The Oarsman Outlook: July 2019

Nearly all financial investments provided solidly positive results during the April-June period, adding to a strong and broad-based early-year advance. Both large-company U.S. stocks and developed-market overseas equities advanced around 4% on the quarter; emerging-market stocks inched ahead, while the frontier-market category jumped more than 6%. Real-estate- and industrial commodity-related investments were up slightly; gold spiked 9% higher. Bond yields fell sharply (the 10-year U.S. Treasury ended at 2.00%, down from 2.41% on March 31), producing robust total returns from all but the shortest-maturity fixed-income investments.

Among large-company U.S. stocks, relatively strong gains came from stocks in the Consumer Staples, Financial Services, Technology and Utilities sectors. Below-benchmark returns were found among Basic Materials, Industrial, Energy and Health Care names. Growth-oriented stocks once again outperformed the value style, with the differential more pronounced among small-caps than in the large-company arena.

Benchmark Performance - Equities

Benchmark Performance - Fixed Income

Review

The April-June quarter featured lackluster economic news, rapidly evolving investor views regarding future monetary policies, and simmering trade-related and other geopolitical tensions. Broadly higher stock prices reflected a glass-half-full interpretation, while relentlessly falling bond yields augured a potentially darker future. Adding to the confusion, the quarter's best-performing asset was gold, which is traditionally viewed as a hedge against inflation and/or a bolt-hole in times of extreme market and/or political turbulence - neither of which seemed much in evidence.

Data released during the period showed the U.S. economy remained on sound footing, though weakness overseas and trade-related uncertainties sapped some strength from the manufacturing sector. Gross domestic product expanded at a +3.1% rate in January-March, up from the previous period's +2.2%. Monthly job growth averaged 168,000 in the four months through June - a slight moderation, but sufficient to push unemployment to a multi-decade-low 3.7%. Year-over-year wage growth remained above 3%. Consumer confidence rebounded from a turn-of-the-year dip and remained within striking distance of post-financial-crisis highs. The manufacturing sector was clearly under pressure, with the purchasing-managers' index falling precipitously; its service-sector counterpart reached a three-month high in June, though it was well off its 2018 peak. Residential real estate continued to cool: April was the 13^th-straight month of decelerating price gains; year-over-year appreciation of +2.5% was the lowest since mid-2012.

Overseas data continued to reflect a broad-based deceleration compared to the stemmy levels of 2017 - but also hinted a bottoming might be under way. First-quarter GDP growth was meaningfully below the year-ago pace in the European Union (+1.2% vs +2.5%), Japan (+0.9% vs +1.1%), and China (+6.4% vs +6.8%), but nevertheless improved marginally from the final quarter of 2018. Likewise, purchasing-managers' surveys, though well off cycle highs, were mostly stable or slightly improved during the quarter. European and Japanese business and consumer confidence continued to deteriorate; Chinese readings were more mixed. Near-recession conditions in major emerging markets (e.g., Brazil, Russia, South Africa, Turkey) probably pushed global growth to the slowest rate since early 2016.

Trade-related and other geopolitical tensions provided an uncertain backdrop throughout the quarter. Following a period of easing dating to last December, the China-US trade war flared anew in May, causing a sharp but brief sell-off on global stock markets. The benign outcome of the much-anticipated Trump/Xi meeting at the late-June G-20 summit was met with a welcome sigh of relief. Tensions between the U.S. and Iran heated up, causing ructions in energy markets; unrest in Hong Kong at quarter-end raised eyebrows; Brexit: anyone still paying attention?

The most notable development of the quarter was a surprising decline in global bond yields. The 41-basis-point (0.41-percentage-point) drop in U.S. Treasury yields was mirrored across major debt markets; by the end of June, the total stock of global debt trading at below-zero yields exceeded $13 trillion. The swoon reflected disappointing economic activity, falling inflation expectations and, importantly, burgeoning hopes for more accommodative monetary policies on the part of global central banks. According to the Bank Credit Analyst, as recently as January more than half the world's central banks were raising interest rates; as we write, Norway stands alone in that camp. Central banks of Australia, India and New Zealand have begun to cut rates, while both the U.S. Federal Reserve and the European Central Bank have clearly shifted to an easing bias. Little more than six months ago, investors expected the U.S. Federal Reserve to raise short-term rates multiple times during 2019 and 2020; today, the yield curve predicts at least two rate cuts in coming months, with more possible next year.

Corporate profits reported during the period - mostly covering the year's first three months - were underwhelming, coming in only about 1% higher than the year-ago period. Wall Street analysts spent much of the quarter trimming estimates, with the aggregate 2019 and 2020 figures each falling around 2% during the period. Nevertheless, profit growth is expected to pick up slightly over the remainder the year, though the anticipated full-year advance (currently around 7%, though still falling) pales in comparison with 2018's eye-popping 22% gain.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1. Dividend Income (for three months this is the annual yield divided by four)
2. +/- Change in Earnings per Share* (average for S&P 500 companies)
3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +4.3% S&P 500 total return?

 Our read: Though Wall Street analysts cut estimates throughout the quarter, the rolling year-ahead figure still posted a solid advance, keeping the increase in valuation in check. Given the notable decline in bond yields, stocks are not unduly expensive at present.

Outlook

Financial markets seem to be telling two different stories about the future. Bond investors appear focused on sluggish economies and political uncertainty and seem skeptical that the pivot in central bank policies will rekindle growth (or inflation). Stock investors, on the other hand, seem hopeful that economic weakness will be transitory, political uncertainties will be resolved favorably, and a monetary-policy regime-change will be salutary.

