Bear Market or Recession? Thoughts on the Market

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Thoughts on the Markets and from our Investment Committee Offsite Meeting

  • Recent market volatility is related to a sudden increase in interest rates-we believe the speed matters
  • We do not see a recession or bear market in the US during the next 6 months
  • Three possible paths forward for the economy and markets over the next 6 months
  • We are modestly increasing our US equity exposure by decreasing cash and commodities exposures given market pullback

As part of our investment process, the Fundamentum Investment Committee conducts periodic “offsite” meetings where participants (including outside speakers) meet and discuss the variables and data that drive the bigger picture positioning of all our strategies. The recent meeting, taking place on October 18th, was timely given recent market volatility that has led to a ~6-7% pullback in the S&P 500 Index from recent highs1. It was likewise timely due to our Tactical portfolios having additional flexibility with most strategies holding upwards of 9% cash, following decisions to reduce exposure to international equities on two previous occasions in 2018.

We believe the recent pullback has largely been attributed to the second spike in long-term interest rates in 2018, with the most recent bout starting in late August1. Recall that the 10% correction in U.S. equities that took place in late January-early February was attributed to the first spike in long-term interest rates, and the end of the low-volatility period that capital markets enjoyed throughout 20171. This time, the rapidity of the ~40 bps1 move higher in the 10-year Treasury Bond yield spooked investors and led to even larger declines in many of this year’s leading stocks-i.e. large-cap Technology stocks. We are also concerned about the longer-term implications of rising interest rates. At some level, higher rates will impact the real economy (two of the more rate sensitive sectors of the economy – housing and autos – are already feeling the effect of higher rates) and the value of all equities as a discounting mechanism, especially “long-duration” assets (growth stocks). In addition, since the spike in interest rates, further volatility has arisen with the beginning of Q3 earnings releases in which some companies such as Nike, Pepsi, Caterpillar and 3M have cited rising costs and margin pressures from a strong US Dollar1 with forward guidance.

This can feel like a precarious and tricky environment for investors, for at this point in the cycle, where we may be achieving peaks in the growth rates of the domestic economy and corporate earnings, and where the Federal Reserve is likely to continue raising interest rates, risks appear to be skewed to the downside.

A major reason we conduct Committee offsite meetings is to allow us to escape the day-to-day trading and research to see the bigger picture of market drivers. When we look at the mosaic of current data from a broader view, the present state doesn’t look quite as precarious as it may feel from our view. This is at least true with the United States. During the offsite meeting, we derived the following three bigger picture paths as probable for the economy and markets over the next 6 months:

  1. Strong US economic growth continues to diverge from the rest of the world (highest likelihood)
  2. The US recouples on the downside with the rest of the world (medium likelihood)
  3. The rest of the world catches up with the US (least likely although not a zero probability)

While there is mounting data to support path 2 and attractive valuations supporting path 3, the most likely outcome from our view is that strong US economic growth continues to de-couple from the rest of the world (which has generally been experiencing slowing growth since earlier this year) in the shorter run. We believe there is still enough time in the current U.S. economic cycle, still enough earnings growth likely in front of U.S. companies and still enough catalysts to warrant additional exposure to U.S equities. This is especially true after the recent pullback which left the S&P 500 trading at about 15x forward earnings estimates1. However, we remain cautious and underweight non-U.S. equities, despite the large pullback and increasingly attractive valuations, as we struggle to identify catalysts for this asset class given the outlook for the USD and the ongoing deterioration of economic forecasts, especially with the Chinese and other emerging market economies. We also remain underweight fixed income as an asset class, and maintain our below-benchmark duration, a significant deviation from the benchmark.

Given our views on the likely path forward, the fact that markets have tended to rally in Q4 during mid-term election years,2 and with much of the S&P 500 companies left to report earnings for Q3 (which we expect to be good overall), we recently added to US large, mid and small sized companies in our Tactical strategies. We did this by reducing cash and commodities exposures. The bottom line for us for the next few months is to maintain focus on US economic strength. This view may change as we transition into 2019.

We appreciate your confidence in our team,

Fundamentum Investment Committee

Chad Roope, CFA® Portfolio Manager
Paul Danes, CFA® - Investment Committee
Trevor Forbes - Investment Committee
Matt Dunn, CFA® - Chief Compliance Officer

Sources:
1 Factset
2 Ned Davis Research: “Downside Risk Perspectives”

10/23/18

Investment advice offered through Fundamentum LLC a registered investment advisor. The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. There is no assurance that the investment objective of any investment strategy will be attained. Investing involves risk including loss of principal. Past performance is no guarantee of future performance. All indices are unmanaged and may not be invested into directly.