Markets: Bump in the Road
Stocks generally registered mid-single digit advances across the market cap spectrum for the quarter, with small cap companies leading the market because of their greater exposure to the U.S. economy where current results are more stable and the future outlook is less clouded than international regions. Small caps’ domestic focus relative to mid and large cap companies also better insulated them from the stock price fluctuations associated with the back and forth rhetoric among world leaders regarding global trade tariffs. During mid-June, these heightened trade tensions caused a temporary bump in the road for secular growth companies that have provided market leadership for the last eighteen months in the post quantitative easing era (where fundamental results have increasingly driven investor decision making). From mid to late June, secular growth stocks and CCI equity portfolios were negatively impacted by profit-taking in year to date winners, and the reversal of fundamental factors such as high quality, strong long term growth and robust upward estimate revisions that had previously been successful. The global economic backdrop remains in a synchronized recovery; however, key parts of Europe, emerging markets (such as Brazil) and China have experienced moderations in their purchasing manager indices that bear watching. Pressures from a stronger dollar, higher interest rates, trade policy uncertainty, increased oil prices, credit spread widening, and political instability have contributed to the recent pause in economic growth from the recent highs. These issues will be monitored going forward to ensure that they do not become more problematic and cause a more sustained slowdown.
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Politics: Year of the Dog Fight
According to Chinese astrology, 2018 represents the year of the dog, an animal renowned as a loyal companion and reliable partner. Mid-February ushered in the Chinese New Year, which also happened to coincide with the early stages of President Trump ratcheting up trade pressures, with a specific focus on China. Symbolically, the ongoing tug of war has resembled an evolving dog fight, with (thankfully) more bark than bite thus far as both sides show their teeth to convey their hardline stance on trade policy. Steel and aluminum tariffs have already gone into effect, another $34 billion of tariffs on hundreds of targeted products took hold in early July (a $16 billion follow-on tranche remains imminent), and the President has threatened another 1-2 programs (each up to $200 billion) for the near term on specific imported good categories from China. President Xi Jinping and the Beijing Ministry of Commerce have promised dollar-for-dollar counter measures against politically strategic U.S. imports (technology, agriculture, cars, etc.) coming into their country. According to 2017 data, China only imports roughly a quarter of the value of products they export to the U.S. ($130 billion vs. $505 billion). Therefore, merely matching the dollar value of goods subject to tariffs is nearing an end before China will be forced to consider additional measures such as more dramatic tariff rates, currency fluctuations, monetary policy, regulatory protectionism and/or foreign investment restrictions. The implications for such incremental actions could prove more challenging to assess and be more impactful to economic conditions.
The dog fight has also begun to attract new participants that could even further escalate trade tensions. The European Union has announced retaliatory tariffs on items such as bourbon, motorcycles and orange juice, India is targeting agricultural products, Canada and Mexico have entered the fray, and other countries are on the periphery poised to sustain the growing anti-U.S. sentiment as the tensions persist. The complexity of these issues will likely take time to resolve, creating elevated idiosyncratic risk in the interim that best suits active managers deciphering which companies are most ideally positioned to benefit.
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Monetary Policy: Bird Watching
Investors continue to remain hyper-focused on the Federal Reserve (Fed) and European Central Bank (ECB), trying to anticipate monetary policy changes based on a mosaic of public comments made by committee members, and scrutinizing meeting releases and subsequent dissemination of meeting minutes for subtle clues as to future policy direction. A rush to judgment is typically made as to whether the collective information resembles a dove or a hawk, and portfolio actions are taken by many looking to capitalize on their perceived edge in identifying the bird species. The reality of the post quantitative easing (QE) era is that the debate thus far is more about whether the dove is of greater or lesser size than previously thought. Central Banks have a stated commitment to gradually unwind the extraordinary measures taken during the 2009 and 2011 U.S. Financial and European Bank crises, so the only controversy is around the pace of this normalization. Thus far, neither the Fed nor the ECB have shown a proclivity to forcefully apply the monetary brakes of more substantial interest rate increases or balance sheet normalization that would threaten economic growth and cause a flock of hawks to reappear. In fact, the ECB expressed a commitment to refrain from increasing interest rates through the summer of 2019, as it simultaneously outlined a roadmap that will temper QE asset purchases from the current €30 billion to €15 billion in the October to December time period (ceasing QE entirely thereafter). The Fed slightly increased its median GDP growth and inflation projections at its June meeting which elevated expectations for a fourth hike in 2018, but they appear to remain on a measured path of (at most) a single modest rate increase per quarter, not enough to spark bird watching fears that hawks may be circling.
