2Q Quarterly Update – 2019
We’re going to party like its 1997…
As June 30 came and went, two major milestones were eclipsed: 1) the United States officially entered into the country’s longest period of economic expansion, surpassing ten years and counting, and 2) the S&P 500 delivered the best mid-year return figure since 1997, coming in at 18.54%. However, unlike the first quarter of 2019 that saw the markets ascend straight up with minimal volatility, the second quarter did not go as smoothly. In May, US-China trade talks broke down, sending the major equity markets reeling more than -6%, producing the first negative month of 2019. Much like we experienced in January, the Federal Reserve came to the rescue, providing investors confirmation that the Fed stands ready to act and cut rates if needed, causing all major markets to snap back in June to close out the quarter with a gain. US large cap delivered the best quarterly results of 4.30% for the S&P 500, while mid and small cap equities trailed, with respective returns of 3.05% and 2.10%. Though historically markets have performed well in the second half of years that start so positively, we do not anticipate a smooth path upward in the remainder of 2019. As we sit today, the backdrop for the US equity markets is plagued with challenges. The US-China trade war still lingers and is marred with uncertainty, and tariffs are exposing an already fragile and softening US economy. Corporate profit growth continues to decline, putting the US in position to possibly face the first earnings recession since early 2016. On top of that, geopolitical tensions continue to rise in Iran and other parts of the world. Investors seem to be pinning their hopes on the Federal Reserve, as the market is pricing in rate cuts totaling .75% by December. Any failure by the Fed to meet the markets’ demands could cause volatility and downward pressure on equities.
While not keeping pace with US indexes, foreign equities still managed to produce solid first-half returns of 14.49% and 10.78% on the MSCI EAFE and MSCI Emerging Market, respectively. During May’s selloff, equities in foreign developed economies held up well on a relative basis, with the MSCI EAFE only down -4.66%. While their June snap-back slightly trailed the US equity markets, foreign markets still eked out positive quarterly results of 3.97% on the MSCI EAFE index, and .74% on the MSCI Emerging Markets index. Much like the US, global economies and markets face many headwinds including deflationary pressures, fading economic growth, and ongoing trade uncertainty. Yet, as in the US, global central banks’ accommodative monetary policy is helping to support risk assets such as equities.
In light of such strong first half equity results, the returns on bonds might be one of the largest surprises in 2019. Typically, when equities rise, so do interest rates, sending the prices of bonds lower. However, we’ve seen yields fall to lows not experienced in several years, with the 10-Year US Treasury yield trading close to 2.0% as of June 30 (down from a high of nearly 3.25% last fall). This produced a quarterly gain of 3.08%, and a YTD result of +6.11% on the Bloomberg Barclays US Aggregate Bond Index.
Tariffs and Trade Continue to Dominate Headlines
As we entered the second quarter, progress in the US-China trade war was optimistic. Many believed a deal would be reached and topped off with a large commencement signing ceremony at the G20 summit in Osaka, Japan in late June. Unfortunately, on May 5, the US-China trade saga soured. President Trump tweeted his intentions to raise existing tariffs on some goods and threatened to place tariffs on the remaining $300 billion of Chinese imports. The US claimed China backtracked on commitments made during negotiations, while China maintains their objection to the US expectation that Chinese laws be changed to accommodate an agreement. Going a step further, the US sanctioned the Chinese tech giant Huawei on grounds of national-security; prompting China to threaten the restriction of access to rare earth metals, which are critical for the production of electronics and military goods. Much like the December 2018 G20 summit in Buenos Aires, Presidents Trump and Xi held a meeting to discuss the trade spat. Similar to December’s outcome, there was no real progress towards a deal, but a truce was forged. America would postpone applying tariffs to the remaining $300 billion of Chinese imports and lift some of the restrictions on Huawei, while China agreed to immediately start purchasing US agricultural products. Other than putting negotiations “back on track” according to Trump, no substantive progress was made in Osaka, potentially setting the stage for the already drawn-out negotiations to be carried on even further, perhaps even into 2020. Many believe Trump is strategically trying to time a deal to coincide with when he starts hitting the campaign trail, while others believe China is dragging their feet to see who the next president will be. Either way, the ongoing tariff dispute will likely continue to play a significant role in equity market performance for the foreseeable future. While the U.S. should ultimately hold the upper hand in negotiations given our trade deficit, further escalations could significantly damage economic growth both domestically and abroad. Ultimately, the road may be long and treacherous, but we remain optimistic that a deal of some sort will eventually be struck.
