QUARTER 2 2019 COMMENTARY
Promising the Moon
Global growth and corporate earnings continued to slow in the second quarter.
The Federal Reserve appears willing to ease the already accommodative financial conditions, even with low unemployment levels and elevated stock valuations.
Interest rates are a focus as lower interest rates often encourage leverage, financial engineering, and speculation, which may create imbalances in the economy and capital markets.
Asset prices around the globe continued to rebound in the second quarter as central banks doubled down on their policy U-turns. Long gone are plans for policy normalization and balance sheet reduction. The synchronized global growth that dominated headlines little more than a year ago is also behind us. With global growth, trade, manufacturing activity and corporate earnings all slowing, markets are looking ahead to the second half of the year in the hopes that lower interest rates will spur continued market growth.
It is unclear whether the current slowdown is a fad or the start of a larger trend that could upend what is now the longest U.S. expansion in history, but investors have placed their bets. U.S. stocks, high yield bonds, real estate and an array of other assets are at or near all-time highs.
2019 2Q KEY MARKET TOTAL RETURNS
Interest rates plummeted in the second quarter as markets anticipated central bank rate cuts. The yield on the 2-year Treasury note declined to end the quarter at 1.75%. The last time it reached such a low level was late 2017 - five interest rate hikes ago. Longer-dated Treasury yields also dove as the 10-year went from 2.4% to 2.0% and is now at levels last experienced in 2016. Looking ahead, the Federal Open Market Committee (FOMC) is expected to lower its benchmark rate by at least .25% later this month. Finally, longer term bonds across the globe, from Germany to Australia, have recently dropped to their lowest levels in history.
At least some of the shift in the yield curve can simply be attributed to central bank guidance. Throughout the quarter, key officials in the U.S. and Europe ratified future rate cuts. For instance, Federal Reserve Chairman Jerome Powell, in his opening comments at the June FOMC press conference, indicated the current state of the economy and inflation was weak enough to justify action relatively soon.
“[M]any participants believe that some cut in the federal funds rate will be appropriate… Though some participants wrote down policy cuts and others did not, our deliberations made clear that a number of those who wrote down a flat rate path agree that the case for additional accommodation has strengthened since our May meeting”
Due to a decade of strong returns, equity investors glossed over signs of economic weakness and other unresolved issues. Trade tensions remain up in the air. The outcome of the G20 meetings was simply a restart of expanded China-U.S. tariff negotiations. Global manufacturing has slowed. U.S. corporate earnings stalled for a second consecutive quarter, and early measures indicate that the third quarter may not be much better. The Atlanta Fed currently expects second quarter real Gross Domestic Product (GDP) growth to be an uninspiring 1.3%, less than half of the growth rate from the prior quarter.
Over time, these factors should influence the trajectory of markets, but with the prospect of even lower rates, economic gravity has been forestalled. Interest rates (and bond yields) act as both the discount rate and low risk alternative to riskier assets. Low interest rates—especially those below the rate of inflation—are a powerful stimulus.
Are crisis-era policies appropriate given the economic and market backdrop? Consumer spending grew at 2.7%, which is consistent with growth rates experienced since the beginning of 2016. The unemployment rate is 3.6%, the lowest in 50 years. First-quarter real GDP was announced to be 3.2%. An overreaction by the Fed in an environment of already loose financial conditions (as measured by the Chicago Fed National Financial Conditions Index) risks completely untethering markets and could send asset prices to the moon.
Inflation may be the only factor that will constrain central banks, but there was nothing in the second quarter inflation data that would prevent the Fed from cutting rates. The most recent reading of the Consumer Price Index (CPI) was 1.8%, slightly below the Fed’s soft internal target of 2%. Furthermore, the FOMC’s preferred measure of inflation, the Personal Consumption Expenditure Price Index, is at 1.5% on a year-over-year basis.
Continuing a decades-long trend, growth stocks outperformed value stocks and larger companies outperformed their smaller counterparts during the quarter. All sectors but energy stocks (-2.8%) were positive during the quarter. Technology continues to lead the way, up 6.1% in the quarter and 27.1% for the year. Four sectors - technology, industrials, consumer discretionary, and real estate - have posted year-to-date returns greater than 20%. The worst performing sector for the year is health care, up 8.1%, which has suffered due to concerns about increased regulation.
Even with the risk-on environment of the second quarter, lower quality fixed income securities trailed their investment-grade counterparts. The Bloomberg BarCap U.S. Aggregate Bond Index was up 3.1% in the quarter and is now up 6.1% for the year. The Bloomberg BarCap High Yield Corporate Index increased by 2.5% in the quarter, which moved it to up 9.9% for the year. Municipal bonds, as measured by the S&P National Municipal Bond Index, gained 1.6%, leaving them up 3.9% so far in 2019.
Developed markets outperformed emerging markets due to increased trade tensions and sub-par earnings growth in the developing world. The MSCI EAFE Index rose by 4.0%, leaving it higher by 14.5% so far this year. The MSCI Emerging Markets Index eked out 0.7% and is now up 10.8% in 2019.
On the macroeconomic front, Eurozone inflation remains well below the 2% target, with recent readings closer to 1%. This provides continued justification for the European Central Bank’s (ECB) third Targeted Longer-Term Refinancing Operation, which is expected to begin in September. It may also spur the ECB to engage in other accommodative measures, such as lowering interest rates further into negative territory. At his final press conference as head of the ECB in June, Mario Draghi stated:
"Looking ahead, the Governing Council is determined to act in case of adverse contingencies and also stands ready to adjust all of its instruments, as appropriate, to ensure that inflation continues to move towards the Governing Council’s inflation aim in a sustained manner."
This slowdown in Europe will be a focus for the new head of the ECB, Christine Lagarde, who currently heads the International Monetary Fund.
After a relatively quiet quarter on the UK’s Brexit situation, the back half of the year should bring some major developments. In late July, we expect the UK to announce its new Prime Minister, either Jeremy Hunt or Boris Johnson. Additionally, the European Union has imposed a Brexit deadline of October.
China’s stock market ended the quarter lower by 4.0%. Across developed and emerging markets, China ranked third to last in terms of performance, besting only Hungary and Chile.
Investors are moving into the second half of 2019 with high hopes that dovish central banks will be able to fan the flames of global trade and growth.
Despite today’s relatively benign macro environment, there are growing risks. Chief among them may be a policy error by central bankers, who risk not doing enough and watching this global slowdown deteriorate into something worse—or if they ease too much, they could further disconnect debt levels and asset prices from economic reality.