Themes this quarter should sound familiar since they are the same issues that have plagued investors for a while now: Federal Reserve monetary policy, trade disputes with China, and Britain’s never-ending exit from the European Union. The combination of these factors has begun to hamper global economic growth, as seen in the slowdown in manufacturing activity.
The U.S. economy is performing better than most. The 2019 GDP estimate for the U.S. is still robust at 2.3% compared to the European Union at 1.4%, the United Kingdom at 1.2%, and China at 6.2% (this is the lowest level for China since 1990). Domestic manufacturing is showing weakness with the ISM Manufacturing Survey falling below 50 (readings below 50 indicate contraction); the last reading of 47.8 is the second consecutive reading below 50. The good news is that consumer confidence remains elevated. The chart below shows the unemployment rate along with the University of Michigan Consumer Confidence Index.
The unemployment rate is still at a 50-year low and wages are rising at a 3.2% annualized rate. Retail spending increased 5.2% over the same period in 2018, as measured by the Redbook Store Sales Index. Consumer spending accounts for roughly 70% of the U.S. economy so it is easy to understand why our economy is stronger than most. The chart also shows that while Consumer Confidence is elevated, the trend is fading. The recent “rolling over” seems to be caused by the three big themes mentioned previously.
Despite the volatility, the S&P 500 was able to eke out a gain in the third quarter, returning a positive 1.7%, and is now up 20.6% for the year. Looking at the sector-level performance for the third quarter, eight of the eleven economic sectors in the S&P 500 posted positive returns. Third quarter performance was led by traditionally “defensive” sectors. Utilities (up 9.3%), Real Estate (up 7.7%), and Consumer Staples (up 6.1%) were the strongest performers. Global macroeconomic concerns, mainly related to weaker manufacturing data, have driven investors to seek shelter in less economically sensitive sectors. Logically, the worst performing sectors this quarter were cyclicals. Energy (down 6.3%) and Materials (down 0.1%) were two of the worst performers. In addition, Healthcare (down 2.3%) has continued to lag the market due to policy rhetoric from Washington that could impact future pricing in the industry.
The final month of the quarter showed a notable shift in the performance of Value vs Growth stocks (chart below). This shift coincided with the move up in the 10-year Treasury yield from a low of ~1.5% during the quarter to roughly 1.7% by the end of the month. The Financials sector, which benefits from a steeper yield curve, returned a positive 4.6% in September.
The consensus growth expectations for corporate earnings in 2019 is 1.3%. With earnings expectations coming down and stock prices moving higher, valuations have gotten more expensive. The forward P/E multiple for the S&P 500 is now ~16.8x, just above the 5-year average levels (of 16.6x).
We are still finding opportunities in this environment, but we are being selective on the price we pay. We are also carefully controlling the amount of our portfolios that is economically sensitive in case the looming recession comes to fruition.
The Federal Reserve has turned “dovish” with current monetary policy. The FOMC cut the Fed Funds rate twice during the quarter and issued the message that this change in policy was a “mid-cycle adjustment.” The first cut was on July 31st, followed by an additional cut on September 18th. The messaging was intended to signal that the Fed was not embarking on a rate cutting cycle, but instead an “insurance cut” to keep the economy strong. The bond market disagreed and in response the yield curve collapsed. The 10-year Treasury note was yielding 2.05% the day before the July rate cut and has fallen to 1.6% today. The market is pricing in a 73% chance of an additional rate cut on October 30th, and two or more additional cuts in 2020. The Fed and the market have opposing views on where rates should be. However, if the incoming economic data is disappointing, the Fed has sent the message that it will be accommodative.
One factor that we believe is impacting U.S. bond yields is the proliferation of negative yields overseas. The ECB, BOJ and other central banks are experimenting with negative overnight rates (similar to the Fed Funds rate) in order to incentivize economic activity and increase inflation, both of which have been below target. At one point during the quarter an estimated $16 Trillion in negative yielding bonds existed globally. As an example, during the quarter Germany was able to issue a 30-year, 0% coupon bond at a negative 0.11% yield. This means that the “investor” agrees to lend Germany money for 30 years, receive zero income over the life of the bond, and get back less than the original principal! This extraordinary monetary policy (which has been in effect for nearly 5 years) does not seem to be effective. The low yields in the U.S. may be a symptom of a yield-starved globe, as international investors flock to one of the only positive yielding sovereign debt available. The chart to the right is from mid-quarter but shows the extent of this phenomenon.
We are hopeful central banks will abandon this experimental policy and look to alternatives, such as fiscal stimulus, to get economies on track.
In May of this year, the House of Representatives passed the Setting Every Community Up for Retirement Enhancement (S.E.C.U.R.E.) Act. Currently lacking Senate approval, the legislation is designed to improve employer access to retirement saving plans and reform existing retirement planning rules. While the law is still taking shape, there are two items that may impact our clients:
• Increasing the Required Minimum Distribution (RMD) age to 72 (Senate version calls for age 75)
• Eliminating the lifetime RMD rule for Non-Spousal Inherited IRAs (commonly knowns as the “Stretch Rule”)
RMDs apply to retirement accounts and begin when the owner reaches 70.5. The basic premise is that the Government allows deferral of income taxes on IRA contributions with the understanding that the account will theoretically be depleted (and taxes paid as funds are withdrawn) by the end of the taxpayer’s lifetime. By extending the RMD age, citizens will gain additional years of tax-free growth but of course that could mean larger distributions, and therefore taxes, down the road.
To offset lost tax revenue from extending the RMD age, the S.E.C.U.R.E. Act eliminates the “Stretch Rule” for non-spousal beneficiaries. Currently, non-spouse beneficiaries can stretch the required distributions over their life expectancy; for younger beneficiaries this could mean many years of tax-deferral. If passed, non-spousal beneficiaries would be required to distribute the entire account balance within 10 years. Spousal beneficiaries will still be allowed to treat the accounts as their own and make distributions over their lifetime. Existing Inherited IRAs would be grandfathered and exempt from the changed rules.
Political gridlock may prevent the passage of the S.E.C.U.R.E. Act but future financial planning opportunities would exist. Some examples include Roth Conversions prior to the RMD age, asset beneficiary titling; and Qualified Charitable Deductions (QCDs). Each client’s unique circumstances would need to be considered before determining the most appropriate action. We will continue to monitor the S.E.C.U.R.E. Act’s progress and will keep you informed if enacted into law.
The markets and the global economy are working through several pressure points currently. Most of these risks that we have outlined, are self-inflicted and therefore solvable. This process will likely be accompanied by market volatility which we view as normal. We would be remiss if we did not mention we are entering election season in the U.S. It has served our investment process well over time to largely ignore the extremes as we work toward the 2020 elections. However, we do expect the headlines generated during this season to stir up fears about the future and that often means market volatility. We like to take the long view in our investment portfolios and please know that we are being diligent in meeting your investment objectives.
Our comments about the economy and the stock or bond markets are based on our own analysis and are not representative of the future performance of any security, fund, or of the overall market.
Our ADV Part II Is always available from our website, simply go to www.smith-salley.com and click on the “Documents & Literature” link on the bottom of the page where you will find instructions on how to access this document.