Investment results in the period ahead will be largely dictated by which of these views is correct. We are cautiously optimistic: we judge the likelihood of a near-term recession in the U.S. to be relatively low (though not negligible), as a healthy consumer sector and a housing market re-energized by lower mortgage rates will continue to offset industrial-sector malaise. A moderate upturn in the global economy also seems plausible: China has strong incentive and ample room to ramp up stimulus measures; the effects of looser monetary policy and lower bond yields should buoy corporate investment and financial-market results; and a narrowing of the growth and monetary-policy differentials between the U.S. and the rest of the world will exert downward pressure on the dollar, which would be salutary for trade-oriented developing markets. Another hopeful development has seen Italian bond yields drop sharply in recent weeks, signaling that another Euro Zone crisis has been averted (for now). Finally, the trade war seems to have entered a(nother!) de-escalation phase - though that could change at almost any moment. Performance of global stock markets and commodities in June suggested investors were sniffing an upturn.

At the same time, we are mindful of persistently depressed business sentiment and languishing bond yields. Were the former to precipitate a slump in hiring, the consumer sector would surely suffer (a healthy June jobs report came as a relief on this front). Meanwhile, a meaningful back-up in bond yields - brought on by a less-dovish-than-hoped-for Fed - could put further downward pressure on the housing market. And we acknowledge that the global outlook is - as always - hugely dependent on the success (or otherwise) of Beijing's ongoing efforts to steer the world's second-largest economy. Further, we do not expect a successful 'grand bargain' to end the U.S./China trade war anytime soon; tensions are likely to ebb and flow (and ebb, and flow), remaining a persistent threat to business and investor sentiment. Tensions in the Persian Gulf, Hong Kong and the still-unresolved UK-leadership/Brexit situation provide plenty that could go wrong.

Bond Yields and Asset Prices - A Primer

Recent stock-market gains likely have numerous 'causes,' but surely an important one has been dramatically lower bond yields. The price of any financial asset reflects the present value of expected future cash flows to the owner (e.g., bond coupons, returned principal, stock dividends). Present value entails discounting future cash flows by an appropriate interest rate. (A dollar tomorrow is worth less than a dollar today.) The discount rate varies with prevailing bond yields; and when yields fall, present value rises. (A dollar tomorrow is worth a lot less when interest rates are high; less so when they fall.) How sensitive present value is to changing yields is called duration. Calculating duration on a default-risk-free bond (e.g., a 10-year U.S. Treasury Note) is straightforward; not so for other investments, like stocks. But as expected cash flows from stocks extend many years into the future, it's reasonable to infer the duration of a stock investment is long - so its valuation is very sensitive to changing yields. A one-percentage-point decrease in prevailing yields (for example, from 3.00% to 2.00%; in line with the change over the past seven months) boosts the price of a 10-year Treasury note by approximately 7%. The effect on stock prices, especially those of consistent-growth stocks with relatively predictable, long-lived dividend streams, is likely larger.

Despite very strong year-to-date results, nearly all global stock-market benchmarks peaked in late January 2018 (i.e., 17 months ago) and finished June 2019 roughly flat to down as much as 15% from their highs. Alone among broad stock benchmarks, the U.S. S&P 500 has managed three slightly higher highs (in September 2018 and April and June 2019), but even that index finished June only 2% above its late-January 2018 level (though dividends would have increased an investor's gain to around 5%; see first table below).

Total Returns: 17 months - 1/26/18 through 6/30/19:

The pattern of returns over the past year and a half differs starkly from what transpired between March 2016 and January 2018 - a powerful 23-month rally when all stock categories rose together and most outperformed the S&P 500 (see second table).

Total Returns: 23 months - 2/29/16 through 1/26/18:

Simple weighted-average math dictates that a broadly diversified portfolio - i.e., one that includes exposure to investments other than the large-company, growth-oriented stocks that dominate the S&P 500 - is likely to have lagged the 'benchmark' over the past 17 months. Conversely, the diversified portfolio probably outperformed between March 2016 and January 2018.

Recent results have added to a yawning multi-year performance gap favoring the S&P 500 over most other major stock benchmarks. As we have noted before, this longer pattern is strongly reminiscent of the second half of the 1990s - a period that was followed by a six-year stretch (2002-2007) when domestic large-cap growth stocks were routinely (and cumulatively) trounced by value, small cap and non-U.S. categories. Thematic and geographic trends tend to reverse over time. We believe there is a growing likelihood that the period ahead (the next 2-5 years, even if not the next 3-6 months) will favor broadly diversified portfolios that include different types of stocks - not just highly valued, domestic large-cap growth shares - as well as high-quality bond investments.

In the near term, we believe the improvement in global liquidity conditions and receding political risks will have salutary effects on real economic activity as well as business sentiment and financial-market conditions. However, we suspect a relatively benign view is amply reflected in the very strong six-month rally. With the economic expansion and equity bull market at record lengths, our portfolio-management focus rightly shifts toward risk mitigation rather than return maximization. Valuations are high across many categories of assets; a sudden downdraft could come at almost any time (as we saw last December). In such an environment, a broadly diversified portfolio including a relatively short-duration fixed-income component should weather any storm while providing substantial growth if the skies remain clear.

We hope you are (finally!) enjoying the summer and encourage your questions and comments regarding our management of your investments.