July 2019
By: Pat Guinet, CIMA®
Second Quarter and First Half Market Recap: Everything Went Up
The first half of 2019 saw robust gains across most asset classes, but it certainly wasn’t a smooth ride. Global stock markets got a jump start on the year thanks to progress in U.S.-China trade negotiations and a newly “patient” Fed, but an abrupt breakdown in the trade talks (announced via Presidential tweet) spurred a sharp market sell-off in May. Stock markets subsequently shook off their swoon in June, rebounding on expectations of Fed rate cuts later in the year and (tentative) signs of re-engagement on the U.S.-China trade front.
The S&P 500 hit a new high near the end of June. Large-cap U.S. stocks shot up 7.0% for the month—their best June since 1955. They were up 4.3% for the second quarter, and a remarkable 18.5% for the first six months of the year—their best first half since 1997.
Developed international stocks gained 5.9% in June, 3.2% for the second quarter, and 14.2% year to date. European stocks have done a bit better, gaining 15.6% on the year so far. In April, the “Brexit can” was kicked down the road at least until October 31, but the risk of a disruptive “no-deal” exit remains.
Emerging-market (EM) stocks also rebounded in June, gaining 5.4%. Although EM stocks were only up 0.8% for the second quarter, their first-half gains stand at 12.6%. The dollar was roughly flat versus EM and developed market currencies over the six-month period.
Moving on to the fixed-income markets, the 10-year Treasury yield continued to plunge from its multi-year high of 3.2% last October, dipping below 2% following the Federal Reserve’s June meeting. This was a near three-year low, and among its lowest levels ever. The 10-year yield ended the month at 2.0%. Bond prices rise as yields fall, driving the core bond index to a 3.0% gain for the quarter and an impressive 6.1% return so far this year.
As an aside—and as further evidence of the consistently poor track record of market forecasters—the consensus of 69 economists and analysts surveyed in January by the Wall Street Journal was that the 10-year Treasury yield would rise to 3% by mid-year. None of them predicted the yield would fall below 2.5% this year, let alone down to 2%!
Mid-Year Outlook: Heightened Uncertainty
Although the markets have been volatile—as markets are wont to be—the developments haven’t been material enough to cause a change in our medium-term (five-year) tactical outlook or our portfolio positioning. Not surprisingly, we still see a high degree of uncertainty and a wide range of plausible outcomes looking out over the shorter-term (next 12 months). But at the margin, we think the macro risks have increased, driven by the negative impact of escalating trade tensions in the context of an already weak global economy and a late-cycle U.S. expansion with stretched valuations and very low yields.
CENTRAL BANK MONETARY POLICY
Central bank policy has had an enormous impact on financial markets since the 2008 financial crisis. We’ve seen that continue in 2019, marked by two major shifts in the Federal Reserve’s stance. First, the Fed shifted from tightening monetary policy in 2018 (where it was raising the fed funds policy rate and unwinding some of the assets on its bloated balance sheet) to a “patient” stance (i.e., rate hikes are on hold) in the first quarter of 2019.
Then at its recent June Federal Open Market Committee (FOMC) meeting, the Fed signaled it was inclined towards loosening policy once again, setting the stage for rate cuts later this year (possibly as early as its July 31 meeting) and/or next year. Fed chair Jerome Powell cited heightened uncertainty around the outlook for global growth, trade policy, below-target inflation, and falling inflation expectations.
Other global central banks are also pivoting back towards looser policies, including recent dovish statements from European Central Bank (ECB) President Draghi.
To state the obvious, looser monetary conditions are generally a stimulant for financial markets and asset prices, all else equal. A lower interest rate implies higher asset valuations (e.g., higher P/E multiples). But all else is rarely equal. And the implications of lower rates and monetary stimulus are not so obvious when you go beyond simple, first-level thinking to consider the broader economic context for these low rates (i.e., concerns about slowing growth and very low inflation). It is also critical for an investor to understand what information and expectations are already being discounted in current market prices.
Regarding the latter, the fed funds futures market is now discounting a 100% probability the Fed cuts rates by at least 25 basis points in July, 92% odds of at least two quarter-point rate cuts by year-end, and 60% odds of three or more rate cuts. Meanwhile, the S&P 500 index hit a new all-time high in the aftermath of the June Fed meeting and Treasury yields hit a multi-year low.
