Quarterly Client Update
We’re still partying like its 1997…
Following suit from the second quarter, global markets were plagued with similar uncertainty around trade, monetary policy and recession fears. However, the S&P 500 was still able to turn in the best three quarters to start a year since 1997, returning 20.55% through September 30, 2019. While the year-to-date gains are impressive, at quarter end, the S&P 500 only sat 4.25% higher than the level it achieved a year ago, and still a couple percentage points below the all-time high, while all other equity indexes (mid cap, small cap, and foreign equities) remain in negative territory from a year ago. As in May, US-China trade escalations in August sent the major equity markets in a panic, causing the S&P 500 to fluctuate greater than 1% on eleven separate days in August; the most such moves in a month since February of 2018. As has been the case all year, and really since the Financial Crisis, the Federal Reserve came to the rescue, providing two rate cuts in the quarter, and pinning hopes of a continued expansion on the shoulders of the Fed. US large cap equities continue to deliver the best quarterly results of 1.70% for the S&P 500, while mid and small cap equities produced negative returns, with respective returns of -0.09% and -2.40%.
Overwhelmed from the US-China trade war, a global slowdown is taking hold and causing very real recession fears around the world; primarily in Germany and the rest of the Eurozone. Further uncertainty around Brexit, trade and monetary policy pushed foreign equity returns negative for the third quarter. The MSCI EAFE and MSCI Emerging Market fell 1.0% and 4.11%, respectively. While not as robust as the US equity gauges, the MSCI EAFE index and the MSCI Emerging Markets index have still produced positive year-to-date gains of 13.35% and 6.23%, respectively.
In light of such strong equity returns through three quarters of 2019, the returns on bonds still 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 since 2016, with the 10-year US Treasury yield trading below 1.5% during the quarter, before settling near 1.65% at quarter-end (down from a high of nearly 3.25% last fall, and 2.65% to start the year). This produced another quarterly gain of 2.27%, and a year-to-date result of 8.52% on the Bloomberg Barclays US Aggregate Bond Index.
Source: Bloomberg Finance L.P.
Hey Xi, here’s my number, so call me maybe?
For many of us, the never-ending saga that is the US-China trade war is getting long in the tooth, yet still many investors hang on every headline involving the pending dispute. If you’ll recall, out of nowhere in May, Trump escalated the issue by threatening to raise the tariffs on some goods and place tariffs on the remaining $300 billion of Chinese imports. Ultimately, Trump delayed implementing these tariffs in two stages: 1) increasing tariffs from 25% to 30% on about $250 billion Chinese imports on October 15, and 2) placing 15% tariffs on about an additional $160 billion imports from China – posing renewed economics risks to US companies, workers, consumers and investors. President Trump continuously clamors about getting a ‘great deal’, but considering the shared goodwill and common interests of both the US and China, a ‘great deal’ doesn’t necessarily have to be a ‘comprehensive deal’; both President Xi and President Trump can give and take. The most significant issues still center around argricultural and energy purchases from China, IP protections, and tariff rollbacks. With China trade officials in Washington DC on October 10-11, we don’t anticipate meaningful progress to develop. However, in order to calm the markets, expect the message out of Washington to center around continued ‘progess’ towards an accord – though lacking any specifics. We don’t believe either party wants the trade war to escalate further, and wouldn’t be surprised if talks on October 10 and 11 come away with a mini deal, and Trump suspends the pending tariff increases set for mid-October, and puts the December tariffs on hold for now.