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Topical Theme: Open Communications
Each June, Russell conducts its annual index reconstitution process. The universe of stocks is first sorted by market capitalization to derive the broader indices, and then segmented into growth and value style indices based on medium term growth forecasts, historical sales per share, and price-to-book measures. This year, some of the more interesting observations from this rebalancing involved Consumer Discretionary and Technology modifications within the different growth benchmarks. The overall Consumer Discretionary weight increased notably in the Russell 2000 and Russell 2500 Growth Indices, while it decreased by a similar amount in the Russell 1000 Growth Index. The opposite phenomenon occurred in Technology, where the weights in the Russell 1000 and Midcap Growth Indices rose more than any other sector, but they declined more meaningfully than other sectors in the Russell 2500 Growth Index and especially in the Russell 2000 Growth Index.
A uniquely innovative change will be coming to the Global Industry Classification Standards (GICS) structure in September, bringing back memories of the dotcom bubble at the end of last century when high-flyers like America Online, Time Warner, and Worldcom formed the foundation of Technology, Media, and Telecom (TMT) stocks that led the market in grand scale fashion. The current Telecom Services sector will be opened up to include Media, Internet Services and Home Entertainment companies from the Consumer Discretionary and Technology sectors, forming a more vast sector named Communication Services. These changes reflect an evolution of how entertainment content, communications and commerce is consumed and delivered across integrated platforms in the internet era. This new sector will comprise a still reasonable 10% of the S&P 500, and include the likes of Netflix, Alphabet (Google), Facebook, Disney, AT&T and Activision that will elevate the growth profile of this sector previously viewed as fundamentally stodgy. As 20-25% of the Consumer Discretionary and Technology sector market cap will be shifting to this new Communication Services segment (which itself increases from 2-3% of the S&P 500), sector-focused funds will need to rebalance; however, classic bottom-up stock picking firms like CCI (where individual holdings drive sector positioning) will be minimally impacted by this effective shuffling of pieces around the same overall game board.
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Outlook: Tension Relief
Strong corporate earnings, a solid economy, and robust employment growth are the ultimate elixir for investor pre-occupation with China trade tensions that only have a minimal impact on GDP. Coming off Q1’s more than 75% positive surprise rate for revenues and earnings1, the EPS revision rate approaching Q2 earnings reports is the second largest in the last eight years and up nearly 1% compared to the ten year average quarterly decline of 5%.2 The domestic economy remains in significant expansion mode according to the CCI Economic Monitor, and employment growth continues to be so robust that job openings now exceed the total number of people unemployed for the first time this century. Other potential concerns include a stronger dollar creating more dramatic pressures in emerging markets that have sizable dollar-denominated debt (like Turkey, Chile and Argentina), higher energy prices that prompt inflationary fears or compromise consumer spending, and further moderation in global economic activity that calls into question the synchronized recovery. A further intra-quarter flattening of the yield curve renewed fears of an imminent recession, but a prominent Wall Street Economist actually shifted her projection for the timing of such a contraction from the second half of 2020 to the latter part of 2021.3 Secular growth and upward estimate revisions have been two of the most successful factor picking strategies this year, and companies possessing these traits epitomize the CCI Positive Momentum and Positive Surprise investment discipline. We are confident that such secular growth companies will continue to prosper in the somewhat uncertain global economic backdrop, despite the pedestrian–like stock price responses immediately after strong earnings reports that have plagued the last few quarters, and resulted in valuation contraction for the first time in seven years. As investors regain confidence in the sustainability of fundamental growth drivers and look past the near term distraction of trade tensions, stocks should experience multiple expansion that translates into a relief rally, affording superior returns to the companies generating the most favorable results.
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1 Factset Research Systems, “Earnings Insight,” June, 8, 2018, page 1.
2 Factset Research Systems, “Earnings Insight,” June, 29, 2018, page 2 .
3 Cornerstone Macro, “Economic Research – Weekly Narrative,” June 10, 2018, page 1.