So, there is a non-trivial possibility the Fed surprises (disappoints) the markets by not cutting as much as expected, or at all. (While the Fed set the table for a cut in July, they still say they are “data-dependent.”) Of course, the Fed is aware of market expectations. And it knows that market reactions to its behavior can impact the real economy, which can lead to further market reactions, Fed reactions, subsequent market reactions, economic impacts, etc. Such self-reinforcing feedback loops may be helpful or harmful to achieving the Fed’s economic mandate. But the Fed can’t always control them.
If this does mark the beginning of another Fed easing cycle, it should give us (and the market) pause looking out beyond just the next few quarters. The fed funds rate is barely above levels where it has ended most other monetary easing cycles. The Fed will have little room—2.5 percentage points—to cut rates before hitting the “zero lower bound,” economist-speak for a zero percent fed funds rate.
Historically, the Fed has ended up cutting rates by around five to seven percentage points during a recessionary easing cycle. That’s impossible from current levels. Also, starting from such low yield levels, the benefit to the economy from additional rate cuts will likely be more limited, thereby diminishing returns. As such, the Fed seems highly likely to engage in quantitative easing (QE) in the next recession as well, despite its questionable economic benefits and with government debt already at historic highs. Will financial markets react similarly to the next round(s) of QE as they did after the financial crisis?
While U.S. bond yields are very low, at least they are still positive. Across much of Europe and Japan, government bonds have negative yields; the total dollar amount of negatively yielding debt recently shot above $13 trillion, a record high. About half of all European government bonds have a negative yield, including almost 90% of German government bonds. The German 10-year Bund recently yielded negative 0.33%, its lowest ever. The ECB’s policy rate (the “deposit rate”) stands at negative 0.4%.
None of this is normal. The consequences of these unprecedented monetary policies are highly uncertain. And we’ve seen the market disruption caused by even modest attempts to unwind them (in the U.S.), or even just the suggestion of beginning to tighten policy (in Europe).
The market’s expectations for imminent central bank easing are clear. But the Fed and ECB’s decisions will still depend to some extent on their assessment of incoming U.S. and global economic data. If the economic indicators improve (e.g., due to a lessening of trade tensions) and the Fed does not cut rates, will equity markets sell off, or will they respond positively to the better-looking economic fundamentals? Alternatively, if the Fed does feel the need to cut rates by 50 basis points in July, will markets have a knee-jerk rally? Or, will they do nothing because such a cut was already discounted in prices? Or, will stocks sell off on fears the cut indicates the Fed is worried about a sharp economic slowdown or recession on the horizon that it won’t be able to prevent?
Historically, stocks have performed well in the 12 months after an initial Fed rate cut, unless the economy is heading into a recession. In the last two cycles, in 2001 and 2007, the Fed’s first rate cuts came several months before the start of recessions, but severe bear markets followed anyway.
The Global Economy
The global economy remains in a sustained slowdown. The revival of trade tensions, imposition of additional tariffs, and uncertainty over further protectionist policies have taken a toll on global trade, manufacturing, and business sentiment, with negative implications for future investment spending and hiring.
Some short-term negative economic indicators:
The evidence among the key U.S. recession indicators we track is mixed but seems to lean towards a low to medium near-term risk of recession. However, some important indicators, while still positive, are weakening. We’ll be watching—along with the Fed and the markets—to see if they continue to trend lower, signaling increasing odds a recession is coming.
On the negative side, the yield curve (3-month T-bill vs. 10-year Treasury) has been inverted for more than a month now. According to NDR, yield curve inversions have been a precursor to each and every of the seven U.S. recessions in the past 50 years, albeit with variable and sometimes long lag times—ranging from six to 23 months. (There have also been two inversions that were recession “false alarms,” in 1966 and 1998.) The widely followed New York Fed U.S. Recession Probability model, which is based on the yield curve spread, jumped to 30% in May, its highest level since 2008.
Let’s also step back and look at this U.S. economic cycle in a broader historical context. As of July, this will be the longest economic expansion in U.S. history, beginning its 11th year. However, it’s also been the most sluggish recovery in the past 70 years. Real GDP growth has averaged just 2.3% per year during this expansion, compared to a median growth rate of 4.4% per year for the prior 11 post-WWII expansions.
There is no economic law that says a recession must occur on a set schedule or duration. While the average post-WWII U.S. expansion cycle lasted around five years, the three most recent expansion cycles (excluding the current one) lasted an average of eight years. Similarly, U.S. equity bear markets have occurred less frequently in recent decades, although they have been severe in magnitude. As the U.S. economy has evolved from manufacturing-based to more service-, technology-, and consumer-based, the nature of the economic cycle has likely evolved. For better or worse, central bank attempts to proactively “manage” the economy and sustain the expansion cycle have also evolved.