While President Trump insists he doesn’t need a trade deal with China to win the presidential election next year, many believe Trump is strategically trying to time a deal to coincide with when he starts hitting the campaign trail. 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. Make no doubt about it, the US-China trade war is having global repercussions. The Eurozone, especially Germany, are heavily dependent on Chinese imports, so as China slows as do other countries. Furthermore, the uncertainty surrounding the trade war is not only impacting US corporate profits, but has brought business investment and capital expenditures to a halt; pinning all hopes of sustained economic growth on the backs of the consumer. With President Trump now also dealing with an impeachment inquiry, he could use a positive outcome on trade. Fortunately for the president, he received a little fiscal policy bump when the budget deal was extended for two years. The deal not only averted another government shutdown and debt ceiling negotiation, but it also eliminated the automatic spending cuts; which would’ve cut federal discretionary spending by roughly 10%. Factor the fiscal policy bump and the expansive monetary policy into the equation, and seems as though President Trump is content underwriting the US-China trade war through other policy measures. On multiple occasions, we’ve mentioned that it’s uncommon for a president’s fiscal policy to conflict with his trade policy; as one is expansive (fiscal) and the other is restrictive (trade). It’s important to remember that tariffs are essentially a tax increase. As tariffs are assessed on goods entering the United States, those increased costs are passed along to the consumer. So, while the consumer is still spending at a healthy clip, the longer the trade war drags on, the higher likelihood the consumer slows their spending, increasing the risks of a recession. While the US should ultimately hold the upper hand in negotiations given our trade deficit with China, further escalations could significantly damage economic growth both domestically and abroad. Ultimately, we believe the road to resolution may be long and volatile, but we remain optimistic that a deal of some sort will eventually be struck – most likely in 2020.
Slowdown, inversion, recession? Oh my…
As the United States enters the final quarter of 2019, it does so by enjoying the longest economic expansion in the nation’s history. Riding the shallowest cumulative GDP recovery, through September 30, 2019, the US has experienced 123 months of consecutive expansion and continues to grind forward. Coming off a robust growth year in 2018 of about 3% that was dragged forward by substantial fiscal policy stimulus, it was to be expected that 2019 would be a transition year to slower growth. According to FactSet, Consensus GDP is expected to show further slowing the third and fourth quarters of 1.9% and 1.8%, respectively; still above the Fed’s long-term growth trend. The labor market is strong, and has perhaps reached levels of full employment, as evidenced by the 50-year low unemployment rate of 3.5%. However, the third quarter experienced a downward trending labor market, only adding 136,000 jobs in September and wage growth declined to 2.9%. Given how late we are in the current expansion, these types of slowdowns should not be too surprising, but since business spending has screeched to a halt due to trade uncertainty, cracks in the labor market could prove troublesome. Spending has already shown signs of slowing in 2019 as tariffs continue to work through the system, so a weakening labor force could perpetuate a slowdown in spending. Given the consumer represents about 70% of the country’s economic growth, a healthy consumer is paramount. ISM Manufacturing continued trending downward, and entered into full contraction mode in September, producing the lowest level since June 2009 of 47.8 (a reading over 50 is considered expansionary, while a reading under 50 is considering contractionary). Non-manufacturing (services) had been the ISM bright spot in 2019, holding up relatively well; that is until September, when non-manufacturing missed estimates and hit a three-year low. Given services makes up the majority of GDP (manufacturing at about 12%) the disappointing September numbers helped kick the fourth quarter off in a volatile manner.
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 as raising rates. After they raised rates for the fourth time in 2018, the market panicked, equities sold off and turned in their worst December performance 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. Low and behold, in July the Federal Reserve joined the other global central banks and cut interest rates for the first time since 2008, and provided a heavy dose of communication that they stand ready to “act as appropriate to sustain the expansion”. The Fed also halted their balance sheet runoff two months ahead of schedule, and described the first rate cut as a mid-cycle adjustment, rather than the start of an easing cycle. Given the bevy of positive economic data reported prior to the September Federal Open Market Committee (FOMC) meeting, the market was unsure whether the Fed would ultimately cut. The Fed cut rates by another 0.25% (25 basis points), after this meeting added a more hawkish spin, signaling that there could potentially be no more cuts in 2019 and 2020. The Fed is in a peculiar position – in addition to the president’s political pressure to lower rates, the economy is still growing above trend; causing dissention inside the ranks of the FOMC. Hawks, like Kansas City Fed Chair, Esther George, dissented and voted not to cut rates. Concerned whether the Fed would have sufficient ammunition to counter protracted trade uncertainty, continued slowing, and the structural headwinds related to demographics and technology, Fed Chairs disagree with the forward direction of the monetary policy. In light of the weak September data reported thus far, we wouldn’t be surprised to see the Fed cut once, or even twice, more this year. However, believe the most likely course is another 25-basis point cut in October, and then wait and see by holding policy steady in December. One thing is for certain, the market is still very dependent on easy monetary policy, and central banks continue to accommodate. Central banks around the world even acknowledge the diminishing return from pumping more liquidity into the system, yet continue to do just that. While many believe the Fed has provided “insurance” cuts to combat the ongoing trade war, the truth is monetary policy cannot fix trade policy, structural unemployment issues, or an aging workforce, so are unlikely to dig us out of any potential downturn. At this point, odds are monetary policy can only delay a recession, not avoid one entirely. Not to mention, the Fed is already operating at a lower base than before the Financial Crisis, constraining how much easing they can deliver to grow the economy.
