Looking Beyond ‘Problem Ahead’ Market Headlines

We have now entered the final quarter of 2018 and the somewhat typical, late year market volatility is upon us. More specifically, the types of market fluctuations that are often associated with October are occurring—not that I feel this will be an October like 2008.

Finding a Balanced View

Much is debated recently in financial media about the lateness of the business cycle, and the high valuations of the stock market generally, not to mention the daily published barrage of ‘end of the world’ musings by U.S. President, Donald Trump. When looking at it all with a balanced view, I’d say the market adjustment downward this week is of the ‘normal’ variety.  There are always problems around us, and the broad media go out of their way to exacerbate things. With the U.S. economy experiencing strong growth and employment numbers, and in the absence of a significant catalyst, I do not expect a particularly worrisome October.

Plunge into Worry or Not?

To my long time readers I apologize for repetition, but some messages are worth repeating. Early this week the major markets moved down a few percent. Reading the headlines I see words such as ‘plunge’. I was almost amused reading about ‘the stock market rout’. Is a few percent down really considered a ‘plunge’? Is a year-to-date gain, in spite of the plunge, really anything to worry about?

Keep a Cool Head

In financial circles we would call these headlines “fake news.” Instead of plunging into worry, keep a cool head. Our good friends at Mawer wrote about the quarter that just passed and the view ahead. We share it with you below.

Excerpt from Mawer: Looking ahead

One analogy we have been using lately is that of a kettle. After you turn it on, it soon begins to make noise providing signals the water is about to boil. We certainly have a mix of indicators that may be considered noise in the markets at this point—a U.S./China trade war, rising interest rates, pressure on emerging markets economies, and Brexit plans. One or all of them may push the markets to boil, but we are not inclined to try to predict the precise moment. We do recognize the growing risks and position portfolios to cushion any downside. As a result, our recent asset mix changes lowered both U.S. and international equities to position the balanced asset mix back to a 60% equity/40% cash and fixed income level.

Thus far, the potential impact of the “noises” we mentioned above are unclear. The U.S./China trade war could lead to slower global growth, or it could present opportunities for some companies to improve their competitive positions. How the Brexit negotiations might be resolved likewise remains unknown. As an example of our approach, we might not be able to predict the results a specific trade policy might have, but we can hold companies we feel can adjust and pivot to new competitive situations or are less-exposed to trade between the affected countries.

A changing competitive landscape is a primary reason we have an investment philosophy that selects enduring businesses run by astute management teams. However, what you pay for an investment is a key driver of long-term performance. Our view is that the largest risk to equity valuations currently is the rising rate environment. This is because higher interest rates mean market participants are discounting future cash flows at a higher rate, hence lowering the intrinsic value of stocks and the corresponding price they are willing to pay for them. One way stocks could hold their value as rates increase is by delivering offsetting higher cash flows. Higher interest rates can also hurt stock prices by making corporate debt more expensive which suggests a less-indebted business could be better positioned to ride out the rise in rates. Our research team has been adjusting for higher discount rates and moving portfolios to more defensive business models with conservative levels of debt. We have reduced emerging markets weights and invested in businesses that are arguably essential in some way—such as Assa Abloy, one of the world’s leaders in door locks (see callout above).

While the rising rate environment is a risk, it is also a reflection of the strength of the global economy. So, while we are spending time this quarter talking about noises in the kettle, there are also positives that could extend the rise in markets. The U.S. leads the way with high business and consumer confidence, strong corporate earnings (thanks largely to lower corporate tax rates) and a near two-decade low in unemployment. Globally, industrial production statistics continue to read expansionary and interest rates in the developed world remain at low absolute levels. Taken together, these can add up to continued growth in equity markets.

The world constantly evolves, and we set about building your portfolio to benefit from this evolution over the long-term. Where there is noise suggesting we are getting closer to a boiling point, we have moved to retain resiliency. This way, we stay the course with a balanced, diversified portfolio that can withstand shocks but still benefit if markets continue to rise.