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The Brave Report: Market Commentary for September 2018

Click here for the pdf version of this report: The Brave Report-September 2018

Will fundamentals win the day? Strong economic numbers continue to drive the markets higher but trade concerns and political posturing have left a cloud over the markets and muted what could have been even greater gains.  With the start of earnings season coinciding with the run-up to midterm elections, there will be a tug of war in the markets as to what will drive investor decisions for the rest of the year. With the possibility of flipping the majority in Congress, I would not be surprised to see some major political posturing from both sides over the next month.  The big question is will this impact the markets or will economic fundamentals and corporate results remain the key focus?

Market Overview

The markets saw mixed results over the last month as trade tensions and political discourse again moved to the forefront. The Dow was the big winner, gaining just shy of 2%. The S&P 500 also moved higher, adding 0.6%. While the NASDAQ, for a change, was the underperformer, losing around a half a percent. Investors continue to be torn between the tailwinds provided by strong fundamentals and corporate results and the headwinds of a potential trade war with China and rising rates. This battle has been playing out for almost the entire year. With earnings season kicking into gear and the run-up to midterm elections over the next month it will be interesting to see how October plays out.

On the fixed income side, we finally saw a meaningful move higher.  After being relatively range bound since the beginning of February, the 10-year treasury seems to have made a sustained move above 3%, reaching a high yield of just above 3.1%. This upward movement is not unexpected as the Fed again raised rates at their September meeting, but it finally looks like the rate increases are putting some real upward pressure on rates.  The questions that remain now, is how fast and how high will rates move now and how will these rising rates impact the equity markets?

Fixed Income Lags: The rise in rates finally seems to be taking its toll on the fixed income universe. Market pundits have been calling for the end in the bond bull run for a few years now but it finally seems that it is materializing. The Fed has not hidden its intention to raise rates over the past few years but that seemed to have little impact on real returns. That story seems to be shifting this year. The chart below illustrates the real return of the major global asset classes since 2008 or the return adjusted for inflation.

Source: Morgan Stanley

As you can see, we are poised to see negative returns across almost all major fixed income classes. As of the end of September, US High Yield bonds is the only place that investors have not lost money year to date and it is only up around 0.2%.  Some investors will argue that fixed income has been on a great run and is due for a little consolidation or even a pullback.  I don’t think these investors are wrong, however, the concerning aspect for me is how this impacts the everyday retail investor, especially those in retirement. Most retail investors flock to fixed income for its perceived safety and steady income.  They look at their fixed income allocation as their safe haven, and in general, it has been for many years.  This year will be very shocking to many when they realize these “safe” investments have actually lost money. These investors should not panic but use this as a learning moment.  There are risks with any investment and it is important to understand the risks associated with what you are investing in. It also should show the importance of diversification.  Looking at the above chart again we see that the very few global assets have performed well either but if you had exposure to US equity you would have helped to balance out the negative performance elsewhere.

Earnings and Mid-term Elections: I touched upon this briefly above but a few factors have been driving the markets so far this year. Basic economic fundamentals and strong corporate results have been pushing markets higher.  These gains, however, are in spite of the political and trade uncertainty that hangs over the markets.  It seems that during times that earnings are in focus the market easily shrugs off these uncertainties.  But when earnings move out of focus, the uncertainties around our current trade and political climate take control and the market stagnates or pulls back slightly.

Over the next month, these factors could have quite a battle as they will all be difficult to ignore. Earnings season is set to kick off but with midterm elections on the horizon, we should see quite a bit of political wrangling as the GOP looks to hold on to their majority.  It would not surprise me to see an attempt by the administration to try to notch a few victories to help solidify the base and motivate voters. Add to this the issues the GOP is having with their Supreme Court confirmation and I think they will need some other big wins in order to protect their majorities. What this wins will look like is the big question mark.

The questions then remain, will this ongoing political discourse distract investors from what is expected to be another stellar earnings season? Or will investors be able to put aside the political uncertainties and focus on what really should matter; fundamentals?

Strategy Commentary

Over the last month, I have added back to some of my equity positions. While the trade conflict with China still has a ways to go until a real deal is reached, there has been some positive progress on other fronts. We are also entering what is expected to be another strong earnings season and this should shift some of the daily focus away from trade negotiations and again allow traders and investors to focus on company fundamentals.  I did not return to a full overweight of equity but brought it back to a more neutral allocation. If we continue to see more resolution on the trade front there could be some great buying opportunities in some areas that were beaten up by trade war fears.

I am still maintaining my overweights to both technology and consumer discretionary.  As expected, I also increased my weighting to healthcare.  Healthcare has outperformed over the last six months and I expect this outperformance to continue especially if trade tensions with China still hang over our economy.

I continue to be underweight on almost all international markets. There are too many headwinds in Europe with Brexit still being resolved and uncertainty in Italy. As I have mentioned in the past, with emerging markets being severely beaten up for the last few quarters I think there could be some country-specific buying opportunities if China and the US can work out a deal. The severity of the pullback, especially in China, does not match up with the economics of the tariffs that have been implemented or proposed. With the trade risk removed, I think there could be a pretty swift recovery.

I continue to be underweight almost all of the fixed income space.  With rates on the rise, we have seen pretty broad-based negative performance throughout the space.  I am maintaining higher cash allocations as a replacement for my fixed income allocations.