Tariffs were a consistent theme throughout the second quarter, signaling that trade deals the US has with other countries is a primary focus for the administration. Adding to investor angst in late May president Trump tweeted the US would impose 10% tariffs on our neighbor to the south – Mexico; threatening to keep the tariffs in place until Mexico took appropriate steps to stop the flow of illegal immigrants across the Mexico-US border. Fortunately, the US and Mexico came to terms, avoiding the 10% tariffs, for now. Trade and tariffs will continue to be a popular theme going forward, especially as the global slowdown continues to develop. Outside of China, we see the EU tariff discussions being the next major trade focus for the US, especially as it pertains to automobiles.
Let the Doves fly?
While the US Economy beat many expectations by growing at 3.1% in the first quarter of 2019, the economy has also shown some cracks. For the first time in many quarters, we witnessed a slowdown in consumer spending, which is worrisome given that the consumer drives about 70% of our economic growth. The labor market, while still strong, has shown some potential signs of softening. May’s job reports added a mere 75,000, which given the stage of the economic cycle we’re in is not all that surprising, but the labor market has been a beacon of dependency for the expansion; and June’s strong rebound adding 224,000 jobs indicates that the labor market, and perhaps even the economy are stronger than many believe. Manufacturing is still in expansionary territory but trending down towards contraction levels. The waning tax incentive enacted by the administration is beginning to drag on the economy, but more importantly, we’re starting to experience the negative impacts of tariffs and trade wars. It’s important to realize that tariffs on imports act like a tax on the consumers. Companies pay more for the goods they import, and more often than not, they pass those increased costs on to the consumers. Goldman Sachs believes the negative impact from tariffs is to be paid for by both the consumer and companies. Rarely do you see an administration’s fiscal policy (tax and infrastructure spending) conflict with their trade policy. While the 2018 tax act added to the consumers’ pocket, the trade war taketh away, essentially negating the economic benefit from the tax cuts.
As global economies slow, investors look to central banks to implement expansionary, or dovish, monetary policy. The central bank in the US is the Federal Reserve, or the Fed. In order to encourage economic growth and expansion after the Financial Crisis of 2008, the Fed implemented expansive, or easy, monetary policy. They lowered rates to essentially 0%, and began buying bonds at an unprecedented pace growing their balance sheet to over $4 trillion. The Fed’s main responsibilities are to control the growth of the economy and inflation, so when growth is falling or negative, they enforce expansive monetary policy. When the economy starts to grow too fast the Fed implements tight, or restrictive monetary policy, such like raising rates. After raising rates for the fourth time in 2018 the market panicked, equities sold off, turning in the worst December in history. In early January the Fed immediately pivoted and changed the outlook from 2-3 rate increases to none. This drastic U-turn in monetary policy sent the market in rebound mode, but rates continued to fall, indicating that the bond market and stock market were in conflict on the short-term outlook of the economy, and signaling trouble may be on the horizon. The yield curve even experienced its first inversion since 2007, albeit short-lived, but immediately recession fears reared its head again.
As trade negotiations faltered in May, investors flocked into Treasury bonds as a safe-haven asset. Recession fears continued to mount, and rates on treasuries continued to fall, with the 10-Year falling briefly below 2%. The yield curve inverted again, this time across nearly all terms, and remains inverted through quarter-end. The market (and the President) again clamored for the Fed to loosen policy and cut rates, putting the Fed in a tricky position. The Fed just drastically changed their rhetoric in January, so they risk losing credibility if they pivot again, especially so soon. On the other hand, should rates continue to fall, and tariffs continue to drag down the economy, GDP could slow down too quickly, and approach or even enter recessionary levels, forcing the hand of the Fed. In early June, Chair Powell did come out and say they are monitoring the situation closely, and stand ready to act if needed. The Federal Reserve reiterated this message after the June meeting, where they removed the language they will remain “patient” in evaluating the economy and lowering rates. The market has gone from predicting the Fed would cut rates once by December, to predicting the Fed will cut rates 2-3 times by year end, and as early as July. There is little doubt the economy is slowing, and we believe the Fed will ultimately cut rates to help remove the inversion and promote growth. However, June’s job report raised some concerns that a rate increase in July is a foregone conclusion. Should the Fed see improvement in data or get any sort of clarity on trade, they may keep rates unchanged for another few months. Second quarter GDP figures, which are expected to drop dramatically from the 3.1% rate achieved in the first quarter, are due to be released the week before the Fed’s July meeting. The market often gets Fed rate decisions wrong, and any misstep detouring from expectation could trigger another bout of volatility for investors.
International Market Overview
Much like the United States, foreign equities have delivered strong first half results despite a relatively disappointing economic picture. The Eurozone, United Kingdom and Japan have continued to struggle to maintain momentum, and while growth is still around trend, the overall tone and direction of the data has fallen off. GDP growth and consumer sentiment have rolled-over, and inflation has begun to soften despite expansive monetary policy. Trade policy uncertainty and the slowdown in China are also a major headwind for developed foreign nations that are adding to slower growth rates. We look for these same headwinds to cause volatility and uncertainty for the next quarter or two.
