Altair Insight: A Long-Playing Record (2Q19) – Quarterly Market Review
“I’m built for comfort, I ain’t built for speed.” – Willie Dixon, “Built for Comfort”
A notable milestone was passed in July when the U.S. economic expansion hit its record 121st month, surpassing the technology-fueled run from 1991 to 2001. Yet fanfare was minimal, even as markets reached midyear with one of the best first-half performances for stocks in decades.
If this expansion were a person, we might be tempted to say “You sure don’t look 10!” or “You have a lot of energy … for your age.”
We would be exaggerating. The truth is the growth rate has been one of the weakest on record. Average GDP growth during the 10 years has been just 2.3%, well below the 3.6% of the last three U.S. expansions. Now this string of positive growth is facing pressure from mixed global economic data, the 16-month-old U.S.-China trade war and geopolitical tensions rising in the Middle East and elsewhere.
So why do we believe this cycle can continue?
In short, as we discuss below: The U.S. economy remains solid if plodding, a near-term recession appears unlikely, the Fed is leading a new push by central banks to ease financial conditions, and strong incentives exist for Presidents Trump and Xi to contain and ultimately settle their trade fight.
This expansion is now more than twice as long as the average (58 months) since World War II. Expansions carry no expiration date, however. A Federal Reserve Bank of San Francisco study of recessions concluded that there is no particular time or age at which an expansion ends. Many developed economies have achieved 15 years of uninterrupted growth; Australia’s current expansion is in year 28.
A long skein of modest GDP growth coupled with muted inflation may in fact indicate a more sustainable pace than a speedier rise would. At the very least, they hardly suggest an economy that is overheating and ready to combust. In the parlance of Dixon, the Chicago blues master, this U.S. expansion was built for comfort – or durability – not for speed.
“Economic expansions don’t die of old age.” – Saying heard late in economic expansions
The originator of that aphorism, late MIT economist Rudi Dornbusch, added that expansions are “murdered by the Fed.” Indeed, Fed mistakes are always possible and hard to anticipate. But we believe that Jerome Powell, having ended the Fed’s nine-rate-hike cycle and so far smoothly engineered its dovish turnaround, is taking the steps needed to avoid a legacy as this expansion’s killer.
Given the uncertainties mentioned above, we do not believe conditions merit taking on more risk. We recommend that clients stay at their target allocation levels in all three of our investment buckets: higher, medium and lower risk.
We do, however, reaffirm our tactical overweights within higher risk to small-cap and emerging-market stocks, two asset classes that had double-digit gains in the first half but underperformed against their U.S. and international peers, respectively.
The performance gap between large caps and small caps is unusually wide and we expect the smaller-company stocks to close it. Only three times in the past 40 years has the Russell 2000 benchmark for small caps been more than 10% short of its all-time record while the S&P 500 for large caps traded at new highs, according to Strategas Research. In all three instances, small caps caught up over subsequent months and made a new high of their own.
Emerging-market stocks, meanwhile, have held up well given the backdrop of a trade war and remain attractively valued.
Please read on as our quarterly discussion takes a look at key issues in more depth:
1. The U.S. economy is slowing but still healthy overall, in keeping with the advanced age of this expansion.
Jerome Powell is said to often ride his bike from his home outside Washington to the Fed some eight miles away. Based on the many times he has uttered the term “crosscurrents” in describing the U.S. economy this year, one might think he travels by canoe or kayak instead.
Powell said in June that crosscurrents had reemerged, adding more uncertainty to a challenging economy. More recently, he said that “crosscurrents, such as trade tensions and concerns about global growth, have been weighing on economic activity and the outlook.” As a result, he declared, the central bank will “act as appropriate” to sustain the current economic expansion.
We believe investors can take confidence in Powell’s assurance that the Fed will work to offset some of the damage that could occur if the trade war heats up or the global economy worsens. But how anxious should we be about these crosscurrents?
An analysis of the economy’s key indicators shows some developing causes for concern, especially with only fading benefits left from the corporate tax cuts that sped up growth a year ago. Yet there are no major stresses or excesses in the economy that point to a near-term recession.
The biggest trouble area is manufacturing, a sector that has shrunk from its more dominant years but still represents 11% to 12% of the economy. A sharp decline in the first half of this year sent the Purchasing Managers’ Index to multi-year lows, barely above the level that indicate a contracting economy. Hiring, output and manufacturing sentiment all have fallen off.
