- Trade war concerns linger over markets, as China stalemate continues and President Trump announces tariffs on Mexico.
- Fed policy remains in the spotlight as market now prices in multiple rate cuts this year.
- Bonds stage another rally in May as the yield on a 10-year Treasury drops to just 2.1%, further inverting the yield curve and stoking recession fears.
- Investors should prepare for more volatility in coming months and maintain high quality focus in their portfolios.
What Piqued Our Interest
The old adage “Sell in May and Go Away” played out in front of us last month, as it seems every risky asset class suffered notable losses. Trade tensions continue to be the primary source of uncertainty, as the U.S. accused China of reneging on trade commitments, while China claimed that unreasonable U.S. demands led to the latest breakdown in negotiations. Regardless of who is at fault, right now neither side is negotiating, and it appears the stalemate could last for several weeks if not longer. Furthermore, in mid-May the U.S. ceased business operations with Chinese telecom giant Huawei, citing security concerns, which has widespread implications across the telecom industry and further escalates the “tech cold war” between the U.S. and China. To make matters worse, on May 31st President Trump tweeted that the U.S. would impose a 5% tariff on all imports from Mexico in response to the country’s perceived failure to stop illegal immigrants from entering the U.S. The 5% tariffs are expected to go into place on June 10 and would rise each month up to 25% by October. This new dispute could also throw a wrench in the yet-to-be-ratified U.S. Mexico Canada Agreement reached last year which was designed to replace NAFTA.
The ramp up in trade tensions has increased recession probabilities as of late, according to several economists at the large investment banks. According to a Morgan Stanley economist quoted in Bloomberg, “A global recession could start within nine months if President Donald Trump imposes 25% tariffs on an additional $300 billion of Chinese exports and Beijing retaliates”. Also notable, JP Morgan increased their probability of a recession in the 2nd half of 2019 to 40% from 25% just a month ago. In addition, the Federal Reserve Bank of Cleveland updated their recession probability to show a significant increase in their forecast, climbing from about 12% today to 35% one year from now. The Fed’s model uses past values of the slope of the yield curve along with GDP growth to predict whether the economy will fall into recession in the next 12 months. Other models provided by the St. Louis and New York Fed also show increased probabilities in recent months.
Due to the increasing recession fears, investors are now betting on multiple Fed rate cuts by the end of the year, according to the CME Group. As of June 4th, the odds of no rate changes stood at just 3%, while one 0.25% rate cut had a 17.6% probability, 35.3% probability for two cuts, and a 44% chance of three or more cuts! To put this in perspective, back in March there was over a 90% chance of no changes to the Fed Funds Rate and going back to Q4 of last year there was a 25% probability of rates being 0.75% higher than they are today. While we don’t see Fed chief Jerome Powell caving to the President’s calls for substantially lower rates, it does appear that the Fed is cognizant of the market impact of the trade wars and may be forced into more accommodative policy later this year.
As noted earlier it was an ugly month for stocks, but after the strongest start to a year in decades the market was long overdue for a pullback. The S&P 500 index reached a new all-time intraday high on May 1st at 2954, and is now trading around 2780 as of June 4th, which is also right at the index’s 200-day moving average. While the S&P 500 lost about 6.4% in May, the large cap index is still positive by 10.45% for the year. The Price-to-Earnings multiple is currently around 17.6 (based on last year’s earnings), which is noticeably cheaper than the 19.4 average multiple over the past 5 years. Every major sector declined last month, with Energy leading the pack falling by 11.3%, followed by technology, down 8.8%. Growth stocks were hit equally as hard as Value stocks, but more defensive sectors such as Utilities and Healthcare saw much more modest declines. Mid-caps performed slightly better than large-caps, but small-caps fell by 7.8% and are now up 9.09% for the year. In general, international stocks fared slightly better for a change, as the All-Country ex-USA index fell by 5.37%. Developed international declined 4.8%, while emerging nations’ stocks (including China) tumbled 7.26%.
Bonds were clearly the beneficiary of the risk off trade, as the Bloomberg Barclays US Aggregate Bond index gained 1.78% in May and is now up 4.8% for the year. Treasuries rallied as the 7-10 year index climbed 3% last month, and the yield on a 10-year bond plummeted from 2.5% down to just 2.1%. The 3-month to 10-year curve is once again inverted, as the 3-month bill is yielding 2.33%, which is signaling that investors are expecting short term rates to fall in the future. Corporate investment-grade credit has continued to perform well despite concerns of overleveraging, as the index rose 1.3% last month and is up 9.16% year to date. High yield (below investment grade) bonds on the other hand, fell by 1.2% and are up 7.5% on the year. Tax-exempt municipal bonds rose by 1.38%, but the spread between the municipal and treasury composite widened to 1%, its widest reading since late 2017. Unlike their taxable counterparts, municipals still exhibit a positively sloped curve which makes intermediate muni bonds more attractive compared to taxable bonds.
We believe that if the Fed cuts rates in the face of weakening economic data, it could possibly do more harm than good. As the chart below demonstrates, more often than not, Fed cuts have been associated with negative returns for stocks, as they generally signal the end of an economic expansion. Given that corporate borrowing rates are already at historically accommodative levels, looser Fed policy could very well create more fear and capitulation than it would to boost spending and inflation. On the other hand, the Fed cut rates in the mid-90’s multiple times without triggering a bear market, so it is possible that looser monetary policy could offset some of the uncertainty created by the trade war. However, given the entrenched positions of the U.S. and China, a prolonged trade war is now our base-case for the remainder of the year. Unless something dramatic happens at the G-20 meeting in Japan later this month, we must prepare for more uncertainties, along with slowing global growth and higher consumer prices created by the tariffs. On May 23, the New York Fed released research suggesting that U.S. households on average could pay $831 per year due to the latest tariff increase on $200B of Chinese imports. Obviously if the U.S. implements tariffs on the remaining $325B of imports as President Trump has threatened, the cost to U.S. consumers could be much greater.
Thus, the bigger question remains; will the trade war escalation eventually push the U.S. into a recession? Only time will tell, but typically recessions are created from one of the following: shocks, excesses, and central bank missteps. Shocks, such as a commodity plunge or war, are virtually impossible to predict and so we waste little time attempting to forecast. Excesses, such as the housing bubble in the 2000’s or the tech-boom of the 90’s are easier to spot, albeit in hindsight. Given the increase in regulations and greater investor caution since the financial crisis, we find it less likely that excess will be the cause of the next crisis. Therefore, we find it most likely that the next recession will be a by-product of the Fed trying to uphold its dual mandate, but with fewer resources than it did 10 years ago, and likely under pressure from the White House. It could also be a self-fulfilling recession as investor confidence plummets due to the perceived outcome of the trade war. We believe that the second half of 2019 could be very volatile due to these concerns, and therefore recommend caution for the foreseeable future. High quality bonds, including a healthy dose of treasuries, should make up a sizeable portion of one’s allocation given one’s risk profile. Growth allocations should err on the side of caution, with a focus on low-volatility funds and other risk mitigation strategies. As mentioned in previous commentaries, we have already rotated our more conservative growth models towards quality and value, and will continue to maintain a conservative bias in the short run. In the long run, we will always advocate for staying invested rather than trying to time the market. Certainly, we’re not endorsing a mass exodus from the markets, but in the coming months investors should be prepared for some rocky days.