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Uncertainty Over Trade Clouds Stock Market 

Despite posting gains early in 2019, stocks have been locked in a sideways groove as stop-and-go trade negotiations between the U.S. and China have kept investors on edge.
 

In the trade clash between the U.S. and China, the past few months have featured a smidge of everything. First, the U.S. uncorked stiffer tariffs. China responded with predictable retaliatory measures. Lately, both sides have softened their tones. Overall, however, there’s been a lot of furious back and forth — with little apparent progress to show for it. That aimlessness has been reflected in the U.S. equity market, which has been somewhat immobilized by the protracted uncertainty over trade. Even with their striking gains early in 2019, stocks have been locked in a sideways groove for much of the past two years as the spasmodic trade negotiations have kept investors on edge.

Once again, the economic outlook is brightest in the U.S., where the mix of low unemployment, solid wage gains and sturdy household finances continues to underpin consumer confidence and spending. The record-setting economic upturn has been galvanized by falling interest rates, with the Federal Reserve trimming rates twice so far in 2019 and expected to do so once more this year. Equities are also being supported by corporate earnings growth, which has been modest recently but is projected to gain considerable steam in 2020.

Certainly, there is no shortage of fretful signs in the U.S., including pronounced weakness in manufacturing, high levels of government and corporate debt, the continued reluctance of businesses to invest until the trade fracas is resolved, and the tenuous growth outlook for major overseas economies. Indeed, long-term rates have sagged amid concern that a series of aggressive easing moves by central banks around the world may not be enough to stave off a further weakening of the global economy. Still, the positives continue to outweigh the negatives, and the threat of a recession taking hold in the near term is low.

The trade war is exacerbating China’s economic slowdown.

Even during periods of relative quiet, the trade brawl with China is hanging over global markets, with each twitch in negotiations stirring short-lived ripples in stock prices. Though the S&P 500 index is just off its late-July peak, it’s not much above where it was in early 2018, when the U.S. announced its first batch of tariffs.

The trade clash has added to underlying problems in the Chinese economy, which is experiencing weakness in exports, industrial output, auto sales and business sentiment. The government has responded with a variety of measures, including an injection of cash into the financial system and smaller steps to boost bank lending, but conditions may trail off further.

Economic lethargy is also taking a toll in Europe, primarily in the German industrial sector, where reduced demand from China has been a major factor pushing manufacturing activity to its lowest level in more than a decade. There is a risk that the weakness could splash into the broader economy and tug the country into recession. The European Central Bank has responded with its most decisive steps in several years, reducing its key interest rate and restarting a bond-buying program not long after announcing that it had finally weaned itself off it.

On the bright side, other parts of Europe, especially France and Spain, are faring better than expected. The French government has worked to boost economic efficiency through moves such as making it easier for companies to hire and fire, and it recently proposed tax cuts for individuals and businesses. And despite the lingering fate of the Brexit showdown in the U.K., our European economist believes worst-case scenarios will be avoided and the outcome ultimately may be more favorable than the general consensus.

Secular trends underpin key industries.

Our portfolio managers have been drawn to industries that are poised to gain from long-run technological, demographic and financial trends. For example, credit rating companies, which assess the quality of corporate and municipal bonds, have a number of favorable attributes, including global growth opportunities, brand-name recognition and significant pricing power. To be sure, the industry is cyclical and its reputation was badly dented in the 2008 financial crisis. But as our analyst discusses, leading companies have navigated the regulatory climate well and seem positioned for growth.

Our managers have also been attracted to companies benefiting from the rising crest of digital payments. Electronic transaction systems are common in much of the world and are slowly catching on in the U.S. That trend is expected to gain strength as smartphone applications grow.

Falling yields boost fixed income returns.

Bond yields continued to decline in the third quarter, with the 10-year Treasury dipping below 2% and European rates sagging further into negative territory. That contributed to strong total returns in fixed income portfolios.

The 10-year yield dipped slightly below the two-year yield, a so-called inversion of the yield curve that has preceded past economic downturns. However, recessions have historically not been immediate, indicating the limitations of the yield curve as an economic signal. The last three times the curve inverted, recessions occurred anywhere from 20 to 35 months later.

Our managers have been mindful of credit risks given the combination of an uncertain global outlook and current market conditions, which do not reward investors for taking incremental risks. Among municipal securities, our managers are drawn to revenue bonds, which are backed by project-specific revenue streams and account for about 70% of the investment grade municipal market. Revenue bonds have typically offered higher yields than better-known general-obligation bonds. On the taxable side, our team continues to favor asset-backed securities with dedicated revenue sources.

Fixed income offers essential benefits, including income generation, capital preservation and diversification from equities. Those traits are especially appealing at a time of ongoing uncertainty in the global economy.

The above article originally appeared in the Fall 2019 issue of Quarterly Insights magazine.