Market Analysis

Market Update

October 28, 2018

On Friday, October 26, the S&P 500 stock index closed at 2659, below the lower bound of our expected trading range for the year of 2700.

In our last market analysis, we expected a more challenging environment for stocks moving into the fourth quarter of 2018 given decelerating economic and profit growth, reduced liquidity, and escalating trade tensions. This has played out as expected but more violently than we anticipated. Having been quickly repriced, the question, as we see it, is whether or not fundamental conditions will worsen and lead to further declines in stocks.

We see four primary risk factors: 1) Federal Reserve monetary policy, 2) Trump Administration trade policy, 3) the health of the Chinese economy, and 4) the Italian budget confrontation with the European Union.

1) Over the last three years, the Federal Reserve has raised the Federal Funds overnight interest rate eight times in quarter percentage point increments from 0.13% to 2.13%, and it has signaled that it intends to raise the rate by a further quarter point in December and three more times in 2019. Given that the economy may be slowing on its own as the sugar high of the Trump/GOP tax cut wears off, this is a dangerous game. If economic data continues to decelerate (quarterly economic growth fell by 0.7% in the third quarter with moderating inflation), and the Fed does not moderate its policy, the risk of recession and further losses in stocks is heightened.

2) If the Trump Administration continues to escalate its trade war on China, global supply chains will face significant disruption leading to higher costs for both consumers and corporations. This will reduce consumptions and investment, further weaken the economy, and pressure share prices. To wit, industrial firms such as 3M and Caterpillar have stated that Administration trade measures are negatively impacting their financial performance.

3) As we have previously discussed, the Chinese economy is built on a fragile, overly indebted financial system. The Chinese authorities recognize this and are attempting to reduce borrowing without causing significant disruption to growth. This is a difficult balancing act, and there is no assurance it can be successfully managed. Trade war is further complicating the situation. As China is the world’s second largest economy, Chinese economic weakness reverberates around the globe, America included.

4) The Italian government, led by a nationalist/populist coalition, wants to increase Italy’s budget deficit beyond European Union guidelines, setting up for a potentially destabilizing showdown between Italy and the EU. Italy is already heavily indebted, and its banking system is among the most fragile in the industrialized world. Instability in the Italian banking system could spread to the rest of Europe and globally.

Whether or not these risk factors individually or in unison lead to a weaker economy and share prices remains to be seen, but we are monitoring them closely. As they have come on the radar screens of investors, volatility has increased, and we would expect that to continue to be the case heading into year end. For the remainder of the year, we see the S&P 500 stock index trading in a range of 2500 to 2900. It closed Friday, October 26 at 2659.

We will continue to execute our strategy of quality, value, diversification, and patience. While we stay abreast of macro-economic developments, our focus stays rooted on the long-term and in individual company dynamics. This has been our policy for the past two decades, and remains so today.

Please do not hesitate to contact us with any questions or concerns. Thank you as always for the trust you have placed in us.

Sincerely,

Patrick Mauro, Daniel Mauro, Henry Criz