- All signs point toward a rate cut at the next Fed meeting in July, which may boost stocks in the short run but signal more troubling times ahead.
- The U.S. and China have resumed their trade talks following friendly gestures at the G20 meeting, but are we really any closer on the key issues?
- The United States is now in its longest economic expansion, as the cycle reached 121 months since the end of the last recession.
- Stocks rally in June to cap off the strongest first half of a year since 1997, as bonds also post impressive gains while rates plummet.
- Our key investment themes of 2019 remain intact: Prepare for higher volatility, rotate towards value and higher quality, position strategically for the long run, and “watch the wild card…”
What Piqued Our Interest
As widely expected, the Fed held rates steady and removed their reference to being ‘patient’ towards future rate hikes at their June meeting. Citing trade uncertainties and muted inflation pressures, the Fed communicated that they would closely monitor the economic situation and act as appropriate to sustain the expansion. The market immediately took the news as a guarantee of a rate cut when they meet at the end of July, the only question is whether they’ll cut by a quarter or half a percentage point. The CME Fed Watch tool now assigns an 80% chance of a quarter point rate cut in July, and a 20% chance of a half percent cut. In addition to the magnitude of the almost certain rate cut, the real question will be is this just an insurance cut for the Fed, or are they basing this on deteriorating fundamental data? If it’s the former, the hope is that like most insurance, we purchase it but never actually need it. If it’s the latter, in our opinion, this would be much more damaging to the market as it would signal that the Fed views the situation as more dire and is proactively staving off the next recession. Much will depend on the data points between now and the July meeting, particularly the jobs report as well as inflation readings. While the market will likely react positively to the rate cut, investors will be paying particularly close attention to the post-meeting news conference by Jerome Powell to determine the Fed’s true justification.
Meanwhile, equities from New York to Shanghai received a boost when Presidents Trump and Xi agreed to resume trade talks at the recent G20 meeting in Japan. Despite the truce, there is still much doubt as to whether either side will bow to the other, or to the hardline nationalists of each country. For his part, President Trump agreed to relax restrictions on telecom giant Huawei, which the Commerce Department recently banned U.S. tech companies from selling to. Trump also agreed to delay any implementation of a final round of tariffs on $300 billion of Chinese imports, while China supposedly agreed to purchase large amounts of U.S. agricultural goods in the immediate future. However, beyond the friendly photo-ops and good faith measures, in reality the two sides are just as far apart now as they were when talks broke down in early May. There is no timetable for completing the negotiations, and little (if any) detail as to how China will enforce laws on forced technology transfer and intellectual property theft, as well as open up their capital markets to foreign investment. Also important is that it is doubtful President Trump will rush to sign any trade deal until after he gets his desired rate cuts from the Fed.
In separate news, July marks the 121st month since the end of the last recession, making this the longest U.S. economic expansion dating back over 150 years. The previous record of 120 months occurred during the 1990s tech boom, according to the National Bureau of Economic Research which tracks and identifies business cycle expansions and contractions. Note the trend identified in the table above, as expansions and the overall business cycle have lengthened considerably over time due to advancements in monetary intervention. It is clear that the Fed plays a pivotal role in stabilizing the economy and elongating economic expansions. As we dig a bit further into the data, the third revision of Real GDP growth for the first quarter held at 3.1%, though it appears that growth is likely to be slower for the rest of 2019. Most of the growth in Q1 came from business investment which may be short lived, as opposed to consumer spending which was the weakest its been in a year. According to the Atlanta Fed’s GDPNow model, they estimate 2nd quarter GDP growth of just 1.5%, which is a considerable drop compared to the 4.2% growth we experienced in Q2 of 2018. However, it does appear that the economy will likely expand through 2019, unless of course the China trade war severely escalates which cannot be ruled out entirely.
