We write on this Fourth-of-July weekend as unapologetic patriots who still believe American capitalism is the greatest compound-interest engine man has devised. Still, as stewards of our client partner’s capital, we need to assess the risks and opportunities both at home and abroad.
The US markets entered the second quarter fairly strong, but were met with President Trump’s Liberation Day. At its low point, the S&P 500 entered bear market territory, credit spreads rapidly increased, and the US dollar continued its year-to-date (YTD) decline. Uncertainty and volatility were high, but both have collapsed as stocks have hit new all-time highs in the US.
Non-US markets have been on a tear. Developed international equities (MSCI EAFE) are up 19% YTD, and emerging markets (MSCI EM) are up 16% with earnings beating expectations, sentiment improving, and the US dollar weakening.
We last told this story in the first-quarter 2024 memo when we reminded client partners of the tale of two decades.
- From January 1999 to April 2011, a $100,000 investment in the EM index rocketed to $530,000, while the same stake in the S&P crept to $136,000.
- The roles reversed from 2011 to 2024. A $100,000 investment in US stocks grew to $490,000 while EM barely grew to $119,000.
- Over the full twenty-five-year stretch, the totals are nearly identical.
The US dollar has been in the news with many calling for its demise. Massive capital inflows, monetary expansion, and economic exceptionalism have propped up the US dollar’s strength. We do not make investments based on currency predictions. However, the US dollar has historically trended over long cycles, and structural tailwinds may be reversing. The US dollar has been structurally strong since the Global Financial Crisis in 2007-2009.
The US dollar is down over 9% YTD, and the low point for this year might have already been reached. However, if the US dollar experiences a structural decline, there are consequences for the investment landscape.
For instance, non-US investments can appreciate for US investors even if those stocks are flat, in local currency terms. In practice, if the euro strengthens against the US dollar, US-based investors can make money even if euro-based stocks are flat.
Emerging market (EM) countries also benefit from a weakening dollar as capital flows into these countries, typically lowering borrowing costs and improving balance sheets across the economy, governments, and companies. Further, EM countries are generally commodity producers. As the US dollar weakens, commodity prices typically rise, as they are priced in US dollars.
As history’s longest-running currency, gold also benefits from a weaker US dollar, as countries and citizens seek real assets that irresponsible politicians and unelected Fed officials cannot print. Like commodities, gold is also priced in US dollars for our client partners. As confidence in fiat currencies wanes, gold becomes increasingly attractive. A weakening dollar typically reflects loose monetary policy and rising deficits. Gold acts as a store of value in both inflationary and deflationary regimes, performing less well when financial assets are booming, driven by modest inflation and good economic growth. As we have written in the past, gold has easily outpaced US stocks (as measured by the S&P 500) since 2000, with gold up 10.5x vs. the S&P 500 up 7x. This is the type of insurance and diversification we seek when deficits go vertical.
Stagflation beneficiaries are positive for the year, with gold up 30% and a broad basket of commodities up 5%. The combination of US dollar weakness and US policy uncertainty has made for a structurally long-term trend in inflation and assets that benefit from inflationary conditions. We’ve written about this in the past, and are well-positioned through our Core Four economic framework.
The Core Four framework serves as a portfolio diversification tool and, to a lesser extent, a forecasting tool. We aren’t making tactical shifts based on where the model points in the next one to two quarters, but we want to ensure our client partners have investments in each of the Core Four.
On a shorter time horizon, the world is experiencing higher inflation yet lower growth, with divergences across countries and regions. With the expectation that inflation remains sticky (above the Federal Reserve’s targeted 2% rate), there is less reason to believe the Fed will make a material cut to its short-term policy rate over the next few months. However, on a 1-year timeframe, material cuts are highly likely.
High inflation is generally positive for commodities, long/short quantitative strategies, and gold. At the same time, it is mixed for equities to the extent that companies can pass on higher prices. The S&P 500 constituents have notched a 13.4% profit margin, only bested by the post-COVID boom. At some point, the consumer will push back against higher prices, but we have yet to see that, as evidenced by strong profit margins and continued earnings growth.
Zooming in on the US economy, we can see that a weakening economy does not necessarily mean a recession is imminent. The last several years can be categorized as a period of labor hoarding – companies over hired in the post-COVID reopening. Although they have not yet laid off employees, they have also not been hiring. This kind of sentiment helps keep the unemployment rate subdued. However, companies are reducing overtime, temporary staffing, and average weekly hours worked. As long as companies can find a way to move forward, that gives them more time to increase productivity by utilizing Artificial Intelligence, which remains the biggest theme in the US stock market.
There isn’t a silver bullet for where or when this happens. However, for now, we know that companies’ earnings are strong. Estimates continue to point to impressive year-over-year growth, with earnings growth estimates expected to be 9% (2025), 14% (2026), and 12% (2027). The S&P 500 trades at 22× forward earnings versus a 30-year average of 18×, so further tariff uncertainty could pressure that premium.
We aren’t here to retract our “unapologetic patriot” claims; however, we are here to say that diversification may finally be back in vogue. Global markets are rotating to non-US assets and investments that “cannot be printed.” Gold and real assets are providing insurance against policy uncertainty and inflationary pressures. Meanwhile, we may be entering the early stages of active management, once again taking the stage from passive investing. More on this in the weeks and months to come.
We’re staying patient and keeping capital where the odds are improving. For most of our client partners, we have sufficient liquidity and dry powder to support their families in the event of a need for access to funds, as well as enough capital to deploy into attractive, risk-adjusted return opportunities.
We appreciate your continued trust and support.
Compliance Disclosure:
Investment advisory services offered through Essential Partners, LLC, an SEC registered investment adviser.
This presentation contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this presentation will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security. Essential Partners, LLC does not offer legal or tax advice. Please consult the appropriate professional regarding your individual circumstance.
Factual material is obtained from sources believed to be reliable and is provided without warranties of any kind, including, without limitation, no warranties regarding the accuracy or completeness of the material. This information is subject to change, and although based on information that Essential Partners, LLC considers to be reliable, it is not guaranteed as to accuracy or completeness. Any market data is provided “as is” and on an “as available” basis. Source information, such as security prices, dividend rates, etc., is obtained from independent financial data suppliers.