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The Brave Report: Market Commentary for July 2019

Click here for pdf version of this report: The Brave Report-July 2019

Note: This report was written over the weekend and prior to the selloff to start this week, which obviously changed some things.

Did we all forget about the trade war?  It seems that most investors forgot that we are still trying to work out a trade deal with China (along with several other countries).  No matter what the earnings look like and how strong other fundamental may be, when put in the spotlight, the uncertainty around the trade war trumps all else and tends to send investors reeling. It seems that any rhetoric or threat about trade makes investors and traders sell first and ask questions later.  The computers and algo-trading systems exacerbate the issue sending stocks plummeting. We saw this in the 4th quarter last year and again in May. I am not saying some selling isn’t warranted but we continue to see outsized moves whenever any negative news comes out about the trade war.  The selling isn’t selective and even companies with no direct impact from trade with China are caught up in the carnage.  This creates frustration for many investors but also tends to create some great opportunities.  By identifying those companies that are unfairly brought down we have been able to find some great long-term buying opportunities. When the dust finally settles the prudent investor should have a list of quality stocks or sectors that they can buy at a discount.

Market Overview

The markets edged higher during the month of July with the Dow Jones Industrials gaining around 1% and the S&P 500 and Nasdaq gaining 1.3% and 2.1% respectively.  This left the indices all hovering close to all-time highs and drove volatility back down again.  This isn’t surprising as volumes tend to shrink during the summer months.  This, however, can be a double-edged sword.  While tepid interest in the markets during the summer months can lull some investors to sleep and make for comfortable vacations, any shocks to the system can have an exaggerated impact since liquidity is lower when volumes are down.  This can sometimes be worrisome entering August as it tends to be one of the worst months of the year for market returns.  Most traders and investors have already seen great gains for the year so it wouldn’t be surprising if any negative news pushes people to take profit and move to the sidelines for the rest of the summer.

On the fixed-income side, rates were stable for the month. The 10-year treasury hovered in the low 2 percent range for most of the month even with an anticipated rate cut later in the month.  This shows me that the most recent rate cut was almost entirely priced in and although some were expecting a larger cut, the lack of movement in either direction confirmed that the cut we got was expected.

Throughout the course of the year, we have had three big uncertainties that the market has been dealing with; the trade war with China, Fed policy and the worry of an earnings slow down.  Even with these headwinds, the market has had one of its best starts to the year in history.  The question remains, where would we be if we get resolution on any or all of these issues? It seems when uncertainty around one of these issues is resolved another one rears its ugly head.  This month was no different.

Trade War: It has seemed for most of the summer that the trade war was taking a back seat to the Fed and earnings season.  This all changed on August 1st when Trump again ratcheted up his rhetoric, tweeting out the threat to add additional tariffs to Chinee goods on September 1st. This broke what had been a cease-fire agreed upon in June at the G-20 meetings. The market reacted accordingly, selling off rapidly.  I expect China to retaliate in some fashion but at this point, there aren’t many more US goods that they can put tariffs on. Whatever form the retaliation takes I expect some market panic to ensue but how long it lasts will be the real question.  It is a sticky time for the Chinese president as Chinese leadership is in the middle of some major political discourse and that could have an impact on what they can do and how much they are willing to compromise. In the same vein, Trump has tied much of his success to stock market performance and a tanking market is not what he is looking for as the election cycle heats up.

The actual financial impact of these new proposed tariffs is minimal, representing around one tenth of a percent of GDP but this last tranche of tariffs will hit retail and the consumer more than previous rounds of tariffs. It has now brought up questions about what the President’s end game is.  So far, the US has taken the brunt of the financial impact of the tariffs. Since first increasing tariffs on China the government has collected around $20 billion in tariffs but have subsidized our own farmers more than $28 billion to account for losses due to tariffs imposed by China.  This doesn’t even factor in the other negative impacts of a trade war, most notably the erosion of business confidence.

We are now at the point where I don’t know if the President has a basic understanding of economics. This is a very scary statement as we have seen a simple tweet can drive markets in either direction. It is difficult to play the scenario forward and see a way that the US comes out as a real winner in this trade war or if it does, what will be the cost to do so. So far, the tariffs have basically been a tax on the American people as the costs just get passed along to the US consumer.  If you factor in the erosion in business confidence and the headwinds this fight has put on the markets the calculus just doesn’t add up for either side.

Earnings:  So far, earnings season has surprised to the upside.  Going into the quarter many expected earnings growth to turn negative after more than two years of double-digit growth as last year’s tax cut stimulus rolls off. However, with around 75% of companies having reported it looks like we could still see low single-digit earnings growth for the quarter. While this is a far cry from the earnings growth we have seen over the last few years it is far better than expected. The shadow of the trade war continues to weigh on quarterly results, especially for companies with Chinese exposure but even with that overhang companies continue to perform well. The domestic consumer remains strong and that seems to be helping to mute the impact of a slowing global economy.

Rate Cut: As was almost universally expected, the Fed cut rates for the first time in over a decade. While some were looking for a 50-basis point cut, the 25-basis point cut was in line with most expectations. The surprise, and for some disappointment, was that Powell’s comments didn’t indicate that this was the start of a series of cuts.  He continued to reiterate that future decisions would be data-dependent, but many were looking for more of an indication of future cuts.  There is still an expectation that there will be another 25-basis point cut sometime in the next six months but beyond that, there is a lot of uncertainty.  Inflation seems to be in check and employment data continues to be in line with the Fed’s mandate. Powell did note the potential for a slowdown in global growth, but this has yet to spill over to the domestic economy.

Strategy Commentary

I have maintained my equity exposure at slightly below normal since cutting some positions in May.  Trade war risks still persist and until we see some real progress on that front there will be an overhang over the markets. The markets have continued to march higher over the last two months, but I am comfortable missing out on some upside until we see some real progress with China. Most expected a trade agreement to be reached by now, but it is still casting a shadow over everything. Until this uncertainty is removed in a constructive way, I am comfortable being slightly below my normal equity allocation.

Domestically, I have maintained my overweight to technology and consumer discretionary.  I did trim some technology back in May but only slightly.  I have also shifted some of my equity exposure to larger-cap companies as the uncertainties in the market make smaller cap stocks riskier. If trade tensions again intensify, I will look to trim more technology exposure.  On the flip side if any serious progress is made with China I will quickly add back to some positions as I think this could be the catalyst for the next leg up in the markets.  However, as I have mentioned in the past the longer this trade war persists the more difficult it will be to undo the damage the year and half of trade uncertainty have caused.

On the international side, I have trimmed most of my international exposure to neutral or underweight. Continued trade uncertainty has muted any potential gains in Asian emerging market although I will look back to the area if trade tensions ease at all.  I am still underweight Europe as I see too many headwinds to expect any substantial growth in the near term.

With rates continuing to drift lower I am maintaining my neutral position in fixed income.  Trade uncertainty has caused a slight rush to safety. This combined with the expectation of a few rate cuts should keep yields suppressed. The big question will be how low yields can go especially considering the rate environment we are seeing around the globe.