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What Did We See?

• The US equity markets experienced some heightened volatility through the second quarter.
• After sinking through most of May, the market rebounded nicely to achieve new all time highs in June.
• The Federal Reserve made a rather significant pivot towards a potential rate cut in 2019.
• Emerging Markets achieved just under 2% returns for the quarter.
• Japan had a slightly negative quarter while the UK added less than 2%.
• Global growth has continued to slow and the US yield curve has signaled more pain to come.

Where Do We Stand?

• While it is difficult to “fight the fed”, we are steadfast in our belief that the economy and the market are currently disconnected.
• In a preponderance of safety for our clients, we have de-risked most portfolios where appropriate and await further data.
• The Fed will continue to remain patient but has clearly indicated they will act quickly as the global environment dictates.
• The yield curve has “weakly” signaled a recession but the economy is on relatively solid footing and the odds of a deep recession remain low.
• We continue to rebalance your accounts accordingly and have been impressed with the power of the asset allocation strategies we employ.

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This quarter we will dive into the unsolved mystery of stock prices. As some of you know, we have seen an incredible rally in large cap stock prices thus far in 2019. In fact, the S&P 500 is up around 17% for the year! Let me repeat that. The S&P 500 is up by about 17% this year. Only half of the year is over and the average person would never believe the market has done so well. With the preponderance of negativity that has permeated our culture, from local, state and federal politics to geopolitical tensions, it is amazing that the market has done so well.

What is driving this and what does it mean?

A Mysterious Cut?

This past quarter equity prices were buoyed by the prospect for a Federal Reserve rate cut. While the current administration has been publicly pressuring the Fed to cut rates, the current group of governors of the federal reserve, including it’s chairman, Jerome Powell, has made it abundantly clear that they will not be bullied into a rate cut. They have also made it clear that any rate cut would be driven by data on the health of the US economy.

Which makes the prospect for a rate cut (or cuts) not necessarily a “good thing” in this analysts eyes. In fact, one may ponder that if the Federal Reserve is in fact cutting rates they are only doing so in the face of poor economic data AND a desire to exhibit their independence from political pressure.  This independence has permeated the institution since its founding. I believe that if there was any doubt as to whether or not rates should be cut, the majority of governors could lean towards not cutting in an effort to display that independence from politics. However, the data may force their hand.

Currently we have seen some weakness in some of the data that the Federal Reserve likely watches. The May 2019 jobs report saw only 75,000 jobs added to the US economy. Economists had expected a gain of 180,000. As you can see below, the trend is heading lower.

Wage growth has also seemed to stall, as you can see below.  While it still remains well over the ten year average (red line), most workers aren’t feeling the benefit because of inflation in food and housing prices.

Despite the slightly bad data, the market thinks a cut in rates would be a good thing. This may be due to the short term nature of stock markets or it may be something else. To be fair, a rate cut very well may be a good thing at first but the old adage “It’s the economy, stupid” comes to mind when I think of the longer term effects of a cut. If the economy is in fact struggling (or beginning to struggle) the data the Fed sees will be too late. And if the data is too late, there will be some level of depressed earnings that will have to flow through the system.

In reality it is not rate changes that will matter to the economy.  It is the availability of liquidity (or reserves) in the banking system that matters. Every prior Fed-induced recession in the US was caused by a withdrawal of reserves, not rate increases. Today there is still $1.4 Trillion  (with a “T”) in excess reserves in the system. Today is not a tight money scenario to say the least.

The US economy is seeing a boom in retail sales, extremely low unemployment and strong enough GDP growth. Certainly there are some signs of weakness in recent surveys (see above) and the yield curve has had some small inversions. However, nothing that should warrant a rate cut has happened, in our eyes.

This is why it is imperative that we watch the earnings picture as it plays out this quarter. By the second week of July we will begin to see how companies are handling and reacting to the pressure that is building.  Can companies weather the storm of higher input prices due to tariffs? Can companies pass this cost on to consumers? Are consumers willing (or able) to handle the higher prices? Many questions that will have implications for the next few quarters may be answered in the next month.

The Mystery of Stocks versus Bonds

Look at the mystery of the bond market versus the stock market in the chart below. While bond yields (red line) have been moving lower since late last year, the stock market (blue line) continues to strive to new record highs. When bond yields and the market separate like this there usually needs to be a resolution. That resolution can come in the form of falling stock prices (blue line goes down), rising rates (red line goes up) or some combination of the two.

As a wealth manager I always try to work in the realm of “highest” probabilities.  What is most likely to happen and how can I protect my clients from it?With weakening economic data the likelihood of rising rates is a pretty low probability event. In the meantime, with the market at or near all time highs one would think a consolidation phase is somewhere on the horizon.

The Mystery of Animal Spirits

There is a recurring narrative at hand that states that the US Economy is in major trouble. This was likely caused by the mini correction the stock market experienced in the fourth quarter of 2018. At that time the Fed was raising rates in a declining market and when they stopped, the market recovered. Hence, many participants believe there is now an immediate correlation between a weak and fragile economy and what the Fed is doing. The story goes, if the economy is so weak that it cannot handle a few rate increases then we are in some serious trouble.

Whether or not this correlation exists is pointless at this point. The market thinks it is true and that is all that matters. If the Fed cuts rates the market will go up. Maybe it has already gone up during June in anticipation of a cut? In which case a lack of a cut could spell doom for the market in the short term.

So why the unsolved mystery of a rate cut? A rate cut at this point will not matter, longer term, to the health of the economy. A rate cut will effect the stock market in the short term because everyone can then say “The Fed saved us”. If, in fact the economy is weak, a rate cut would only be sowing the seeds of future problems. Because if those real  problems do eventually materialize, the Fed will then have one less arrow in their quiver to deal with it.

Where do we stand at Shorepine Wealth Management?

Everything above speaks, once again, to a later cycle mentality that can lead to fits of volatility. This means taking a more defensive position while maintaining one’s asset allocation strategy as closely as possible. Sometimes in this game you need to dance, sometimes you need to sit and sometimes you hide under the table. Today’s environment calls for a little dancing.

We continue to monitor this recession story very closely.  As stated last quarter, “While we would hate to have our clients miss any returns, we are also keenly cognizant of the need to protect our clients from losses.” We are well positioned to better handle these “fits of volatility” within your portfolios today than we were last quarter. Note that we did not make any wholesale changes as we are true believers in the power of asset allocation.  Losses can be mitigated by a good allocation strategy.

Overall, we see no signs yet that a recession is imminent. While some monthly data points have been weak, those can recover in one month. One doesn’t want to place the fortunes of their future on one or two bad months of data. It is true that global growth is slowing. It just may not be enough of a slowdown to turn over the whole apple cart, as they say.

If you have any questions or have experienced any changes in your financial situation please do not hesitate to contact me.

We appreciate your being a part of the Shorepine Wealth Management family and wish you all the best!

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