The financial markets advanced during the third quarter amidst continued anxiety surrounding trade deals and interest rates. The S&P 500 Total Return Index (“Index”) returned 1.7% during the third quarter. The Index is up 20.6% on a year-to-date basis through Sept. 30, 2019.
Within Talbot Financial clients’ portfolios, Technology and Consumer Discretionary were the best performing industry sectors for the third quarter and the year-to-date periods. Both sectors continue to meet our disciplined criterion of balance sheet strength, return of cash flow and long-term secular growth.
Conversely, Energy and Health Care were the worst performing sectors for the third quarter and year-to-date periods. We continue to see value opportunities in specific companies within each of these underperforming sectors. In the Energy sector, we are concerned about the impact of longer-term supply/demand imbalances; and therefore, we remain materially underweight in the sector as compared to the Index.
Turning to the broader economic environment, on an ongoing basis we monitor a series of indicators to gauge the relative strength of the U.S. economy. These indicators continue to suggest a healthy underlying economic environment. It is worth noting a more recent development that the yield curve, one of the seven indicators, is flashing a cautionary signal as it relates to the threat of a potential economic recession.
The yield curve is a graphical representation of the relationship between bond yields and maturities. A yield curve that slopes up and to the left is considered “normal” and is indicative of a healthy economy (represented by the line in the graph below as of Dec. 31, 2013). A yield curve that is either flat (represented by the line in the graph below as of Sept. 30, 2019) or slopes down and to the right is considered inverted, and historically indicates a pending recession.
The explanatory power of the yield curve comes from understanding the drivers of short and long-term interest rates.
Short-term interest rates are controlled by central banks. In the U.S., the central bank is the Federal Reserve Bank (the “Fed”). The Fed raises or lowers short-term interest rates based on its outlook for the economy. If the Fed believes that economic activity is slowing, it lowers short-term rates to stimulate growth. If the Fed believes the economy is overheating or inflation is rising, it raises short-term interest rates to curb economic growth/inflation. The lowering of short-term rates is expansionary to the economy, while the raising of short-term rates is recessionary.
Long-term interest rates are determined by market forces, mostly the outlook for inflation and the economy. If the market believes the economy to be strong or inflation to be increasing, then long-term rates will naturally increase to compensate for lost purchasing power. Conversely, if the market believes the economy to be decelerating or inflation to be low, then less compensation is necessary and long-term rates will tend to remain low.
Thus, an inverted yield curve is historically triggered by the Fed increasing short-term rates and the market driving down long-term rates. The current, and intermittent, inversion of the yield curve appears different for the following reasons:
- The Fed is driving short-term interest rates lower, not higher. As previously stated, falling short-term rates are expansionary in nature.
- Long-term rates never rebounded from the Financial Crisis as Growth Domestic Product (GDP) growth and inflation remained subdued over the past 10-years. Additionally, there is $17 trillion of negative yielding foreign debt, thereby keeping U.S. long-term rates low.
- If short-term rates are dropping (expansionary) and long-term rates never increased in the first place, then the signaling from the current yield curve appears less meaningful as a leading indicator than in the prior economic cycles.
In summary, we expect additional short-term rate cuts this year by the Fed will revert the yield curve back to a normal slope by year-end.
At the same time, we acknowledge the possibility that more leading economic indicators may begin to signal an impending recession. In such a scenario, we may consider modest changes in client portfolios intended to tilt portfolios towards a more defensive structure. We may increase allocations to sectors that have historically been more resilient in recessionary downturns. As an example, increasing the portfolio allocation weight of the Health Care sector, while scaling back on Industrials, a more cyclical sector. In addition, we may moderately increase cash holdings in the portfolios (e.g., increase cash from 2% to 4%). An increased cash level would serve to mitigate some potential downside portfolio market risk and prepare for opportunistic buying if valuations become more attractive. Lastly, if we see greater signaling towards recession, we may rotate a small allocation to fixed income securities. The investment strategy would focus on short-term bonds in order to manage interest rate risk.
Importantly, history has demonstrated it is “time in the market” not “timing the market” that drives long-term equity returns. Further, economic expansions have lengthened while contractions have shortened. Hence, any potential changes we make in client portfolios would be incremental to mitigate some downside risk in a market correction.
The bottom-line is the U.S. economy continues to grow. Odds of a recession remain nascent. As you would expect from us, we remain focused on owning the stocks in great companies over the long-run.
Please find attached your third quarter 2019 portfolio review to supplement the monthly account statements available from Schwab. The report provides a performance summary of your portfolio compared to the S&P 500 Total Return Index and lists your portfolio holdings by industry sector.
As always, we welcome the opportunity to review your portfolio in detail. Please do not hesitate to call us with any questions.
Talbot Financial, LLC