Markets: Growth Nirvana
U.S. equities registered robust returns in the third quarter, as evidenced by the S&P 500 Index increasing at its highest rate in five years and extending its advance to become the longest ever bull market upturn. Growth stocks, which again significantly outdistanced value shares across the market cap spectrum, drove the advance, most notably in the smid cap and mid cap segments. Robust fundamentals led the way, as S&P 500 and small cap companies generated their strongest earnings growth since 2010, and small cap earnings growth exceeded large cap for the first time in over two years. Revenues were a similarly powerful contributor, as S&P 500 companies generated their highest revenue rate increases since 2011. Compounding this underlying strength was the magnitude of upside surprise, as S&P 500 companies generated the highest percentage since FactSet began tracking this data in 2008.1 These impressive corporate results provided perspective for investors to minimize the anxiety created by global trade friction, interest rate yield curve compression, and global economic uncertainty. Within this environment, active managers (particularly in the growth space where CCI focuses) were able to successfully navigate portfolios through the idiosyncratic risks associated with tighter monetary policy, tax reform, trade policies, and currency fluctuations. Active management for growth portfolio managers was most effective in the small cap, mid cap and smid cap segments, as more than 75%, 40% and 55% beat their respective benchmarks, according to Bank of America2 and Jefferies.3 The unique challenge of significant mega cap concentration within the large cap index resulted in more pedestrian results in that space, as only 10% of managers exceeded their bogeys according to Bank of America.2
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Interest Rates: Dangerous Curve Ahead?
Despite a very recent rally in longer term interest rates, the slope of the yield curve (difference between 2-year and 10-year Treasuries) has steadily declined since early 2017, as the Federal Reserve has embarked on the unwinding of quantitative easing by gradually increasing short term rates coincident with an improving domestic economy. The long end of the curve has remained relatively anchored due to contained inflation expectations and comparable global rates that continue to be restricted by foreign central bank actions. Recessionary concerns have increasingly permeated investor mindsets of late, as the yield curve continues to flatten, approaching zero or a negative differential between short and long term interest rates. A yield curve inversion has been one of the most reliable leading indicators for recessions, preceding each of the last seven downturns and nine of the last twelve economic declines. The debate around which components of the yield curve have the most predictive power has become more spirited recently, spearheaded by a research report out of the Federal Reserve Bank of San Francisco that suggests the difference between 10-year and 3-month Treasury rates is the most useful term spread for forecasting recessions.4 This differentiated view was embraced by several leading sell-side economists, in part because it suggested that the economy was not as close to the start of a downturn as the 2-10 year spreads might indicate, but also because other data such as credit spreads, banks’ willingness to lend, wage inflation, consumer confidence, and the purchasing manager index were not signaling an imminent recessionary threat. Regardless of which yield spread is preferred, these indicators typically have an eighteen month to two year lead time. This is consistent with the consensus view that a recession is unlikely until 2020-2021 or later. Historically, equity markets remain positive up until about six months before recessions hit, with leadership at the latter stages of the economic cycle and initial stages of recession coming from the secular growth companies that are the focus of the CCI investment discipline.
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Consumer: Money Really Does Grow on Trees
Consumers are the engine of growth for the domestic economy, comprising about two-thirds of U.S. GDP and representing about twice the combined impact of business investment and government spending. Strong employment trends, gradually improving wages, and tax reform benefits (having been the most comprehensive legislation in thirty years) have elevated consumer confidence and created a favorable environment that enabled Target and Walmart to generate their strongest comparable store sales growth results in over a decade. The’ consumer’s strength is further validation that the domestic economy does not have recession in its sights. Augmenting this already encouraging backdrop, individuals received a stealth-like holiday “present” in late July when the Bureau of Economic Analysis magically revised upwards the personal savings rate for ten of the previous eleven years. This hypothetically disproved the idiom that money does not grow on trees, as consumers were bolstered overnight with several hundred billion dollars of potential spending power. The savings rate went from 3.3% under the old methodology in Q1 to 6.8% using the new approach in the second quarter. The six month revision was the largest on record, and more than ten times greater than the last comprehensive change that was conducted three years ago. The primary components of the modification were alterations to personal income that increased compensation, proprietor income, and dividend/interest income. The magnitude of the savings rate modification partially explains the more muted economic improvement that transpired prior to the passage of tax reform legislation, as consumers were more focused than previously thought on improving their financial position and accumulating wealth. These adjustments are broadly favorable for future consumer spending, and should serve to prolong the economic cycle as individuals gradually tap into these heightened savings to fund a portion of consumer spending. It bears noting, however, that roughly half of Americans still lack any form of savings, and the preponderance of the benefits from these revisions accrue more to affluent individuals who have less propensity to spend incremental dollars compared to lower income consumers. Therefore, any benefits from the enhanced savings rate will evolve over time rather than provide a more immediate boost to the overall economy.