Flagging business confidence is another emerging soft spot that has significant implications for the economy and markets if it persists and affects spending. So far, business spending is declining but has yet to go negative. We are watching companies’ outlooks closely during the second-quarter earnings reporting season that is now under way for any signs of pulling back further.
The anemic global backdrop is more of an issue for the U.S. economy than any deterioration in domestic data, however. The budding weaknesses in manufacturing and business spending both relate to the slowdown in trade and the global economy and could be shored up with a trade-war deal. We remain confident that will happen, but it remains unclear how much damage could be done to the economy first.
The economy’s strengths, in the meantime, are more plentiful than the glass-half-empty view of many market pundits. As economist Don Rissmiller of Strategas Research wrote recently: “Rarely have we seen so much pessimism with the U.S. stock market making new highs and the coincident indicators of real U.S. economic growth performing in an acceptable fashion.”
The Leading Economic Index, comprised of 10 economic components, declined in June but the six-month growth rate remained positive. Consumer confidence is still elevated despite recent softening. Household spending is estimated by the Atlanta Federal Reserve to have expanded at a 3.9% pace in the second quarter. The job market has bounced back from a spring slump, adding 224,000 jobs in June. Unemployment remains just above a five-decade low at 3.7%.
We expect global growth to pick up in the second half based on both China’s decision to stimulate its slowing economy more aggressively and central banks pledging more easing. Geopolitical risks remain high with Middle East tensions involving Iran simmering, Italy’s financial woes festering and Brexit looming under new British Prime Minister Boris Johnson. But barring an unexpected shock, the global slowdown may have bottomed and a pickup could be in store for the remainder of the year.
Our belief is that equity markets will continue to be supported by a solid U.S. economy in the second half of 2019. An eventual trade agreement, however, is necessary to sustain the current market cycle.
2. The trade war’s shadow on the global economy is spreading.
The U.S.-China trade war that began in March 2018 already has lasted longer than expected, yet now the distinct possibility exists that it could linger into 2020. Can the global economy bend further without breaking if it does?
We believe the economy will maintain sufficient strength, with central banks’ assistance. But the slowly detrimental impact of the trade war on trade volumes, business confidence and other areas has heightened uncertainty and risk.
Direct consequences on the economy thus far have been muted. Global growth, while slowing, is still positive. The main engine of the world economy, the United States, remains sturdy. Yet the recent decline in a number of areas is not sustainable if a global recession is to be avoided.
As with the U.S. economy, weakened manufacturing is a red flag. The global manufacturing sector has fallen below the 50 level (a collective 49.6 in June) that denotes a decrease or deterioration.
World trade flows have seen the biggest decline since the financial crisis, prompting global banks to project the worst year for global trade volume since 2009. The Fed’s semiannual Monetary Policy Report published in July said the latest tariffs – imposed in May on $200 billion of Chinese goods – “appear to have lowered imports and exports in the U.S. and elsewhere.” Actual and planned capital expenditures by businesses, too, have slowed in 2019 as the trade war offsets the positive impact of tax cuts and deregulation.
Counterintuitively, we think hope can be drawn from the fact the U.S. and China are beginning to feel pain from their trade fight; it should increase the motivation to avoid new tariffs and reach a deal. An additional, threatened $300 billion in Chinese import tariffs would jolt the global economy if the trade truce reached by the two sides at the G-20 summit in late June collapses.
We believe economic and political incentives are high for both sides and a deal will be made prior to next year’s election. President Trump is motivated to stimulate the economy to aid his reelection, and there is no easier way for him to do that than ending the trade war. History has shown that presidents almost always succeed in their bids for a second term when there is no recession. President Xi, too, would no doubt like to avoid provoking a global recession with his economy decelerating.
Whenever it comes, an agreement is likely to provide an additional lift to markets, although more volatility is likely before that occurs
3. Markets are counting on the Fed to come to the rescue (again) even if it is not an economic emergency.
The Federal Reserve’s baseline outlook, Powell said this month (July), is for economic growth to remain solid even in the face of his oft-mentioned crosscurrents. The labor market remains healthy and consumer spending has been steady. But the Fed knows that if it waits until there is an emergency, it will be too late to undo the damage.
