with Daniel McNabb, Chicory Wealth Investment Specialist
The second quarter of 2019 has showcased the abnormal environment we have been experiencing recently. On one hand we see strong economic indicators with the lowest unemployment rate since 1969, low inflation, and solid corporate profitability, while on the other hand we see slowing economic growth both in the U.S. and globally, a reversion of the yield curve (generally seen as a harbinger of tough days ahead), and aggressive trade policies sewing uncertainty into an already unsteady global situation. This summary will go through the various factors that analysts are looking at to predict the trajectories of the U.S. and global economies and will discuss in part, what steps Chicory Wealth is taking when reviewing the assets in our investment models.
You may have read recently that the Fed is considering a new round of rate cuts aimed at combating what we see as weakening economic conditions both in the U.S. and abroad. I think it is important first to look at those conditions and secondly to examine the likelihood of a rate cut and what it would mean for the average investor.
The current economic expansion has now lasted more than 10 years, which has surpassed the length of the 1991-2001 expansion, which was previously the longest in U.S .history. The most recent data shows the real GDP growing at about 3.1% annualized, which is close to the long-term average for the economy. However, expectations for the second quarter numbers put the annualized number somewhere between 1-2%, which signals a slowdown to a more moderate pace of growth. The number of non-farm payrolls added in June was a solid 224k, following a weak month in May of only 72k. We will be watching for the revision of these numbers, which will become available in the next few months. We think it likely that we will see the new payroll numbers trending downward in the future. Part of this can be seen as a consequence of a declining number of legal immigrants and the supply of labor being squeezed. Because of this, we do not see strong job growth as a high probability going forward unless something changes here.
Wage growth has been modest at about 3.1% year-over-year recently. We are definitely still waiting for the strong wage growth that many hoped (despite strong suspicions) would result from the corporate tax cuts. In part because of the repression of wage growth and the lower tax rates, we see that corporate profitability is up about 3.4% year-over-year per the first quarter numbers. The expectations for future corporate profitability are generally biased toward the optimistic, so we must view said expectations with a grain of salt. The large volume of stock buybacks that has resulted from the cash left on hand after the tax cuts skews the earnings per share numbers on average by about 2%, but even factoring this out, profitability has increased as revenues have generally risen.
On the global stage, there is some rather ominous data coming out, particularly in regards to manufacturing and exports. Global manufacturing is at the lowest point since 2012, with the PMI index in the U.S. falling to 51.7 (numbers below 50 signal a contraction in manufacturing output). Most of the slowdown is in the economies of countries that rely heavily on manufacturing such as China, South Korea, Japan, and Germany. There is consensus that this weakening is spreading, however, so we will be keeping an eye on that. This slowdown has been exacerbated by the aggressive trade rhetoric employed by the current U.S. administration, which has deviated from the normal pro-trade policies of past administrations. We believe that if this rhetoric changes, the markets will react favorably, as the proposed tariffs are generally seen to be a bad move for both the U.S. and global economies.
So, this is the situation in which we find ourselves. We think it very likely that the Fed will lower rates in the coming months. Historically since 1971, lowered rates during a period of economic expansion have always led to growth in the stock market over the 3-, 6-, 9-, 12-month periods directly following the cut. However, I think it is important to view the proposed cuts in a more dynamic light. While the lower interest rates will help companies continue to borrow money cheaply and help them maintain profitability, the effect of these rates on the global economic situation might be minimal. In other words, the economic indicators we are seeing show a number of potential weaknesses that might not be fixed by cutting rates.
You are likely asking, “What is Chicory Wealth doing to manage the risks they perceive in the market?” There are a number of steps we are taking here. We continue to monitor the stocks we hold in our models for signs of a deteriorating financial situation, or Environment, Social, or Governance (ESG) “score” downgrades. On top of monitoring the quality of the investments we hold, one of the main tenants of responsible investing is picking the appropriate balance of stocks (generally a more volatile investment) and bonds (which usually have less dramatic price changes) in a portfolio. This mix is customized for our clients’ particular situations and is updated as that situation changes. For those clients in retirement for whom we create a monthly “paycheck,” we are making sure we have a silo for their cash needs at the ready and out of harm’s way should things get volatile and there is a market sell-off. We “rebalance” portfolios back to the target mix of stocks and bonds at least twice per year, which serves to keep the amount of risk within our targets.
Our overarching mantra is, “Take the least amount of risk necessary to meet the clients’ goals.” Our ongoing financial life planning process allows us to monitor these goals, even as they may change over time, and adapt the portfolio as necessary to suit the clients’ personal circumstances. This process also helps us to support them in keeping an eye on the long-range prize (even if in retirement, as retirement can last 25 to 30 years!) and to not let short-term fluctuations – even those caused by slowdowns or recessions – cause them to make poor decisions that might harm their chances of achieving their dreams.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this commentary is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. Chicory Wealth makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Photo above by Markus Spiske of Unsplash