Brexit remains a factor, as the April deadline came and went without a deal. Prime Minister Theresa May struggled to unite leadership and pass her “soft Brexit” deal. Such a deal would give the UK Common Market access, but come with the cost of European Union (EU) membership, without any influence on regulation. The EU granted a final Brexit extension, set to expire this Halloween. Adding to the doubt of reaching a deal, Prime Minister Theresa May resigned from her post, and the United Kingdom is currently holding court to determine the next Prime Minister, tasked with trying to do what Theresa May could not – unite leadership and agree to terms on Brexit. Should Boris Johnson win, the likelihood of a no-deal Brexit increases. Johnson has made it no secret he intends to leave the EU, deal or no deal. The preference for market participants is for a smooth Brexit, with a deal in place, as a “no-deal” scenario could be damaging to both UK and broader Eurozone economies.
In line with the US, central banks around the globe stand ready to accommodate and cut rates. The problem is that most global central banks have little room to cut, and will be forced to implement additional rounds of Quantitative Easing (QE). The European Central Bank (ECB) intends to leave rates unchanged for now, but still plans to implement a third round of Targeted Longer-Term Refinancing Operations (TLTRO-III) in the near future; similar to the Fed’s Quantitative Easing (QE). With more than $12 trillion dollars in negative yielding bonds globally, central banks will look for additional measures to accommodate, such as tiered deposit rates to help banks. Complicating matters even more and adding to the uncertainty is the path forward for EU monetary policy, as the European Central Bank is currently searching for the replacement of Mario Draghi, who is serving his final summer as the ECB’s chair. With these headwinds present, we wouldn’t be surprised to witness a bumpy second half for developed markets. On the positive side, valuations are still attractive relative to the US, as they are approaching 20-year lows, and dividend yields remain attractive compared to historical levels.
Despite ongoing trade issues, emerging international markets delivered reasonably strong first-half results. While the slowdown in China continues to be a major headwind, the Fed’s U-turn and a relatively stable US dollar served as catalysts for support. Historically speaking, valuations on emerging market equities are still attractive on a relative basis, but there remains two major factors in play that will likely drive results for the rest of the year: the US-China Trade negotiations and the overall slowdown in China. Like nearly all other central banks, the People’s Bank of China (PBOC) and the Chinese government continue to add stimulus to try and kick start the economy. US-China trade negotiations and tariffs continue to drag, and are somewhat offsetting the stimulus efforts. Though a prolonged trade war could cause further slowdowns, we remain cautiously optimistic on China’s growth and emerging market equities.
We should also note that the continued escalation of tension in Iran could have a negative impact on markets. While we don’t believe President Trump wants to get militarily involved in the Middle East, there are volatile personalities involved, and the situation bears monitoring in the coming months.
To start the year, many anticipated an earnings recession, or two subsequent quarters of negative earnings growth, to occur in the first half of this year. While the first quarter did come in better than expected, according to FactSet Research Systems, we did experience our first negative quarter of -0.4%, and estimates as of June 30 are that second will also decrease -2.6%, marking the first consecutive negative quarters since the first half of 2016. Given the adverse weather, global slowdown, and US-China trade dispute, as companies begin reporting, our focus will be around future guidance; as CEOs provide insight as it pertains to their forward outlook.
The equity markets and bonds markets have achieved year-to-date returns well beyond most 2019 forecasts, and we’re only half way through the year. While we are indeed cautious about some of the political turmoil and tariff issues, we are not of the position that we are headed for a recession in the next 6 months, or on the verge of a major equity market crash. The market continues to test new highs, before retracing again. However, it will be important to see stronger corporate earnings reports and guidance at the end of the second quarter, and progress in the global trade scene before long, or a more ominous path could take hold. The US and China make up the world’s largest two economies, so they’re critical to overall global economic health, especially with slowdowns already underway in Europe and Japan. Resolution to the trade dispute would be welcome around the globe. It’s our belief that market volatility will continue to exist for the remainder of the year, especially over the next few months, and we would urge more modest return expectations for the foreseeable future.
When markets shoot up like they have in 2019, it’s easy for investors to become complacent and let the good times roll. However, these are the moments that give us pause, as we reassess current portfolio positioning; looking for opportunities to rebalance portfolios back to long-term strategic targets. As always, by maintaining a disciplined approach with a focus on diversification, we hope to provide you the confidence to keep a long-term perspective in line with your own personal risk tolerance and objectives. We appreciate your business and ongoing trust, and invite you to reach out to your advisor should you have any questions, or to schedule your next review.
The preceding commentaries are (1) the opinions of Chris Osmond and Eric Krause and not necessarily the opinions of PCIA, (2) are for informational purposes only, and (3) should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results.
Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”) and Prime Capital Wealth Management (“PCWM”).