Despite a serious bout of market turbulence and an inversion of the yield curve, stocks held onto their best year-to-date gains in over two decades during the 3rd quarter. Lower interest rates supported modest gains for many asset classes – even as weakness in global manufacturing spilled into the U.S. Some of this weaker data has investors anticipating future easing by central banks around the world in an effort to facilitate stronger economic growth. After reaching record highs in July ahead of the first U.S. rate cut in over a decade, stocks tumbled into August as investor confidence slumped on renewed fears of Brexit, less central bank independence, and an escalation of U.S. trade tensions with China and the EU. In September, however, a spate of better-than-expected economic data lifted spirits as investors largely shrugged off an Iranian missile attack on Saudi oil facilities and an impeachment inquiry with the market closing just a couple percent off all-time highs. Meanwhile, bond yields – after plummeting in the month of August on recession fears – retraced some of their fall as core Consumer Price Index in the U.S. accelerated to an 11-year high of 2.4%.
In our view, the consumer (see GDP chart, above) continues to power steady growth in the U.S. economy, and exports are small enough that we can withstand the costs and uncertainty involved in supply chain overhauls driven by trade frictions. Consumer confidence remains strong, and investors appear willing to ignore the implications of what a slower economy might hold in store for earnings provided inflation remains contained and the Fed lowers interest rates further. We expect sluggish growth to persist through year end and anticipate another year-over-year deceleration in quarterly earnings as companies report Q3 results. Given elevated stock market valuations in the U.S., we believe diversification will serve investors well over the coming decade. After the worst relative performance for value stocks in 70 years, the tide may be turning as antitrust proceedings begin to ramp up against Big Tech. In the U.S., we prefer dividend payers/growers that offer resilience with strong balance sheets and ample cash flow. Overseas, cheaper relative stock valuations appear to already discount ugly news headlines. Within fixed income, given the backdrop of slow profit growth and minimal inflation, we favor higher yielding, short-term debt and asset-backed securities. Meanwhile, real assets offer a hedge against unexpected inflation that could accelerate as central bank interest rate cuts stimulate growth.
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