While a truce may be at hand, a lasting peace remains elusive and other uncertainties linger.
Eighteen months ago, we penned an essay titled Are Trade Wars Good? in response to President Donald Trump's tweet that trade wars are good and easy to win. In our article, we cautioned: "We should be hesitant of dismissing the president's rhetoric as mere words, and instead we should be preparing for an inflection point in U.S. trade policy." We further answered our own question in the negative, stating that "trade wars are not good, as they lead to inflation in the short run and hinder growth in the long run."
Since then, innumerable trade-related tweets have followed, and we ourselves have written countless articles discussing the potential impact that trade-related uncertainty was having on the global economy.
Throughout the entirety of this ongoing state of confusion and consternation, we maintained the view that investors should be cautious but not bearish. This equated to adopting a modest overweight to risk assets relative to safe assets within a balanced investment portfolio.
This summer, however, nearly all the major economic data embedded within our asset-allocation model turned negative, corporate-earnings growth stagnated and trade rhetoric grew increasingly bellicose. As a result, we began to suggest that a more-balanced approach to risk was appropriate.
This slight shift proved beneficial: Through Aug. 31, stocks declined modestly in the second quarter and bond prices rose as global interest rates fell dramatically on the back of a weakening economic outlook. Simultaneously, the number of times the word "recession" appeared within Google's popular search engine climbed to a level not seen since 2009 -- not a predictive variable we give a lot of credence to, but it suggested that a recession could become a self-fulfilling prophecy and reflected a risk-off mindset amongst investors.
The first half of September, however, was characterized by an abrupt change in this narrative. After falling over 120 basis points (1.2%) in the first eight months of 2019, long-term bond yields have spiked 44 basis points since Labor Day. Consequently, prices of long-dated bonds fell nearly 8% earlier in September, partially reversing a massive 24% rally that occurred between January and the end of August.
Throughout 2019, stocks have advanced. Looking beneath the surface, however, reveals a more interesting storyline: In the one-year period ending Aug. 31, 2019, large-cap equities gained nearly 3%, whereas their small-cap brethren declined over 12%. Post-Labor Day, while large-cap stocks have added to their gains, small-cap stocks have jumped twice as much. Similarly, stocks associated with cyclical companies considerably outpaced others earlier in September after previously underperforming by their widest margin since 2000, when the Tech Bubble inflated.
The proximate cause for this rapid shift in sentiment can be linked to a stabilization in economic data in China, aggressive pro-stimulus measures announced by several major central banks and posturing by China and the U.S. that suggested both parties may be interested in reaching a trade truce.
In particular, toward the end of September President Trump agreed to delay the date on which new tariffs were set to take place and China signaled a willingness to purchase additional agricultural products produced in the U.S. Both sides are apparently seeking a de-escalation, as economic pain was jointly being felt, even if not publicly acknowledged by either.
As a result, investors are right to ask if it is safe to add risk back into their portfolios. In our view, while a truce may be at hand, a lasting peace remains elusive and other uncertainties linger. Purchasing U.S. crops is a positive development for sure. Moreover, it is tangible and resonates within many of the people who voted the president into office in 2016.
On the other hand, theft of intellectual property, forced technology transfer and subsidization of state-owned enterprises are not easily understood by most Americans and are far more complex to resolve. These are issues Trump and his advisors want addressed. This is the basis for our view that trade tensions may persist even if the threat of new tariffs has diminished.
Additionally, the economic impact from tariffs is just now being felt. For instance, early in September we learned that U.S. inflation hit an 11-year high in August. Against this backdrop, we think it will be interesting to hear what companies say about profit margins when they report third-quarter earnings in October.
Monetary policy has become a decided tailwind. Unresolved, however, is how the gap narrows between policymakers' views and market expectations. Currently, the Federal Reserve anticipates cutting interest rates modestly, whereas the market believes more aggressive actions are necessary. This difference creates the potential for further uncertainty.
Moreover, the levers central banks can pull to curtail further economic weakness are dwindling in number and losing their efficacy given the already low level of interest rates, a point the European Central Bank emphatically emphasized earlier in September. Brexit-related risks also loom, and other important regions around the world still appear unstable (e.g., Hong Kong and the Middle East).
In short, while several positive developments have recently materialized, in an environment defined by high levels of uncertainty and more disparate outcomes relative to the recent past, we continue to believe a balanced approach makes prudent sense.
To learn more, please contact a Key Private Bank advisor.
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