We certainly do not want to rush the next few months, however, it’s time to start thinking about the end of the year and what we should expect from the markets heading into 2020. Key themes that we expect to remain in focus include the Fed’s use of monetary policy, global growth, trade with China and stock valuations (to name a few). We also expect conversations around U.S. elections and a slowing U.S. economy to join the daily headlines.
The most consistent message to our clients in these communications over the past several quarters has been to stay committed to your individual investment strategy (despite the plethora of uncertainties surrounding the market). We feel it is necessary to repeat this message once again, as we find ourselves now half way through the year with broad U.S. equities at or near all-time highs.
The current, now longest in history, economic expansion continues and the Fed seems determined to do what it can to keep it going. While we fully acknowledge that a recession is expected to occur, it is our job to avoid making short-term decisions to the detriment of long-term investment objectives. Instead, we want to focus on the strategic decisions that will add real value to you, irrespective of unpredictable market fluctuations. These decisions include, but are certainly not limited to, your global asset allocation strategy, strategic sourcing of distributions, efficient rebalancing and active portfolio tax management.
Broad market strength in the first half of 2019
Equity Market Results
Most major equity indexes experienced double-digit growth during the first half of the year. U.S. large cap stocks, represented by the S&P 500 index, were up roughly 18.5%, while international developed and emerging market stocks were up 14% and 10.5%, respectively (1). While a majority of the upside came in the first quarter, investors were still buyers of stocks in the second quarter, reaching all-time highs in many cases. This sharp recovery comes on the heels of a significant market downturn in the fourth quarter of 2018.
Fixed Income Results and Outlook
Fixed income assets are also off to a strong start in 2019. The yield on 10 year U.S. Treasuries declined from 2.7% at year-end 2018 to 2.0% at the end of 2Q 2019. As of June 30, 2019, the Bloomberg Barclays U.S. Aggregate Bond Index was up 6%, municipal bonds were up 5%, investment grade corporate bonds were up over 9%, and high yield bonds were up 10% for the year (2). While the economy can continue to grow at current levels, we have taken notice of the signals coming from the bond market. A cursory glance at the inverted U.S. yield curve suggests recession risks are higher than they were at the start of the year. As we look to the second half of the year, we see historically low spreads to U.S. Treasuries across many fixed income asset classes along with very low yields. Over 20% of the global government bond market is actually yielding less than zero. So, while we do not see significant upside to our fixed income strategies for the balance of the year, we feel exposure to the asset class is important. The benefits of income, diversification and low to negative correlation to equities makes fixed income an important part of our portfolio construction process.
Longest recovery in history; can it continue?
The current economic expansion that began in June 2009 is now over 10 years old. Many factors can be attributed to the length of this recovery, including strong accommodative policy, the relative attractiveness of investing in the U.S. versus abroad, pro-growth policy and muted (more sustainable) GDP growth to name a few. These contributing factors remain and while the economy is certainly susceptible to a pending slowdown and global shocks, we should not fear a recession simply because of the length of this recovery (and subsequent Bull market in stocks).
You may have heard the phrase, “new normal” used when discussing growth in the economy. The relevance here is that this current economic recovery has been fueled by slow but steady growth. Quarterly real GDP growth has averaged just 2.2% over the past 40 quarters (with 20% of the quarterly GDP readings at 1% or below). The point is that while GDP growth expectations have been reduced for 2Q 2019, potentially in the 1.5% - 2% range (down from 3.1% in the first quarter), it is still within this new normal growth (3). We believe that the current level of GDP growth is sustainable in the near-term and we expect that investors will continue to push out expectations for an economic recession.
It has proven to be a difficult task for the U.S. to attempt to adopt a more restrictive policy over the last few years in the face of global monetary policy instability. Following the last recession in the U.S., the Fed maintained rates at historic lows for 7 years and has since raised rates 9 times over the past 4 years. Globally, there is heavy stimulus coming out China, Europe and Japan and the Fed does not want to deviate too far from the rest of the world. Interest rate cuts, as indicated by the recent dovish comments from the Fed, are now priced into the market. The median expectation is for the Fed to reduce the Fed fund target rate by 0.50% this year, starting as soon as the end of July. Not cutting rates could be negative for the market.
Challenges remain as the Fed has limited levers to pull to respond to the next economic downturn. The Fed funds target rate remains at historically low levels (2.25%-2.5%), thus there is little room to reduce rates. The U.S. is also sitting on a bloated balance sheet with a high deficit. Coupled with sustained lower growth, higher financial instability and increased tensions abroad we certainly do not want to diminish the difficult job the Fed has trying to navigate these waters.
Trade, U.S. Economy and Global Growth
The trade dispute with China is the most front and center risk that could pose a threat to the global economic outlook were it to escalate even further. At the time of this letter, trade talks have resumed, however, it does not appear that any material progress has been made since negotiations last stalled. We anticipate heightened market volatility as news surrounding China continues to unfold.
As we stated earlier, economic growth in the U.S. is steady and the late stage of this recovery continues. Based upon current jobs data and consumer sentiment surveys, the consumer remains strong (i.e. the consumer is working and spending money). Manufacturing in the U.S. has showed signs of softening, but it has not yet been enough to derail the low single digit GDP growth that has persisted. The U.S. is still an attractive place to invest when compared to its global counterparts. While this may be due more to the weakness in places like China and Germany, it is an important contributor to the strength of our domestic economy.
Signs of global weakness are prevalent. One indicator, the global manufacturing index, has been declining since early 2018 and fell below 50 in the second quarter for the first time in several years. This index offers a read on roughly 90% of global manufacturing output and a reading below 50 signals a decrease from the previous month (4). The ongoing trade war is expected to exacerbate the issue. With uncertainty and lack of confidence, it is logical to expect reduced global spending and investments both domestically and abroad.
Stocks are at all-time highs and the current economic expansion is now the longest on record. The Federal Reserve seems poised to reduce rates and keep the recovery going. Risks to the recovery persist, namely weakening global growth and “trade wars”. Over the next six months and heading into 2020 we expect to endure periods of increased volatility, at a time when the world will be focused on the upcoming U.S. presidential election.
We said this last quarter (and many times over the last couple of years), but we will repeat nonetheless: staying committed to a strategically designed investment plan is crucial to achieving your long-term goals. As evidenced over the past few years, it is extremely difficult (if not impossible) to predict what the market will do over a short period of time.
Chart A) 2019 Year to Date Total Return of Major Asset Class Indexes
Source: Bloomberg; 2019 year to date total return, International, emerging market, S&P 500, Barclays Agg indexes
1,2 - Source: Bloomberg: S&P 500 Index; Emerging Markets Stock Index = MSCI Emerging Markets Net Total Return Index; International Markets Stock Index = MSCI EAFE Total Return Index. Bloomberg Barclays Aggregate Bond Index; Bloomberg Barclays National Muni index; Bloomberg Barclays US Corporate Investment Grade Index; Bloomberg Barclays US Corporate High Yield Index
3 – Bloomberg GDP data. Trading Economics US GDP Growth Rate. https://tradingeconomics.com/united-states/gdp-growth
4 – Bloomberg; JP Morgan Global Manufacturing PMI
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