involve additional risks. Smaller companies typically have a higher risk of failure, and are not as well established as larger blue-chip companies. Historically, smaller-company stocks have experienced a greater degree of market volatility than the overall market average.
Equity investments tend to be volatile and do not involve the guarantees associated with holding a bond to maturity.
In general, the bond market is volatile as prices rise when interest rates fall and vice versa. This effect is usually pronounced for longer-term securities. Any fixed income security sold or redeemed prior to maturity may be subject to a substantial gain or loss.
Fixed income investments are subject to various risks including changes in interest rates, credit quality, inflation risk, market valuations, prepayments, corporate events, tax ramifications and other factors.
The investor should note that vehicles that invest in lower-rated debt securities (commonly referred to as junk bonds) involve additional risks because of the lower credit quality of the securities in the portfolio. The investor should be aware of the possible higher level of volatility, and increased risk of default.
Municipal bond offerings are subject to availability and change in price. If sold prior to maturity, municipal bonds may be subject to market and interest risk. An issuer may default on payment of the principal or interest of a bond. Bond values will decline as interest rates rise. Depending upon the municipal bond offered, alternative minimum tax and state/local taxes could apply.
The price of commodities is subject to substantial price fluctuations of short periods of time and may be affected by unpredictable international monetary and political policies. The market for commodities is widely unregulated and concentrated investing may lead to higher price volatility.
Investments in real estate have various risks including possible lack of liquidity and devaluation based on adverse economic and regulatory changes.
Other Sources: Bloomberg; California.gov; Russell.com; First page index returns are calculated on a total return basis using the following indexes: S&P 500 (SPX), MSCI World (MXWO), MSCI Emerging Markets (MXEF), BofA Merrill Lynch U.S. Treasuries 1-10 years, BofA Merrill Lynch U.S. Agencies 1-10 years, BofA Merrill Lynch U.S. Corporates 1-10 years A-AAA, BofA Merrill Lynch U.S. Municipals 1-10 years A-AAA, Russell Top 200 Index, Russell 1000 Index, Russell Midcap Index, Russell 2500 Index, Russell 2000 Index, Credit Suisse High Yield Index (CSHY), MSCI U.S. REIT Index (RMZ Index).