As many have said: History rhymes but doesn’t exactly repeat. This is also true when it comes to the economy and financial markets. It’s never entirely “different this time.” But each new cycle is always at least somewhat different from prior cycles. History is an invaluable guide to understanding the cyclical nature of markets and the investor herd behavior that drives them. But structural change also occurs and must be considered and incorporated within a cyclical historical framework. Certainty and precision in this regard do not exist.
As such, successful investors must remain flexible and open-minded, but still grounded in a fundamental investment discipline. In our case: globally diversified, risk-managed, and long-term valuation-driven. When will the recession happen? What will the Fed do next? We always invest with a range of potential outcomes, scenarios, and risks in mind.
Outlook for Trade and Other Geopolitical Risks
Unfortunately, the risk of a geopolitical shock on financial markets is ever-present. Most recently, there is heightened potential for a military conflict with Iran. But there are many other potential geopolitical flashpoints and unknowns: Brexit remains unresolved. The tug of war between democracy, populism, nationalism, and autocracy continues around the globe. The U.S. presidential election next year will likely create additional market uncertainty. China’s rise and challenge of the United States as a global superpower goes well beyond just the current trade conflict. The Middle East (beyond Iran) remains a potential flashpoint. Don’t forget about North Korea. And so on.
New information is continuously reflected in financial asset prices. We incorporate the potential for external shocks (geopolitical and otherwise) within our strategic (long-term) portfolio construction, multi-asset/multi-strategy diversification, and shorter-term downside risk management through our DRAAMS investment platform.
Uncertainty is a constant presence and volatility can always return to markets. Those of us who own stocks need to be prepared to ride through the inevitable down periods. It’s the shorter-term price we pay to earn their higher expected returns over the longer term.
In the event of an external “shock” event, it historically has paid not to panic and get out of the market. Rather, it is during these moments when one’s investment discipline pays off, opportunistically looking for attractive investments that may be “on sale” due to excessive short-term market fear.
Closing Thoughts on Our Portfolio Positioning
Our analysis of U.S. stock market valuations and expected returns implies the market consensus is discounting an overly optimistic outlook. Since most market participants tend to simply extrapolate recent trends (whether positive or negative) into the future, this is understandable. But our analysis—informed by history and applying forward-looking judgment—leads us to a base-case scenario where the expected annualized return from U.S. stocks over the next 5 to 10 years is in the very low single digits. This is well below the upper single-digit expected return we require to bear the full risk of owning stocks. As such, we remain underweight to U.S. stocks across our portfolios.
On the other hand, we continue to have modestly overweight positions to European and emerging-market (EM) stocks. Our analysis indicates their valuations are very attractive relative to the U.S. When pessimism is high, asset prices are low. Investing at low prices implies high(er) future returns. In our assessment, these markets are implicitly discounting a lot of bad macro news and poor sustained corporate earnings growth. Our base case, which we believe uses reasonably conservative underlying assumptions, generates high single-digit expected returns for European and EM stocks over the medium-term horizon.
Further, if the growth differential between the United States and the rest of the world narrows, the U.S. dollar will likely depreciate, providing an additional tailwind to foreign stock returns for dollar-based investors.
On the other hand, if the United States falls into a recession and bear market, our portfolios have “ballast” in the form of still-meaningful exposure to tactical funds, core bonds, cash and alternative strategies that should hold up much better relative to stocks. These lower-risk, diversifying positions have been a drag on our overall returns over the past several years as U.S. stocks have been in a raging bull market. But we’ve seen their benefits during the occasional market corrections, including in last year’s fourth quarter. And……. let’s not forget the lessons learned during the Great Recession and Bear Market of 2008 – 2009.
Our more defensive positioning will be an excellent (and long-awaited!) opportunity for us to re-allocate some of our capital back into U.S. stocks at lower prices and much higher expected returns.
This has been an unusually long U.S. economic and market cycle. But we firmly believe it is still a cycle, and that our patience and fundamental valuation discipline will be well-rewarded as it turns again. As always, we appreciate your continued confidence and trust.
Certain material in this work is proprietary to and copyrighted by Litman Gregory Analytics and is used by Guardian Financial Partners, LLC with permission. Reproduction or distribution of this material is prohibited and all rights are reserved.