The final inflection point along the yield curve – the 2/10, and the metric most market pundits put their stock in, inverted in the third quarter, which is also the first time the yield on a 2-year Treasury bond was greater than the yield on a 10-year Treasury bond since 2007. Upon the 2/10 inversion, recession fears spiked, pushing bond yields even lower. Given the last seven recessions were preceded by a yield curve inversion, an inverted yield curve is important to monitor and naturally stokes recession fears. However, it’s important to note that not every inversion has led to a recession (i.e. 1967 and 1998). Typically, recession indicating inversions last for several months, so many are speculating if the 2/10 inversion that occurred in the third quarter was an anomaly, or just plain and simple – “maybe this time is different?” According to Credit Suisse research, prior to the last five recessions, the 2/10 curve was inverted for an average of 22 months before a recession occurred. So perhaps this inversion was more of a byproduct of low to negative global yields, and not an ominous predictor of a recession.
But this begs the question: are we headed for a recession? As we previously mentioned, ISM manufacturing is definitely in contraction territory, but many other indicators are signaling the US economy is okay. The US has never had a recession without a spike in Unemployment Claims (those filing for unemployment for the first time), which are currently trending downward at all-time lows. Wage growth at 2.9% is still higher than inflation and lower than the +4.0% wage growth that has hit before previous recessions. Consumer Confidence typically falls dramatically before a recession, yet is still trending upwards. The last three recessions (1990, 2001 and 2008) all saw oil prices surge more than 150% prior to the recessions, which does appear to be a legitimate concern at this time. Consumer savings rates typically drop leading up to a recession, but they’ve been trending up for more than three years, and now sit over 8%. Housing starts and home prices usually plunge prior to a recession, and they continue to grind slightly higher. Before the last three recessions, the Fed Funds was greater than Nominal GDP, which is currently not the case, and with the Fed in easing mode, we would have to see a pretty remarkable slowdown in Nominal GDP to fall below the Fed Funds rate. Many other indicators convey similar signals. To summarize, we believe that while the US economy is definitely softening, traditional recession warning signs are not sounding alarms; leading us to believe the longest economic expansion in our country’s history has legs to keep running, or at least to jog or walk at a brisk pace.
Deal or No Deal
Much like the United States, foreign nations are plagued with policy uncertainty. However, foreign equity markets still manage to deliver fairly solid 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 continues to disappoint. GDP growth and consumer sentiment have rolled-over, and inflation has begun to soften despite expansive monetary policy. Trade policy uncertainty, significant geopolitical risks, and the slowdown in China are also major headwinds for developed foreign nations that are adding to slower growth rates. We look for these same headwinds to cause volatility and uncertainty for the remainder of the year.
Brexit remains a factor, and while the most recent European Union (EU) extension is set to expire on Halloween (10/31), we should have a pretty good idea on the Brexit status after the EU October 17-18 Summit. However, a last-minute deal could still be reached. Conversely to what many were hoping, Boris Johnson was elected to serve as Theresa May’s successor as the Prime Minister, and has been tasked with trying to do what Theresa May could not – unite leadership and agree to terms on Brexit. Johnson has made it no secret he intends to leave the EU, deal or no deal. After the House of Commons passed a measure blocking Johnson’s push to leave the EU without a deal, Johnson went so far as to call for a snap election, which he lost in a landslide. No doubt the UK is suffering as a result of the UK inability to strike a deal. Not to mention the impact the uncertainty is having on corporations in both the UK, Eurozone and globally. Much like the trade uncertainty in the United States, the uncertainty surrounding Brexit is causing companies to halt investment and capital expenditures; hindering economic growth. One of the main hurdles left to overcome is the “Irish backstop”, or an agreement that aims to prevent an evident border between the Republic of Ireland and Northern Ireland once Brexit occurs. Boris Johnson and Irish PM Varadkar recently stated they could see a “pathway to a deal” on the Irish backstop, providing a gleam of hope for an actual deal and ‘soft’ Brexit. Ultimately, there is still so much to work before a deal can be reached, so while the recent progress with Ireland gives us more optimism than we had on September 30, we believe the EU will ultimately grant Boris Johnson and the UK another extension, only prolonging this more than three-year saga even longer; perhaps even into 2020.
