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Third Quarter Update & Fourth Quarter Strategy

2019-10-07

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After a difficult summer for equity investments, investors returned from their summer holidays in a bullish mood and drove stock prices higher in September.  The quarter was marked by a continued slowdown in the global economic data, offset by further monetary easing from the US and Europe.

In the US, the Federal Reserve (Fed) cut interest rates in July and September in an attempt to prolong the economic expansion in the face of an economic.  While the economy continued to add jobs, the pace of growth of aggregate hours worked in the economy has slowed meaningfully.  Consumer confidence also declined from elevated levels.  US equities delivered 1.7% over the quarter but have been unable to break above the July all-time-high.

Many economists are calling for a recession in coming months due to the continued weak economic data – the manufacturing sector has been contracting for a few months, but until last week the services sector of the economy has remained in expansion mode.  Last week, the services sector reported contraction as well.  If the combination of a weak manufacturing sector combined with a weak services sector turns GDP negative for two consecutive months, we will indeed be in an economic recession.

We have seen the bond market act accordingly – the yield on the 30-year treasury bond today has again dropped below 2%.  The yield curve is inverted from 3 months to 10 years while roughly flat from 2 years to 10 years.  The inverted yield curve is considered historically to be a leading indicator of a potential recession – its track record is not 100% accurate, but at roughly 80% it is something we definitely need to be watching.

In spite of the slowing economy, the stock market continues to trade near its all-time-high.  In the graph above you will see that since the July high of 3,027 on the S&P 500 Index, we have moved up and down within a tight price range, but there has been no significant move either up or down – price rallies are sold and price dips are bought.

Investors are clearly confused – the ones with a positive view see the Fed lowering interest rates and buy the dips while the ones with a negative view see the weak economic data which causes the lowering of rates and sell when prices move higher.    Who will win this tug of war?  That is the question we are all waiting to see – will the bearish minded investors get their recession, or will the Fed rate cuts strengthen the economy and move the stock market higher?  There is no way to know until the economic data is reported.

However, with the market near all-time-high, the risk is clearly to the downside.  Given that, we continue to be cautious and maintain above average allocations to cash and fixed income.   One issue that we are watching closely is the lack of liquidity in the markets – the Federal Reserve has recently increased its activity in the overnight lending markets that the big financial institutions participate in when they need access to significant liquidity to balance their books.  Right now, the Fed has it under control, but a liquidity driven market correction is something we want to avoid as they are fast and brutal.  By being suspicious of the stock market at these levels we are remaining cautious, overweighting precious metals, bonds, and cash equivalents, we are protecting our clients’ investment capital while the current uncertainty plays out.

–Mark