Lower rates seem virtually assured starting at the end of July. As we publish this commentary, the CME Group’s widely used FedWatch tool projects a 100% probability of a rate cut at the Fed’s July 30-31 meeting, with further reductions by year-end.
Fed officials have cited the need to revive inflation as part of their dual mandate to promote stable prices and maximum employment. They are concerned about it lagging persistently below their 2% target rate as well as about uncertainties caused by the trade war and slowing global growth. The reality is that they also keep one eye on the markets.
This is a Fed-driven rally, as investors showed when they embraced the central bank’s reversal earlier this year of plans for two more rate hikes in 2019. Confidence was fraying as the trade war continued and recession fears surfaced. The Fed’s pivot from hawkish to dovish is the primary reason for U.S. stocks’ best first half in decades.
For better or worse, then, this rally requires more Fed stimulus to keep going. We believe the expectation of multiple rate reductions in the second half, an assumption that Fed officials have done nothing to rebut, should support stocks for at least the rest of the year. Certainly the market historically has reacted positively to the initial reduction in a rate-cut cycle – even more so when it is not followed by a recession.
Rate cuts are no guarantee the economy or markets will strengthen, of course. The consequences of similar past pivots are mixed. Among the four most recent instances of the Fed shifting from raising rates to lowering them, stocks rallied twice (1995, 1998) and slumped twice (2001, 2007).
We believe, though, that the conditions surrounding the 1995 and 1998 cuts bear the strongest similarities to today’s.
In 1995, global and U.S. growth was slowing and the Fed justified its three rate reductions by pointing to weakening inflation. Also like the current situation, the president (Bill Clinton) was up for reelection the following year – historically a period when stocks have stayed strong, perhaps with the assistance of a presidential nudge or two.
In 1998, the Fed eased policy at a time when the stock market was in decline following the collapse of the hedge fund Long-Term Capital Management. Stocks turned around after the rate cuts. As is the case today, the Leading Economic Index was virtually unchanged over the six months preceding the 1995 and 1998 cuts – perhaps the clearest evidence of similarity.
The 2001 and 2007 reductions both came with the U.S. economy on the verge of recessions, which we do not think is the case now. Thus we do not view these periods as comparable to today.
This time, too, monetary stimulus is promised not just by the Fed but also by the European Central Bank. Under outgoing President Mario Draghi, the ECB is expected to cut interest rates, which already are negative, and reportedly also is considering relaunching its bond-buying program.
We are monitoring earnings reports closely for any signs of multiple companies scaling back their outlooks, along with any further deterioration in growth estimates. For now, we continue to believe that a dovish Fed and easier financial conditions will provide an important underpinning for markets through the remainder of 2019.
4. An uncertain inflation outlook is prompting us to add other real assets in addition to commodities as inflation hedges.
A puzzling absence of meaningful inflation in the quantitative-easing era has confounded both investment and economic experts. Moreover, inflation expectations have fallen over the last year based on the breakeven inflation rate, which has spent 2019 below the Fed’s target of 2%.
We do not believe inflation is dead. There is reason to believe it could spike unexpectedly, such as if a tight U.S. labor market creates upward wage pressure or through a fiscal stimulus package, so we want to maintain a certain level of inflation hedging in portfolios.
However, we have reduced our expectation for the potentially high inflation that is a hallmark of the later innings of business cycles. We believe there are other assets that also can offset the impact of more moderate, non-traditional bouts of price increases.
As a result, we will be positioning our portfolios to include more than just commodities, which tend to be robust hedges of very high and unexpected inflation but carry a lot of volatility along the way. We plan to opportunistically add other real-return and real-asset securities such as floating-rate debt, infrastructure equities, natural resource equities and Treasury Inflation-Protected Securities (TIPS) to protect the portfolio from more mild inflationary periods as well.
Inflation can take different forms and thus requires a variety of assets that are inflation-sensitive due to their underlying fundamentals and not simply responsive to inflation surprises. By broadening the exposure of our portfolios’ inflation-fighting assets, we will be able to diversify the higher-risk category through lower correlated assets that will reduce the overall volatility of the portfolio and potentially enhance returns through various inflationary environments.
5. Yields fall into rare territory, a boon for bond investors but with mixed implications.
This year’s steep decline in government bond yields has generally spelled good news for bond investors, since prices rise as yields fall. The slide to multiyear lows sends a more cautionary message about the future of the economy, however. While we think a recession in the next year remains unlikely, a continued drop would be cause for further concern.
