- As widely expected, the Fed cut the short-term rate by 0.25%, which based on market reactions didn’t seem to please anyone.
- President Trump, upset with “only” a 25-basis point cut, ratchets up the trade war by imposing 10% tariffs on remaining $300 Billion of Chinese imports.
- Research from investment banks shows broad but slowing trend of corporate buybacks which could be troubling for stocks.
- The Fed is in a predicament: Further rate cuts may boost investment spending but could also send further disturbing warning signs on the economy.
- While there are still several bright spots in the economy, ultimately the uncertainties caused by the trade war may be the catalyst which derails this expansion cycle.
What Piqued Our Interest
To say the least, its been a wild couple of days since the Fed cut interest rates by 0.25% at their July 31st meeting. Beginning with the post-meeting news conference, Fed chief Jerome Powell confused market participants when he referred to the cut as simply a “mid-cycle adjustment”, and not the beginning of a “lengthy cutting cycle.” He later clarified his comments, stating this doesn’t rule out future rate cuts, but at this point the indecision was prevalent and traders were left to ponder the future path of interest rates. In an effort to be more transparent to both Wall Street and Main Street, Powell holds post meeting conferences at every meeting, not everyother as his predecessors did, but it appears his efforts may only be contributing to the ambiguity of Fed policy. In addition to his 180-degree pivot on monetary policy, his attempts to communicate to the public in plain speak may possibly be creating more havoc than he intended.
As the market was struggling to interpret Powell’s intentions, on August 1st President Trump helped ensure the next rate cut by announcing a new round of 10% tariffs on the remaining $300 billion of Chinese imports. Citing that China had not stepped up its purchases of US agriculture products as promised, Trump ratcheted up his rhetoric as the two countries have laid blame on one another. Following this on August 5th, China allowed its currency (the Yuan) to fall below 7 CNY to 1 US Dollar, a key psychological level, and the weakest level since early 2008. In addition, China also halted all U.S. agriculture purchases, and did not rule out slapping additional tariffs on U.S. goods. All of this led to the largest selloff for U.S. equities this year and heightens the probability of a protracted trade war in the months to come. In a move that was largely symbolic, the U.S. Treasury followed by designating China a currency manipulator for the first time since 1994.
Another eye-raising trend has been the slowdown in corporate buybacks, which have been a major factor helping propel the market in recent years. According to an article in the Financial Times which cited analysis by both Goldman Sachs and Bank of America, the rate of growth in buybacks is set to slow considerably in 2019 as the effects of the corporate tax stimulus wear off. While the overall level of buybacks is expected to reach $940 billion in 2019, according to Goldman, the rate of growth has slipped to 13% from 54% last year. As corporations drain their cash to repurchase shares, if buybacks decelerate further this could manifest yet another headwind in addition to global trade and monetary policy uncertainty. Also notable, as 2nd quarter corporate earnings season comes to a close, companies in the S&P 500 on average have reported year-over-year earnings decline of -1%, the first consecutive quarterly losses since 2016, according to FactSet. They also report that on average analysts are expecting a decline in earnings of -2.2% in Q3, and that the percentage of companies issuing negative guidance is above average. These reports, in conjunction with the continuing slowdown in global manufacturing, leave us very concerned especially in light of the current trade tensions.
Like the dog days of summer, the equity markets were relatively tranquil in July, leading up to the FOMC meeting on the last day of the month. The S&P 500 total return index gained 1.4%, while small-caps rose by just 0.6%. Stocks in the Info-Tech and Communication Services sectors led the way, each rising about 3.3%, followed by Financials and Consumer Staples which each gained around 2.5%. The laggard sectors included Energy stocks (-1.8%) as well as Health Care (-1.6%), which are the trailing sectors year-to-date. Overall, growth stocks continue to lead, although the difference narrows as you move down the capitalization scale, and for small-caps, value stocks now lead by a small margin. International stocks lagged the U.S. yet again, as the broad all-country ex-US index fell by -1.2% in July. Stocks in the Euro area fell by -2.25%, while China fell by -0.54% and Japan was slightly higher by 0.14%. In general, both developed and emerging markets performed similarly, as the U.S. dollar index climbed by about 2.5% against a basket of major foreign currencies. The Bloomberg Commodity Index fell by -0.67%, but Gold was a lone bright spot climbing by 1.7% and is now up over 12% as investors seek a safe haven in the face of global trade concerns.