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The fast approaching midterm elections have moved to the forefront of the market landscape during recent months. Beyond the emotional debates being captured by the nation’s media, investors are frequently reminded with vivid memories of the most recent Presidential election that whipsawed portfolio performance and caught many portfolio managers flat-footed in November 2016. Historically, equity markets have faded in the couple of months leading up to midterm elections, before rallying in October as outcome visibility improves and the investment implications are assessed. This rally normally continues into the next year, as the six month rate of change around midterm elections (since 1950) has been more than twice the increase in non-election years. In addition, since 1928, S&P 500 returns in year three of all Presidential cycles have more than doubled the average increases registered in any other year of a President’s term. The consistency of the market’s advances around these events has been equally impressive, as the S&P 500 has not declined in the twelve months following a midterm election in over seventy years. While this time could always be different, historical precedent provides more than reasonable confidence that the bull market journey has further progress ahead.
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Emerging Markets: Thanksgiving Hangover
Emerging markets were one of the weakest segments of the global equity markets, as pressure from the rising U.S. dollar and economic/inflation concerns negatively impacted Argentina, South Africa and others. The poster child for these struggles was Turkey, with issues coming to a head in early August when the lira plummeted 20% in a week and bond yields skyrocketed above 20%. This shock jolted investors out of their tryptophan-induced complacency that had them ignoring the decade’s second worst decline in a Group of 20 currency over the past year. It also created an immediate uneasiness in investors akin to overindulgence in turkey, stuffing and mashed potatoes at a Thanksgiving day feast. The political confrontation between the U.S. and Turkey Presidents, climaxed by a dispute over an imprisoned American pastor, exacerbated an already tenuous situation, and resulted in steel/aluminum tariff sanctions imposed against Turkey. Turkey lacked the defenses to combat these sanctions, given its limited foreign currency reserves, significant U.S. dollar-denominated debt, and budget/current account deficits. The country’s Finance Minister did, however, begrudgingly take a page out of the financial crisis recovery handbook by announcing a modest fiscal austerity savings program in September after the initial shock faded. In contrast, Argentina also unveiled a sweeping governmental budget cutback initiative early on, but additionally sought the financial assistance of the International Monetary Fund to combat the blustering economic headwinds.
While Turkey individually represents only a fraction of global GDP at 1% (Turkey, Argentina and South Africa combine for only 2.2%), there are potential spillover effects to countries such as Spain, France, Italy, and the U.K., where banks have exposure to more than $150 billion of Turkish debt. Dramatic emerging market deterioration can also create significant de-risking in U.S. markets, as was the case with the Asian contagion in 1997-98 that caused the S&P 500 to approach bear market territory. While these potential threats exist, there is a contingent of investors who surmise that emerging market declines have actually been beneficial for smaller cap and higher risk U.S. stocks as global portfolios are repurposed within the same risk level securities. In addition, emerging markets as a whole are financially stronger and more disciplined than years past, so any widespread proliferation of economic difficulties to regional neighbors is not expected to be a major threat.
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Outlook: Remain Disciplined
The fundamental backdrop remains conducive for the CCI Positive Momentum & Positive Surprise investment discipline to prosper. Corporate earnings growth is poised to modestly decelerate, increasing the scarcity value of secular growth companies that are the firm’s focus, and better enabling them to stand out fundamentally. The uncertainties described in the initial paragraph should also continue to reward quality companies that our methodology emphasizes because of their sustainable business models and industry leadership that helps facilitate smoother navigation through cross-currents. Consumer confidence and strong employment should keep the domestic economy vibrant, while small business optimism and CEO confidence (along with corporate tax reform) have created a renaissance in capital spending that should ultimately create productivity improvements. Despite the recent removal of the accommodative language in the latest meeting statement, these benefits should help contain inflation and keep the Federal Reserve on a gradual monetary policy tightening path. Modest concerns, however, include the unprecedented divergence in U.S. (versus rest of world) equity market performance that could tilt global investors away from domestic stocks, friction with China that could extend beyond tariffs to broader actions, and ongoing multiple compression that might offset the favorable earnings increases forecasted. While challenges always exist, they must be evaluated within the context of a landscape featuring no significant credit stress, stable inflation, increased domestic competitiveness, robust revenue growth, and fiscal stimulus that accelerates next year and dramatically outweighs any negative effects of tariff sanctions. Near term, equity markets seem positioned to follow the historical path of rallying after the midterm elections and into the third year of a Presidential cycle, with growth stocks continuing to provide leadership as they typically do at this stage of the economic cycle.
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1 FactSet Research Systems Inc., “Earnings Insight,” August 31, 2018, page 6.
2 Bank of America, “U.S. Mutual Fund Performance Update,” October 3, 2018, pages 3-6.
3 Jefferies, “U.S. Equity Strategy,” September 30, 2018, page 6.
4 Federal Reserve Bank of San Francisco, “Economic Letter,” August 27, 2018, page 1.