The 10-year U.S. Treasury yield, above 3.2% at its peak last November, fell to a 2 1/2-year low of 1.9% in early July – reflecting pessimism about the longer-term prospects for the economy amid tariffs, slowing global growth and lower inflation expectations.
Internationally, the drop has been even more dramatic. Nearly a quarter of the bonds in the Bloomberg Barclays Global Aggregate Index, worth about $13 trillion, have negative yields. The dovish shift of global central banks – not just the Fed but also the ECB and the Bank of England – has accelerated the decline, since further monetary easing will translate into even lower interest rates worldwide.
A return to yield levels above 3% for the U.S. 10-year any time soon will come only after a reacceleration of growth. Yet a return to the 1.4% low reached in 2016 seems similarly unlikely given the economy’s overall stability.
One focal point: We have been closely tracking the spread between the 3-month and 10-year rates on the yield curve since they inverted in May – meaning the longer-dated yields have been paying out less than their shorter-dated peers. That is the equivalent of the bond market expressing concerns about the economy and historically a reliable indicator of a coming recession.
The yield curve steepened considerably in July, however, going back into positive territory shortly before this commentary’s publication. That trend should continue as the Fed lowers short-term rates further. Coupled with the fact that the equally important 10-year/2-year spread did not invert and has remained steady this year, we believe a recession is not just around the corner.
We remain optimistic about equity markets for at least the second half of 2019. Central banks have pledged easier financial conditions and the U.S. economy continues to be a linchpin of the global economy.
While the risk of a recession is growing as GDP growth slows, we believe the chances of one occurring in the next 12 months remain small. The job market and other key indicators are positive and there are no signs of significant distress or excess in the economy.
The greatest risk to markets is the threat of escalation in the U.S.-China trade war, which would pose danger to already weakening global trade. We believe the strong political and economic incentives for both sides to avoid a breakdown will result in a deal in advance of next year’s U.S. presidential election.
The multiple rate cuts that Fed officials appear to be leaning toward are justified in the face of subdued inflation, slowing global growth and the recent partial inversion of the yield curve. Equity markets should benefit unless trade-war negotiations collapse for an extended period.
We expect the U.S. dollar to decline against other currencies, a boon for international stocks, as the Fed cuts rates, growth moderates and the trade deficit widens. President Trump has advocated action to lower the dollar.
We still believe small-cap and emerging-market stocks hold strong potential despite the relative underperformance of both categories in the first half. Valuations and prospects for both remain attractive and emerging-market stocks should benefit from a trade-war resolution while small caps should outperform if the U.S. economy reaccelerates following a trade agreement.
Quotes of the Quarter
“TARIFF is a beautiful word indeed!” –Donald Trump, U.S. president
“We are now embarking on a new Long March, and we must start all over again!” – Xi Jinping, Chinese president
“Global commerce is being hit by new trade restrictions on a historically high level.” – Roberto Azevedo, World Trade Organization director-general
“We will act as appropriate to sustain the expansion.” – Jerome Powell, Federal Reserve chairman
Slowing economy? Trade war? No worries – investors shrugged off both in the first half of 2019.
Markets continued to reflect optimism on both counts in the second quarter, confident the Federal Reserve will soon ease lending conditions and President Trump will ultimately close a trade deal with China. The result was the U.S. market’s best first half since 1997.
The iShares S&P 500 ETF followed up its best quarter of the bull market from January through March with a solid 4.2% return in the second quarter, leaving it up 18.5% for the year. The entire gain and then some came in June, the month when Fed Chair Jerome Powell promised that “We will act as appropriate to sustain the expansion.”
Financial stocks led the way in the quarter, up 8%, although tech firms delivered some of the largest gains. Technology was the top-performing sector for the first half, up 27%. Five companies, mostly tech giants, accounted for fully a third of the S&P 500’s second-quarter gain as they extended their 2019 momentum: Apple (+40% year-to-date), Amazon (+27%), Facebook (+44%), Microsoft (+32%) and Walt Disney (+27%).
Small caps lagged their larger counterparts, likely on fears about cooling domestic growth. The iShares Russell 2000 Index ETF edged up 1.9% in the quarter for a 16.8% first-half return.
