“Goodbye Yellow Brick Road?”

 In News, Quarterly Update, Strategy Updates

Fed Pivots, Trade War Ensues and Earnings Loom

Over the past 18 months global investors have experienced a number of crosscurrents which created quite a bit of drama, yet yielded little upside in global stock markets. For those less invested during this strange period there has been little missed opportunity. During the past year and a half we have witnessed stock indexes attempt new highs not once, but three times, without success. We find this current fourth attempt of interest, since it is in the face of impending earnings results, well-documented slowing economic growth, trade wars and an inverted yield curve – all of which has caused the Federal Reserve to finally agree that we may have veered off “the yellow brick road” as they now consider lowering interest rates. If and when the Fed reduces rates, will it be too late given the well-publicized weakness in so many economic indicators? And what should investors anticipate for the second half of this year?

Source: Bloomberg

In many of our previous Strategy Updates, we have emphasized the importance of data: economic and corporate profit growth is essential for meaningful stock market returns. However, a third prong – policy – has played an increasingly important role in financial markets as evidenced by trade wars and the Federal Reserve. Has our path to generating great long-term returns changed? Should we say, “Goodbye yellow brick road?” We think not.

As we have discussed in detail, trade wars pose a significant risk to global financial markets as companies are forced to rethink supply chains, which impacts margins and ultimately profitability. With earnings season right around the corner we have already seen a few companies like Broadcom and FedEx report poor quality earnings with explicit citation of geopolitical uncertainties – namely the trade war! It will be interesting to see if these reports are the “canary in the coal mine.” We continue to believe that this trade war must be resolved in order for this market to resume a longer-term uptrend.

Jerome Powell and his colleagues at the Fed have pivoted their policy from just short six months ago, which has led investors to price-in rate cuts by year’s end. The purpose of lowering interest rates is to stimulate an anemic economy and inflation rate while attempting to counteract the inverted yield curve, which has historically preceded recessions. However, the idea of cutting interest rates so soon and so aggressively suggests that the US economy and moreover global economies are not on firm ground – a view we have had for some time now. We certainly do not want to “fight the Fed” if they do decide on a more accommodative policy path like European counterpart, Mario Draghi. However, simply flooding the stock market with additional capital is a bandage on a ten-year wound, which has never fully healed post 2008. The Fed’s lack of tools – specifically the inability to cut rates further from an already low level – leaves the global economy particularly vulnerable as we go forward. This is why we stand prepared to thoughtfully add stock exposure if the Fed acts as the markets want, yet keep on hand risk management tools, such as stop-loss orders and sector management, if simply lowering rates does not get this economy back on track.

While both global economic growth and earnings quality have decreased over the past few quarters, they are still positive (particularly in certain sectors), which bodes well for businesses with consistent revenue models – think goods and services you cannot live without! These are the types of companies we want in your portfolio. The better than expected index performance in defensive sectors such as utilities, consumer staples and healthcare this year has validated our thesis. A lower interest rate environment would also offer more interesting opportunities in the public real estate market (REITs) and select business models. We are cautiously optimistic that the backdrop of low inflation, an accommodative Fed and resilient economic and earnings data will get this market back on track. We expect several corrections along the way as policymakers and companies alike navigate this new landscape and we stand prepared to thoughtfully add exposure to sectors and companies performing well in this environment. Should trade talks continue to break down, the Fed act too late, or corporate profits and economies deteriorate further, we are well prepared to weather the storm.

As you know, we are a highly competitive team and always strive to put the odds in your favor for a great year of performance. Our defensive posturing over the past 18 months in the face of data described above has not cost your portfolio a great deal. We pride ourselves on delivering great long-term performance by managing our way through catastrophic declines and participating in long-term uptrends. When there are periods of conflicting asset prices and data we tend to err on the side of caution, as protecting capital in bear markets allows you to better reach your long-term goals of retirement, spending policy guidelines, or next generation legacy. In that spirit, we continue to look for further evidence of better earnings quality, economic growth and trade resolution before we become significantly more invested with your portfolio. We think such a period may come sooner than most investors think.

We hope you find this update helpful and if you have any questions about your portfolio, wealth plan, or have experienced a significant change in your finances, please feel free to contact us.We appreciate your continued vote of confidence in our work!

Your Team at Main Street Research.

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