The U.S. equity market roared back in June as it climbed by 7%, more than making up for May’s selloff. ‘Animal Spirits’ returned in full force on the premise of dovish Fed speak and lower rates, as cyclical sectors led the charge. Within the S&P 500, the Materials sector gained 11.6%, while Energy was up 9.2% and Technology stocks were up 9.1%. On the flip side, defensive sectors lagged with Utilities up just 3.2% and Staples up 5.2%. Overall, the S&P 500 is now up over 18% to start the year, which is the strongest 1st half of a year since 1997. Small caps are slightly trailing large caps, posting a 16.75% return YTD. International stocks climbed in June as well, as the MSCI Europe index gained 6.7%, while the Asia-Pacific index returned 5.4%. The Emerging Market index rose by 6.2% and is now up 10.6% on the year but is trailing developed international by about 3.5%. Meanwhile the U.S. dollar, which has been generally strong over the past year, fell by roughly 1% in June compared to a basket of other major currencies. U.S. dollar strength is often correlated with Emerging Market weakness, as much of their debt is denominated in the Greenback currency.
Focusing our attention on the fixed income markets, June was another relatively strong month for bonds, as the Bloomberg Barclays U.S. Aggregate Bond index rose by 1.3% and is now up 6.1% for the year. The Bloomberg/Barclays Treasury index increased by 0.9% in June, while the Credit index jumped by 2.3%. Once again, longer-dated bonds outperformed shorter-dated bonds, as interest rates fell and the yield on the 10-year U.S. Treasury dropped to just 2%. High yield corporate bonds gained 2.3% last month and are now up roughly 10% in 2019. On the tax-exempt side, municipal bonds returned just 0.37% for a total return of 5.1% this year, but this return omits the post-tax benefits of federally tax-exempt income.
As we are now at the midpoint of 2019, we thought it would be a good exercise to revisit our ‘Key Investment Themes of 2019’ which we originally published last December. While not all of our predictions have played out exactly, overall we find that our themes remain just as relevant today compared to six months ago.
- Volatility is Here to Stay: Volatility plummeted in the first Quarter, and then skyrocketed in May before subsiding in June. While volatility has not been as high as it was in the 4th Quarter of 2018, we expect it to ramp up if trade concerns reignite or other geopolitical events escalate.
- Rotation from Growth to Value: The longstanding trend of Growth outperforming has still not reversed and has even widened as of late, as Growth is now up 21% year-to-date compared to 15% for Value. Our more conservative models now have a Value-bias to help protect on the downside, while our more opportunistic models have maintained a growth focus.
- Focus on High Quality: The iShare Quality Factor ETF (QUAL), is up roughly 20% YTD compared to 18% for the overall U.S. market. In addition, high quality bonds have rallied as the 10-year U.S. Treasury fell by 0.68% to just 2.0% currently. Our focus on high quality remains our key call for the remainder of 2019.
- Position Strategically for the Long Run: Our call for income and capital preservation strategies have helped conservative clients participate in the market while lowering their overall volatility. For all other clients, staying invested and not trying to “time the market” has been the prudent course of action.
- Watch the Wild Card: President Trump continues to have a profound impact on the markets. He considers the market as the ultimate barometer of his success and will continue to pressure the Fed to achieve his desired accommodative monetary policy.
Regarding our outlook for the remainder of the year, we remain cautious due to myriad slowing growth figures, along with the potential for a flare up in trade tensions. Citing Factset’s Earnings Insight, roughly 77% of the S&P 500 companies which issued earnings guidance have given negative guidance for the second quarter. Overall, earnings are expected to post yearly losses for the 2nd and 3rd quarter of 2019, which would mark the first three quarter losing streak since 2015-2016. In other data, the Conference Board’s Leading Economic Index (LEI) flattened in May, as weekly unemployment claims, the ISM new orders’ index, and stock returns all detracted from the index. While we haven’t seen a decline in the LEI, we are paying particularly close attention to the underlying trends of the 10 components, as we know that better or worse is more relevant than good or bad when it comes to predicting market behavior.
That being said, we believe the time to get defensive is upon us. Despite the recent progress in trade talks, if the final round of Chinese tariffs is implemented this will have a much more profound impact to end consumer goods and could significantly hamper GDP growth. We are modestly optimistic that this won’t come to fruition but plan to position our investments accordingly in case they do. We continue to favor equities over bonds, but prefer higher quality, dividend paying, and more defensive sectors which tend to outperform in down markets. Cyclical stocks have outperformed for several years but tend to perform poorly at the end of the business cycle, and therefore exposure should be limited at this stage in the game. In all, we believe the best course of action for clients is to remain invested in accordance with one’s risk profile, while employing varying measures of risk mitigation strategies to offset potential volatility. We may not get every one of our market predictions right, but by investing strategically and for the long term we can considerably optimize our probability of success.