“It’s Déjà Vu All Over Again”
That famous quote attributed to baseball legend Yogi Berra could just as easily apply to the stock market today. In fact, it strikes us that many of Mr. Berra’s “Yogi-isms” apply to today’s stock market, but we digress… Fear of a recession at the end of 2018 caused the Federal Reserve to announce early this year that planned interest rate hikes were being put on hold. That set the stage for this year’s strong rally in stocks, despite a brief interruption in May over rising concerns about slowing global growth and deepening trade tensions. In early June, the Fed proclaimed that it was ready to pivot again by cutting rates if economic conditions deteriorated further, and the rally was back on. In spite of a recent return to worries over growth and trade, the S&P 500 advanced 17% year-to-date through the end of August.
“I Knew the Record Would Stand Until It Was Broken”
While the U.S. is enjoying the longest expansion since we began recording economic cycles in 1854, it has been a rocky road. Generally this recovery has been shallow and drawn out with intermittent slowdowns. We are currently experiencing our third global slowdown in this decade-long expansion. It is not enough to push us into a full-blown recession, but is certainly a noticeable retracement from prior levels of economic activity. These periodic pauses help explain the historic length of this expansion. They also help to explain why inflation has remained subdued, since high levels of growth can trigger dramatic price increases. Our economy hasn’t had the opportunity to overheat as has typically happened in the past, forcing the implementation of monetary measures that not only slowed growth, but ultimately culminated in recession. With tame inflation, interest rates have hovered near historically-low levels.
“You Can Observe A Lot by Watching”
Domestic GDP growth this year came in at a robust 3.1% in the first quarter and declined to 2.1% in the second quarter. That number will likely drop further in the third quarter due to global economic headwinds. Growth in the fourth quarter should benefit from global monetary and fiscal stimulus, including likely additional interest rate cuts by the Federal Reserve. We expect roughly 2% growth for the year as a whole, in line with the average for this expansion.
The picture internationally is quite different than here at home. China, the world’s second largest economy, is experiencing its slowest growth in more than 25 years. The growth rate of the Chinese economy peaked at 10.6% in 2010. It has since gradually fallen to the 6% level targeted for this year, a modest rate which few believe will be reached. Overall debt in China has quadrupled in the past decade, with corporate debt accounting for two-thirds of the total. Much of this money has been poorly allocated and invested, resulting in a rash of 18,000 bankruptcies last year–twice as many as the year before. Until recently, bankruptcies in China were almost unheard of.
Other major economies are also suffering, but to a lesser degree. Manufacturing weakness is evident in Japan, Germany, the United Kingdom, Taiwan and Australia and is manifested by factory output and orders that are lower than a year ago. Not surprisingly, many of these countries’ economies are export-driven and very directly impacted by the increased trade tensions.
“The Future Ain’t What It Used to Be”
Despite the recently increased rhetoric around the U.S. and China trade talks, it is possible the severity of the trade wars may be peaking. While complete resolution could be a lengthy process and its timing difficult to handicap, both sides need progress to be made. Measurable damage has already occurred to economies around the world and the uncertainty involved has negatively impacted business investment spending both here and abroad. A return to a more normal trade environment would be a welcome boost to global economic growth.
Slow growth, low inflation and weak economies have resulted in low bond yields worldwide. The 10-year U.S. Treasury bond is down from 2.7% at the end of last year to 1.5% recently. Comparable 10-year yields in Japan and Germany are actually negative! Central banks around the world are shifting toward easier monetary policy. In the U.S., rates on short-term bonds are above those for 10-year treasuries. Having just changed course and reduced interest rates in July, it is widely expected that the Fed will implement additional rate cuts in order to eliminate the inverted yield curve and support continued economic growth.
Stocks have benefitted from low rates lifting valuations and prices. Another boost to stocks has come from corporate share buybacks. Publicly owned companies generally return excess capital to shareholders in two ways: increase dividends or repurchase shares. While both approaches can increase share prices and benefit shareholders, buybacks have attractive aspects for both corporations and their shareholders. Share buybacks have been around for as long as corporations have existed. They give companies flexibility when it comes to spending excess cash, in addition to commonly offering shareholders preferential tax treatment versus paying dividends and offsetting dilution from employee stock options. Share repurchase activity has accelerated recently, hitting a record last year of $800 billion and estimated to reach $940 billion in 2019. With fewer shares outstanding, earnings per share have also increased by roughly 2% annually the past few years.
“It Ain’t Over ‘Til It’s Over”
Despite stocks having generated strong gains this year, and now facing global economic headwinds, there are solid reasons to believe that the market can continue to build on these results. Two key foundations for our economy, employment and consumer spending, remain robust. Our portfolio companies have reasonable valuations and continue to perform well. The market looks ahead and discounts back to the present. Investors are already looking beyond this latest economic swoon and focusing on the remedies on the horizon. The odds remain firmly in our favor that we will experience additional gains in the foreseeable future.
Holger Berndt, CFA Director of Research