While 2018 saw many central banks tightening, 2019 is a year of global easing. In the past two months alone, 35 central banks of emerging market countries announced rate cuts. Japan continues to pump excessive liquidity into their economy, and as a parting gift, Mario Draghi and the ECB delivered a broad-based easing policy which included a 10-basis point (0.10%) rate cut into negative territory, an open-ended Quantitative Easing (QE) program, tiering of the negative rate for banks. If you’ll recall, QE is a form of expansive monetary policy where a central bank hopes to stimulate the economy by pumping liquidity into the system by buying bonds. Central Banks became very dependent on these QE programs during and after the Financial Crisis. The ECB announced they will begin purchasing 20 billion euros worth of bonds a month on an open-ended basis. With all of these headwinds present, we expect a rocky road moving forward to close out the year in developed foreign markets. However, given that valuations are still relatively attractive, and the extensive monetary policy being implemented, should we get any clarity around Brexit and/or trade policy, we would expect developed markets to benefit.
While the slowdown in China continues to be a major headwind, when the Fed decided to cut rates in July, the outlook for emerging markets should’ve turned optimistic. Contrary to 2017 and 2018 when US rates were rising and the Fed was tightening – which is typically a bad environment for emerging market equities – falling rates and an accommodative Fed should weaken the dollar, providing a boost to emerging market countries and their respective equities. However, the positive effect has been negated by the extensive global easing taking place with central banks around the globe. The excessive amounts of liquidity have devalued foreign currencies, causing the US dollar to actually rise in value; which negatively impacts emerging markets and their equities. 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. In hopes of stimulating their economies, 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.
Implications – Unintended Consequences
Historically, markets have performed well in the last quarter of the year, and on the surface, with negligible inflation, a strong consumer, and low interest rates, the backdrop looks favorable for equities. However, we do not anticipate a smooth path upward for the remainder of 2019. As we sit today, the backdrop for the US equity markets is also marred with challenges. The US-China trade war still lingers and is tarnished with uncertainty, and tariffs are exposing an already fragile and softening US economy. Corporate profit growth continues to decline, and according to FactSet, are expected to fall about 4% year-over-year for the third quarter, or the largest year-over-year decline since 2016. Additionally, geopolitical tensions continue to exist in Saudi Arabia, Iran, Syria, United Kingdom and other parts of the world. Investors seem to be pinning their hopes on a positive trade outcome and the Federal Reserve, as the market is pricing in additional rate cuts in October and possibly December. Any missteps in trade, or by the Fed to meet the markets’ expectations, could cause volatility and downward pressure on equities. Our fear is the unintended consequences of the Fed’s actions. In theory, lower rates should stimulate the economy, but a zero-interest rate environment for numerous years did little to promote inflation and produced the nation’s weakest recovery. So why is this time any different? More importantly, we fear for clients, particularly risk averse clients who lack the ability and/or willingness to take additional risk, yet need income, will start to stretch. When investors chase yield in a lower rate regime, they often move down in credit quality or increase their exposure to high yielding interest rate sensitive equities, like REITs and Utilities. This yield seeking behavior often leads to portfolios over leveraged with risk. Should a downturn occur, the unintended consequences of lower rates and higher risk profiles will have greater negative repercussions. We strongly caution against this type of behavior. It’s times like this where focus on quality is imperative.
On the opposite side of the spectrum, when markets shoot up like they have in 2019, it’s easy for investors to become complacent. 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.
Chris Osmond, CFA, CFP®
Chief Investment Officer
Investment Advisory Committee
Eric Krause, CFA
Investment Advisory Committee
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”).