The three months ended September 30, 2019 brought both tumultuous world events and corresponding volatility. At one point during the quarter, stocks declined nearly six percent over six trading days. Geopolitical developments ranged from an attack on prolific Saudi oil facilities to the announcement of a formal impeachment inquiry of the President. This compounded the almost daily swings between hope and fear resulting from the trade war with China. Despite these challenges, the S&P 500 produced a modest gain while our accounts were roughly flat.
Declines in two railroad stocks were a significant drag on performance for the quarter. These have been successful longer-term holdings for us as the adoption of precision railroading drove operational and financial improvements. However, the recent slowdown in manufacturing resulted in disappointing traffic volumes this year despite progress on expenses. In response, we eliminated the position in the more mature turnaround situation (it has already reached industry leading margins) and added to the more open-ended story. On the positive side of the ledger, our investment in the leading dollar store operator added value as the company delivered accelerating comparable store sales.
Equity markets are trading at levels roughly the same as six months ago notwithstanding numerous gyrations in between. This “unstable equilibrium” is the result of a tug of war between two powerful forces: the negative impact of slowing worldwide industrial activity and the positive influence of lower interest rates across the board. The industrial malaise can be traced to the tariff war as cross-border trade turned sharply lower while capital spending chilled by uncertain policy. The benefit of lower interest rates has a latent effect on economic activity but is much more immediate in financial markets.
The recent news of what is being labeled as a Phase I trade accord may be the impetus needed to positively sway the tenuous equilibrium in equity markets. While it does not mark the end of the trade war it could be more of a constructive truce. This mini-deal, if enacted, will not turn around industrial activity overnight. However, it may put the worst of the tariff war behind us, reducing the tail risk of a near-term recession. Some of that risk was apparent when 10-Year Treasury yields dropped to 1.45% in September. There have been many head fakes with prior negotiations so caution remains warranted. That said, a détente would help both sides, particularly in light of the approaching election in the U.S. and ongoing protests in Hong Kong. We expect more headlines back and forth, but this development brings a positive bias to the equation. If so, then the current mini-recession may play out similarly to 2013 and 2016 when the combination of stimulus from lower rates and reduction of political risk pushed economic activity back towards trend-line growth:
This optimistic scenario may not play out as strongly for stocks as the previous two years because 2020 is an election year. It is still early for the market in general to discount the election, but at some point its uncertainty could cap valuations. It is not too early for the election to be a factor for the health care sector given the dramatic changes to the status quo being proposed. We have been reducing exposure to the sector steadily since the beginning of 2019. We also trimmed our weighting in higher-flying software stocks. Their secular growth remains intact but the valuation premiums placed on that visibility is at risk near-term. On the other end of the spectrum, we have added to our semiconductor position and initiated a probe in an oil refiner.
On the fixed income side of balanced accounts, the optimistic scenario discussed above may put a floor on bond yields. Anticipated cuts in Fed Fund rates could steepen the yield curve rather than shift longer-term rates downward. Although a bottom may be forming, we doubt that rates will have a “V” shaped move up because trillions of dollars of bonds in Europe trade at negative yields. A deal on Brexit would alleviate some of the downward pressure on yields on the Continent but monetary policy by the European Central Bank remains aggressive and massive. Our portfolios are positioned with slightly below benchmark duration.
The fourth quarter is off to strong relative performance as several of our stocks have delivered strong earnings reports.