Market Commentary | January 2020
Cooking Up Growth (and Risk) in the Markets
In chemistry, there is a phenomenon called a “super-saturated” solution. If you try to dissolve a solid (say, salt) in a liquid (say, water), at a certain point the liquid cannot dissolve any more of the solid, and the solution is “saturated.” If you add heat, though, you can dissolve more of the solid than normally possible, and the solution becomes “super-saturated.” Remove the heat, and it is no longer liquid; it solidifies again.
You may have already guessed that we mention this process of altering the state of a solution in the chemistry lab as a metaphor for stock market price movements. Instead of solvents, though, we pay attention to the interaction of elements such as interest rates, job creation, global trade relations – and ultimately investor sentiment.
The Risks of Sentiment: Irrational Exuberance
Over the course of 2019, the Federal Reserve lowered interest rates three times, following their previous nearly three-year stretch of gradually raising rates. Interest rates are like the heat applied in the lab, with lower rates magnifying the ability of corporate, government and individual investors to borrow money. They then use that debt for additional spending, product development, or other forms of business expansion. Beyond the US, many global governments are again keeping rates low – or negative – to support employment and economic growth.
Despite the significant price growth in the S&P 500 in 2019, there remains a sense among investors and economic decision makers that the status quo of positive – though tepid – economic growth will continue to support financial markets. This combines with efforts to roll back regulatory policies, which have accelerated since Trump’s election in 2016, to add “heat” and alter the state of the market. Regulatory shifts, low-interest rates, and perceived stabilization in areas such as trade tensions with China all expand the market appetite for risk.
When markets rise on sentiment, rather than fundamental revenue and earnings growth, the risk of volatility and price correction increases over the near-to-mid-term. Unfortunately, this is where our metaphor must part ways with the saturated solution in the lab because the variables in economic and market behavior are far too varied for controlled experimentation.
And our clients are asking the expected question: “will stocks go down now?” Effectively they want to know if the market’s pursuit of risk is becoming unwise – and if we should be more conservative. This is an understandable query after such a dramatic rise in the value of the S&P 500 stocks; still, we can’t predict what markets will do next. Knowing that we structure our client portfolios with relatively stable fixed-income investments that will serve as a source of liquidity if a period of contraction in the economy and equity prices does arrive. This cautious structure is designed to allow the more volatile stock allocation (and our clients, themselves) to tolerate the intermediate term ups and downs; to remain invested for future moments of market opportunity.
The Benefits of Sentiment: Seeds of Innovation
Next, an odd juxtaposition. Overly positive sentiment can lead to disjointed risk-taking in financial markets, and conversely, the natural feelings of worry and concern about market, social and environmental risks can pave the way to a stronger economy and future growth. Last century the Cold War created a dire vision of possible nuclear war; today, the vigorous spread of intensive carbon use through economic globalization has created a new and also dire vision of climate collapse. The Cold War was a period of international anxiety and concern; it was also a period of heavy investment in innovation and satellite technology based on that concern. This crisis-period innovation has a clear and direct link to the GPS systems and accurate weather forecasting that we use on a daily basis today, both of which have also led to billions of dollars of efficiency gains for companies around the world.
Developing global agreement about addressing climate change has been difficult, but there has been concrete progress in many countries with carbon credit trading. Major 20th-century trade policy issues included labor costs and migrant workers, but in the 21st century, carbon border taxes are likely to become “the frontier of trade policy.”1 Further, the development of the global economy over the previous 50 years seems to be shifting its growth center to China and India, and the “new globalization” is a race to innovate in technology rather than manufacturing or services.
One important benefit of the global effort on climate change is the innovation we expect in the coming decades. Commitments to sustainable energy generation by state governments2 and federal government support of green building technologies3 are two examples of a virtuous circle between policy and industry innovation. There are struggles as well. The development of carbon emissions trading systems has grown slowly because state governments in the US and China have not yet committed to mandatory systems. As efforts to handle climate change accelerate, though, we are confident that innovation will continue to accelerate, and we see that innovation as a big positive for stock market growth over time.
We remain cautious when we consider current stock valuations, even with our optimism about innovation, and the opportunities for invested capital to make a difference – and to grow at a rate that maintains our clients’ purchasing power over the long term. It is with this lens that we build and steward client portfolios heading into an election year, knowing that our clients’ wealth and well-being is meant to support them and their families for decades to come.
As always, we are grateful for your trust in our partnership with you, and we look forward to talking about your individual portfolios, shared concerns, and unique opportunities throughout the years ahead.
This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.
- “As World Economy Shifts Gears, Trade Growth Slows,” Adam Tooze, New York Times online, January 19, 2020.
- As of 12/31/19, twenty-nine states and Washington DC have established requirements for renewable power generation. Most have minimums ranging from 10% to 45%, although thirteen states have minimums from 50-100%.
- The US General Services Administration (GSA) has worked for nearly nine years helping operationalize next generation green building technologies. See https://www.gsa.gov/governmentwide-initiatives/sustainability/emerging-building-technologies/about-gsas-proving-ground-gpg.
This commentary on this website reflects the personal opinions, viewpoints, and analyses of the North Berkeley Wealth Management (“North Berkeley”) employees providing such comments, and should not be regarded as a description of advisory services provided by North Berkeley or performance returns of any North Berkeley client. The views reflected in the commentary are subject to change at any time without notice. Nothing on this website constitutes investment advice, performance data, or any recommendation that any particular security, portfolio of securities, transaction, or investment strategy is suitable for any specific person. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. North Berkeley manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results.