Since our last commentary on October 11, 2018, the S&P 500 has both held a minor rally from $2728 to $2814 and subsequently fallen even further to today’s close of $2642. From a macroeconomic standpoint, the three primary overhangs – global trade concerns, Italian debt issues and rising interest rates – remain roughly the same as they were on October 11. Fundamentally, the main incremental negative has been weaker than expected corporate earnings. Third quarter reports were actually strong on average, but this was trumped by negative forward-looking guidance and qualitative commentary, in particular with regard to global trade uncertainty, the strength of the US dollar, rising wage pressures/labor shortages, and high transportation costs. As we mentioned previously, the shift in investor sentiment from very positive to negative and now very negative has also played a large role in the market correction, and gives us a reason to be hopeful going forward. When volatility spikes and investors are highly pessimistic (such as today), it is often a good time to be buying into the market.
Looking ahead, we won’t hear again from most corporations until late January/early February, but there are a number of macroeconomic catalyst events before then that will likely determine how the market finishes the year:
- Italy – 11/21 – The specific issue here is that the Italian government submitted a budget request that violates EU deficit rules, and they are refusing to change course. The bigger issue is that the EU is a fragile institution that may not be able to survive Italy, with its massive debt load, having major economic issues. The failure of the EU, while still very unlikely at this point, would have significant negative global economic consequences. Tomorrow we will hear the EU’s response to Italy’s latest refusal, but this issue will likely drag out for some time, with the acuteness of the issue best measured by the spread between Italian and German bond yields.
- Economic Data – 11/23 and 12/7 – The first major economic data points for November will hit Friday morning, with the final US jobs report for the year on December 7. Lately, US growth has been very strong (hence the wage pressures/labor shortages that are starting to crimp US corporate profit margins), but global growth has shown signs of weakness.
- Federal Reserve – 11/29 (meeting minutes), 12/5 (Powell testifies before Congress) and 12/19 (policy decision) – Current Fed guidance implies four more interest rate hikes between now and the end of 2019, while the market is only pricing in two. If the Fed continues to dismiss the recent market volatility and geopolitical concerns, the market could have further downside as it must start anticipating even higher rates.
- G20 Events – 11/29 through 12/1 – The big event here will be the meeting between President Trump and Chinese President Xi. Many media reports have speculated an outcome similar to when President Trump met with European Commission president Juncker in July, i.e. a “cease-fire” of sorts that keeps current tariffs in place, but a vow to refrain from enacting further tariffs while negotiations continue. A better outcome would be a true trade deal or the removal of existing tariffs, but these are seen as unlikely. A worse outcome would be no cease-fire and the US enacts the further tariffs that it has already threatened.
Finally, you may be wondering how the workflow of our Investment Team adjusts in response to market corrections and the concurrent pickup in volatility. As long-term investors who are not attempting to time the market, the simple answer is that our investment methodology and portfolio risk management procedures do not change. We do not panic, we stay the course. That said, we are naturally busier for two key reasons:
- The volatility can create large price swings in individual stocks, significantly changing our relative rankings and prompting more trading.
- While we believe the swing in investor sentiment from positive to very negative has been a major contributor to the recent decline, there has also been new information and risks that have caused justifiable moves. These up-to-date fundamental changes must be incorporated into our thoughts on a company before we trade.