Congratulations are in order…the end of the second quarter marked the longest economic expansion since 1854! Thus far, the U.S. economy and capital markets have climbed the proverbial “wall of worry” for all of 2019. In our last letter we referenced the Federal Reserve’s change in expectations from potentially three rate hikes in 2019 to possibly a rate cut if justified by economic conditions. This led the stock and bond markets to expect even more fiscal stimulus. While the Fed did say at the latest press conference that they will react appropriately to keep the expansion moving forward, the markets almost immediately priced in three rate cuts in 2019. Along with Fed policy, the continuation of trade negotiations on multiple geographic fronts has fueled uncertainty. There seems to be a strong link between these trade debates and the economic weakness we are witnessing overseas. How the U.S. will fare in a slowing global economy is a main point of interest. In a complicated environment, investors have honed their focus on these two variables: The Fed and tariffs.
Estimates for first quarter GDP come in at a robust 3.1%. Some of this above average growth is being attributed to inventory build and more favorable trade flows. Most economists agree that these two variables are not paths toward sustainable economic growth and in fact some data on manufacturing weakness is apparent. Estimates for second quarter GDP have been revised down and the Atlanta, St. Louis and NY Fed now see second quarter growth of 1.5%, 1.47%, and 1.3%, respectively. Annualized GDP for 2019 is still projected at a healthy 2.5%, although estimates for 2020 and 2021 are now back below 2%.
Two reasons for lower growth expectations and potential Fed rate cuts (beyond the perpetually low inflation readings) are the recent PMI measurements and the latest non-farm payroll report. In June, the Markit U.S. Manufacturing and Services PMIs both were reported at 50.9. This indicates that both sectors are just barely expanding (numbers below 50 indicate contraction) and the readings have been consistently coming down. The change in non-farm payrolls (new jobs) was reported at +75k compared to an estimated 175k.
The manufacturing weakness we now see domestically has been developing overseas for quite some time. The chart below shows that Japan, China, South Korea, and the Euro area all in contraction territory.
Global demand is weak and trade tensions are beginning to affect business confidence. These trade disputes (we include Brexit and the U.S/Euro tariff discussion here) could erode business confidence to the point of layoffs which would result in lower consumer confidence as well. Consumer trends have been strong and have elevated our economy as the envy of the world. So, any further disruption to business confidence/investment could lead to what economist call “talking yourself into a recession.” For now, we are hopeful these trade issues will be favorably concluded, as all sides have incentives to reach an amicable solution.
While we are cheering the longest economic expansion in 165 years, the graphic below shows the somewhat shallow recovery relative to history and it is the slowest in the post-war era. So, yes, the recovery has been long, but it’s also been slow. While opinions vary on why, our hypothesis is the severity of the Great Recession/financial crisis was more than just a cyclical slowdown.
We also believe the large sovereign debt accumulated globally (in many cases debt/GDP ratios exceed 100%) has contributed to the crowding out of private investment and further reduced economic potential. In any viewpoint, the facts of the situation are that the U.S. is still at “full employment,” inflation is stubbornly below 2%, and we now have an accommodative Fed ready to loosen monetary conditions.
The S&P 500 continued the strong rally, returning a positive 4.3% for the quarter, and is now up 18.5% for the year. The month of May posted a negative 6.4% for the index, as concerns over the briefly re-imposed tariffs on Mexico impacted investor enthusiasm. Although the dispute with Mexico has been resolved, (causing a 7.1% rally in June), on-going concerns around Chinese tariffs and Fed policy continue to linger.
Macro-economic concerns are now showing up in company operating results and consensus expectations for 2019 corporate earnings are a subdued 2.7%. With earnings expectations coming down and the market continuing to grind higher, valuations have gotten more expensive. The forward P/E multiple for the S&P 500 is now 16.7x, just above the 5-year average of 16.5x.
Looking at the sector-level performance for the quarter, ten of the eleven economic sectors in the S&P 500 posted positive results. Results were a “mixed bag” with Technology and Financials providing the best returns. Financials (up 8.0%), was the best performing sector with positive news from the Government stress tests & increased capital returns coming late in the quarter. Technology (up 6.1%) was an outperformer during Q2, and is now up 27.1% YTD.
The Energy sector (down 2.8%) was the worst performing sector in Q2 and the only sector in negative territory. Oil supply growth, driven by production gains in the U.S., along with demand concerns in a slower global economy, have kept oil prices in check. Many of the more economically sensitive sectors have not fully participated in the equity rally as macro-economic growth concerns surface. Case in point is the small cap Russell 2000 index which was only up 2.1% in the quarter and is lagging the broader market YTD. Healthcare (up 1.4%) has continued to lag the market after being the best performer for all of 2018. The chart below shows how the main thrust of the market has been narrowed to more defensive sectors lately. Factoring in the Q4 2018 downdraft, the S&P 500 is only up 2.5% over the trailing 3-quarters.
The Federal Reserve’s monetary policy and inflation expectations control the shape of the yield curve. With such dramatic changes in both variables one should not be surprised at the abnormal shape of the current yield curve below.
The blue line shows the rather dramatic inversion that has emerged. In one year the bond market moved from a somewhat steep curve to the opposite. One year ago, inflation expectations were rising and the Fed forecasted the Fed Funds rate to reach 3.0% to 3.5%. That vision was not prescient to say the least. The dramatic steps the Fed undertook to reduce the balance sheet (draining $50B a month in liquidity) and quickly raising the overnight rate had the expected effect: it slowed down the economy, maybe even quicker than the Fed itself had factored in.
The yield on the 10-year note began the year at 2.6% and has fallen to 2.0% today. Corporate spreads have tightened up to a below average 52 basis points, showing no signs of duress in an economy that is slowing. We are skeptical that these two conditions can hold for much longer. The economy is either weak enough that the Fed will be forced to cut rates (which would push corporate spreads wider), or the economy is healthy and the 10-year yield has fallen too far.
In this environment we are avoiding corporates and managing duration by staying in the intermediate sector of the curve and locking in 1-3 years of call protection. While we do expect the next move by the Fed to be a rate cut, we think the market has “overshot” in expectations and rates should normalize. The current implied probability of a Fed rate cut at their next meeting is 100% meaning the market already has it priced in. How much of a cut is in question; there is a 20% chance of a 50 basis point cut on July 31, with over 80% chance of a 25 basis point cut. We are still leaving room for no cut given all the economic data slated to come out but a 25 basis point cut does seem highly likely.
In case you’ve missed the message, the Fed and trade disputes have taken over the narrative right now. These issues are the main catalysts for market movements over the short term. Over the last few quarters we have taken active steps in our stock and bond portfolios to prepare for the version of the future we deem most likely. Reducing, while not eliminating, the cyclical factors in the stock portfolios and maintaining pristine credit quality in bonds has been one clear directive.
One quick note on the firm – we have added two new faces to the team, B.J. Szafran and Adam Wojtkowski. B.J. will be helping new business development efforts here in the Triad while Adam will be starting a presence for SS&A in the Boston area. Both gentlemen bring a unique skillset to our team and will add to the value we strive to deliver to all clients. As we grow, our commitment remains fixed on delivering personalized financial planning and portfolio management. Thank you for the opportunity to serve you!
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.