MARKET REBOUND

Stock are off to their best start in over 20 years. A more benign Fed with respect to future interest rate increases and solid earnings reports drove the sharp reversal from Q4. The bond market also performed well reflecting declining interest rates. While the US economy has lost some momentum, it remains on sold footings.

Most issues weighing on stock prices during the fourth quarter were resolved in a positive fashion. US recessionary concerns proved to be overblown. Reported economic data revealed a slowing US economy albeit one that is still growing. Worries that the Fed would make a policy mistake by raising interest rates too far or too fast were assuaged when the Fed said that it would pause hiking interest rates to gauge the state of the economy. Fears of a trade war with China leading to a global recession dissipated as productive talks increased the likelihood of a resolution. Jitters that a long-term government shutdown would impact the economy disappeared once a budget deal was reached. Finally, the Mueller investigation concluded with a report that there was no collusion between Russia and President Trump. While none of these add to US or global growth, eliminating these potential negatives relieves the stock market of uncertainty. This led to expanding stock valuations as investors were increasingly confident in the outlook.

Although several potential negatives and uncertainties are “off the table”, risks remain. There is no guarantee that the China – US trade dispute will be successfully resolved. China and particularly Europe are exhibiting slower growth, which could still impact global growth.

The stock market is at a crossroads. As stock prices near their all-time highs, decreases in corporate earnings estimates have stock valuations close to their historical average. At this late stage of the business cycle, it is unlikely that valuations will expand materially. Upside for stocks will have to come from earnings growth.

Earnings growth is typically a function of corporate revenue growth and margins. Revenue growth should be additive as we currently do not forecast a recession. Expanding margins have been an important component of the current bull market. Declining labour costs, increasing international sales and lower taxes have all contributed to margin expansion. Unfortunately, most of these tailwinds are peaking or are at risk of being unwound.

Labour as a percentage of Gross Domestic Income has been falling since 1980. This was partly due to declining union membership, less bargaining power on the part of workers and the rise of China (with significantly cheaper wages) as a global manufacturing hub.

The US – China trade dispute (and punitive tariffs) has led US corporations to seek other manufacturing sources besides China. The rise in labour costs in China has also made that country less attractive for low-cost production. Unfortunately, few other countries have the scale or infrastructure to be a global manufacturing powerhouse to replace China as a source of low-cost goods. This means that corporations will have to absorb higher wage costs and tariffs (impacting margins) or pass them along to customers.

Worries about income inequality is also on the rise. The democrats have made this a central plank of their platform which could result in a higher national minimum wage. This would impact corporate margins in labour intensive sectors of the economy.

Companies have used havens and other avoidance schemes to lower taxes over the last few decades. The 2018 tax cuts capped a multi-decade decline in corporate rates with tax rates likely bottoming. Left leaning candidates are campaigning on everyone paying their fair share, including corporations. If the Democrats win in 2020, we should assume they will be aggressive in raising corporate tax rates.

With the recent slowdown in economic growth, bond prices increased as yields decreased. This resulted in bonds returning a robust 3.9% during the quarter. With the decline in yields, bonds are less attractive than they were three months ago. We expect bond returns will track bond yields which are currently in the low single digits.

This cycle is one of the longest on record, but that does not necessarily presage its impending doom. The economy continues to grow and there has not been a substantial change to corporate earnings prospects. Although we expect stocks to provide positive returns, they are less attractive than they were at the beginning of the year due to their big upward move. We have become increasingly defensive with respect to stock selection. We have sold some companies that are more cyclical in nature and added stocks where the business model is more durable. With bonds providing low single digit returns, we continue to prefer stocks over bonds.