Growth outpaced value as the investing style of choice in the extended risk-on environment. The iShares Russell 1000 Growth ETF was up 20.9% at midyear after a 4.2% quarterly rise; its value counterpart had a first-half gain of 15.8% following a second-quarter advance of 3.6%.
Non-U.S. stocks also delivered double-digit gains virtually across the globe in the first half, albeit less impressive than those of their American peers. Buoyed by expectations of coming Fed rate cuts, international stock investors also drew confidence from China pumping monetary and fiscal stimulus into its economy to partially offset trade-war pressures.
The iShares MSCI All-Country World ex-US ETF, a benchmark for all non-U.S. stocks, rose 2.8% and was up 13.4% at midyear. Developed economies fared best, collectively; the iShares MSCI EAFE ETF added 3.5% for a 14.2% return over the year’s first six months. In local currencies, the first-half return was a tick lower at 14.1%, reflecting a 0.1% decline in the dollar since the beginning of 2019. France’s market stood out with a 19.3% return for the first half, while Japan lagged with a 6.0% gain.
Emerging markets were more volatile amid the progress and setbacks of trade talks, but still positive. The iShares MSCI Emerging Markets ETF eked out a 0.7% gain from April through June and was up 10.7% over the first half. The biggest winner was the Russian market, up more than 28% on rebounding oil prices and perceptions that new U.S. sanctions were unlikely. Other first-half returns of note: Brazil 14.7%, China 12.9%, India 6.5%.
U.S. real estate investment trusts benefited as the Federal Reserve halted its interest rate-hiking cycle after more than three years and set the stage for coming reductions. REITs reached midyear as the top-returning asset class (+19.3%) despite underperforming the broader market in the second quarter with a 1.7% return.
Internationally, REITs were essentially flat, inching back 0.1%, but posted a strong 13.3% return through six months. As with domestic REITs, concern about slowing economic growth weighed on investors’ enthusiasm.
Commodity prices rose in the first half by 4.8% even under the cloud of the U.S.-China trade war, but evidence of waning global trade growth sent the asset class to a 1.9% second-quarter loss as proxied by the iPath Bloomberg Commodity Total Return ETN.
Crude oil futures increased by close to 25% in the first half amid growing geopolitical tensions, particularly in the Middle East involving Iran. The gain came exclusively from January through March; crude fell 3% in the second quarter amid worries that the lingering trade war is causing the global economy and oil demand to slow.
Grains were the top-performing commodities sector, with corn up nearly 18% and wheat up 15% on a mixture of trade turmoil and weather issues. Precious metals also were among the biggest gainers as the Fed adopted a more dovish outlook on interest rates, the dollar weakened and geopolitical concerns mounted. Gold, the heaviest-weighted individual commodity in the Bloomberg index, climbed 9% in the quarter and reached a six-year high above $1,440 an ounce in late June. Palladium surged 14%.
The HFRX Global Index, a benchmark representative of the hedge fund universe, underperformed stocks and delivered returns comparable to those of bonds: 1.6% for the quarter, 4.2% for the year to date. That still left it with the best first-half return since 2009 as funds benefited from betting on stocks, trend-following and activist strategies.
The HFRX Equity Hedge Index, an investable benchmark of long and short equity funds, followed a strong first quarter with a 0.0% return from April through June for a 6.0% rise in the first half.
Bonds delivered a strong quarter as the 10-year Treasury’s yield fell below 2% for the first time since 2016 amid increased concern about an economic slowdown and heightened expectations that central banks will step in to cut rates. Bond prices rise as yields fall.
Taxable bonds had particularly sturdy returns from investors bidding up these bonds in a flight to purchase safe assets. The Vanguard Total Bond Market Index ETF was up 6.1% for 2019 after a 3.1% second-quarter gain.
Tax-exempt municipal bonds, affected by different factors, were more modestly positive. Altair’s investable benchmark for the municipal bond market, a blend of the Market Vectors’ short and intermediate ETFs, was up 1.6% in the quarter and 4.1% for the first half. Issuance of munis has slowed and the market remains supported by low supply and high demand.
The material shown is for informational purposes only. Past performance is not indicative of future performance, and all investments are subject to the risk of loss. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to accurately and consistently predict future market activities. Information presented herein may incorporate Altair Advisers’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security. While efforts are made to ensure information contained herein is accurate, Altair Advisers cannot guarantee the accuracy of all such information presented. Material contained in this publication should not be construed as accounting, legal, or tax advice.