Bonds inched higher in July as the U.S. Aggregate Bond index gained 0.22% and is up 6.35% through the end of July. Municipals gained the most, climbing 0.81% (pre-tax) while high yield bonds also climbed a respectable 0.56%. Rates held fairly steady during the month, at least until July 31st when rates plummeted following the Fed rate cut announcement. The yield on the 10-year fell from 2.02% on July 31 to 1.74% on August 6, while the 5-year yield fell to 1.54%. This of course has further contributed to the inverted yield curve, which is known as a recessionary indicator as it reflects forward expectations of lower growth and inflation. As before, longer maturity bonds benefitted from the flight to quality, as the Long U.S. Government index is now up almost 16% year to date, although it does carry significant duration risk should rates reverse higher. Given how low yields are across the rest of the developed world (Japan’s 10-year yield is -0.19%, Switzerland is -0.89%, Germany is -0.54, etc.), we believe that the risk for future yields remains to the downside.
In our June commentary we discussed how Fed rate cuts, though stimulative by design, are more often associated with negative returns for the stock market. While its certainly too early to jump to conclusions, we continue to believe that further rate cuts along with disconcerting messages from the Fed could be more damaging and offset the positive impacts from looser policy. Ultimately, the volatility we are experiencing in the early days of August is primarily due to trade war uncertainty rather than Fed policy, but the two factors are invariably linked together. President Trump believes that more accommodative monetary policy can counterbalance the uncertainty he has created by ramping up the trade war with China and our other trading partners. However, this could be a dangerous miscalculation if business spending continues to deteriorate due to trade concerns. The purpose of monetary policy, by design, is to provide price stability and full employment, and has limited tools to offset the economic impact of tariffs and trade uncertainty. Unfortunately, we believe this could get worse before it gets better.
Regarding seasonality, August and September historically have been the two of the worst months for the market, both averaging negative returns going back to 1945. After the strongest 1st half for the stock market in 20 plus years, it seems plausible that we may experience another pullback given all of the trade tensions and other macro headwinds. The trade tensions between the two largest economies are likely not going away anytime soon, which could have a tremendously negative spillover effect on the rest of the world. Add to this the increasing likelihood of a “no-deal” Brexit and we could be in for some volatile days ahead in the market.
As we’ve stated in the past, however, there continues to be a number of bright spots in the economy that leaves us cautiously optimistic for continued growth. The labor market remains incredibly strong with unemployment at just 3.7% and initial unemployment claims holding steady near multi-decade lows. Wage growth in July grew by 3.2% year-over-year, which has also been stable as of late. Inflation remains well in check, with Core PCE inflation at 1.6% as of its last reading, well below the Fed’s 2% target. Sentiment indicators such as consumer confidence and small business optimism, while off their recent highs, are still generally strong and could reverse higher if a trade deal is struck. Also, from a technical standpoint, the S&P 500 relative strength indicator, which is a measure of short-term momentum, shows that the market reached “oversold” levels on August 5, which could support a rebound in the short run. All eyes will be on the S&P 500’s 200-day moving average, currently around 2790, to see if the market breaches this level or if it finds support.
Our investment strategy of market participation with a risk mitigation focus has never been more relevant as it is today. Regarding equities, we complement our core holdings with a suite of low-volatility funds, options-based strategies, and value-oriented allocation funds, which combined will minimize the downside risk in the portfolio. Meanwhile our fixed income allocation emphasizes high quality U.S. treasuries, minimizes credit risk, and seeks to benefit from a flight-to-quality during risk-off periods like we’re experiencing now. Finally, our alternative investments such as private real estate deliver steady income with low correlation to stocks, while our structured note strategy provides 10-20% buffers against market drawdowns. Our prediction for increased volatility in the latter half this year appears to be coming to fruition. Make sure your investment portfolio is properly aligned to withstand the outcomes, to help you achieve your long-term investment goals.
By: Gary Quinzel, Vice President, Chief Investment Officer
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