A Q3 investor watch list

Proceed with caution, but by all means … proceed. This was the overarching message in our third quarter equity market outlook.

We believe U.S. stocks can grind higher in the new quarter, underpinned by strong fundamentals and an economy that is still growing ― albeit nearing the final legs of its multi-year expansion.

The rebound from late 2018 losses was robust in the first half and evident across sectors, as shown below.

The second half is unlikely to be a repeat. Yet we are not ready to shift to risk-off. Our stance at the midyear point: risk-on and risk-aware. Slowing growth, combined with earnings uncertainty and higher (but not prohibitive) valuations, argue for a strategy aimed at upping portfolio resilience. To us, this amounts to a stock-by-stock approach to portfolio construction that emphasizes quality companies with strong balance sheets and solid free cash flow. It’s a strategy we’re employing in BlackRock Equity Dividend Fund.

Such a tack is particularly relevant given three wildcards that we believe have the potential to guide stocks moderately in either direction in the months ahead:

1. U.S.-China relations

A resumption of talks after the June G20 summit is a favorable sign, and we believe both nations have incentive to arrive at an agreement on trade. Yet the battle for global technology dominance is an even thornier issue that is likely to rage on. The upshot: A trade deal, however modest, would be a positive for stocks in the near term, but expect a protracted cold period to generate headlines and market gyrations through time.

2. Monetary policy

Stocks have cheered the Fed’s dovish tone and potential for a rate cut in the second half. The medium-term question that market participants will begin to ponder is whether a rate-cutting cycle would be an insurance policy to keep the economy buoyant or, more worrisome, a defensive front to forestall a recession. The upshot: Look for a rate cut to boost stocks, but the subtext will be important to monitor for signs that late-cycle may be approaching recession.

3. D.C. politics

2020 election campaigning has kicked off with the first Democratic debates and rallies by incumbent Republican Donald Trump. The agenda and rhetoric of the various candidates (with more than 20 hopefuls seeking the Democratic nomination) is sure to include proposals affecting the health care and technology sectors, where both public interest and regulatory scrutiny are high. The upshot: We like both sectors but believe a stock-by-stock approach is increasingly important.

Risk on and risk aware

Across our fundamental active equity platform, a growing share of risk-taking budgets has been dedicated to stock-specific variables. This type of focus on company-level risks is one way to seek insulation from macro uncertainty. We also advocate a quality bent in pursuit of portfolio resilience as the market and economic cycles wear on.

Still, investors can take some solace in the idea that neither of these cycles is known to die purely of old age. And one thing I really like about this particular bull market: It has not been based on irrational exuberance. It has climbed a wall of worry to reach current levels. The low conviction has limited any build-up of dangerous excesses―and that could imply there is room to go.

Tony DeSpirito is Director of Investments for U.S. Fundamental Active Equity and a regular contributor to The Blog.

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