Charles Dickens's Great Expectations tells the story of Pip, an English orphan who rises to wealth, deserts his true friends, and becomes humbled by his own arrogance. As investors, we must remain vigilant to focus on the fundamentals and not to be swayed by overly optimistic, or pessimistic, forecasts of coming events.
Expectations – the Bad and the Good
- Global economic data makes for grim reading. The global manufacturing Purchasing Managers’ Index (PMI) was below 50 for a fifth consecutive month - its longest continuous period in contractionary territory since mid-2012. European economies, particularly Germany, have been at the forefront of this slowdown as escalating trade tensions between the U.S. and China have seen the region get caught in the crossfire. Exports make up 20% of GDP in the Eurozone and the decline in world trade volumes has weighed on growth. In addition, domestic political disagreements over EU budget negotiations as well as the ongoing Brexit pressures have added to economic uncertainty. British Prime Minister Boris Johnson insists that the UK will split from the European Union by October 31, even though EU officials have requested several significant changes to Johnson’s new Brexit deal.
- Regarding U.S.-China trade, senior Chinese trade officials have narrowed the scope of issues the country is willing to discuss and have implied a reluctance to agree to any wide-ranging deal with the U.S. China’s top trade negotiator, Vice Premier Liu He, said the country would make an offer that does not include any commitments on industrial policy or government subsidy reforms. Analysts suggest that China’s hand is strengthening in negotiations amid the Trump impeachment proceedings, along with the weak U.S. manufacturing data.
At the same time the U.S. is placing tariffs on a wide variety of Chinese goods, it now has been given the go ahead from the World Trade Organization to impose tariffs on as much as $7.5B worth of European exports annually in retaliation for illegal government aid to Airbus, the French airplane manufacturer. A list has been released of hundreds of European products that will get new tariffs as early as Oct. 18, including 25% levies on French wine, Italian cheese and single-malt Scotch whisky. The main target, however, is Airbus aircraft made in the European Union which face a 10% duty that could hurt U.S. airlines which have billions of dollars of orders waiting to be filled.
- As a sign of growing pessimism about future growth in the economy, The National Association for Business Economics sees slower GDP growth and rising recession risk ahead, primarily because of the trade war and its impact on capital spending and investment. Additionally, the negative sentiment can act as a “self-fulfilling prophesy” by convincing companies and consumers to slow their spending “just in case” the perception becomes reality. Investors, who are also consumers, can get caught up in the negativity as well.
- Slowing growth is not necessarily a bad thing – muted expectations have kept interest rates and inflation well contained which makes stock valuations more attractive. Bond yields are at a multi-year low and stocks are not expensive.
- Worries about the duration of the current economic cycle are not reflected in consensus global earnings estimates for next year and beyond, with this year’s growth challenge primarily a function of tough comparisons to last year’s tax-cut driven record earnings. Should the rosy forecasts for a strong earnings rebound in 2020 materialize, stock prices will certainly be higher as we move through 2020.
- Consumers are still optimistic about their personal circumstances. With U.S. unemployment at a 50-year low, wages rising, and more job openings than available workers, the service economy is still expanding despite a slowdown in manufacturing.
- The Federal Reserve, which controls short-term interest rates, is currently in an easing mode having lowered interest rates twice since July (a total of 0.50%) and is poised to lower rates further if needed to support the economy.
- Leading Economic Indicators (LEI) continue to reflect a steady, positive outlook for the U.S economy and give no warning signs of an imminent recession.
Third Quarter Highlights
Markets in the third quarter of 2019 looked surprisingly similar to the second quarter as more U.S.-China trade war uncertainty and a lack of clarity on future interest rate policy caused a sharp increase in volatility in the middle of the quarter, but the S&P 500 remained resilient and ultimately recouped those losses to finish the quarter not far from the new all-time highs established in late July.
The third quarter started strong as news of a “trade truce” between the U.S. and China, which was announced at the G20 meeting in late June, combined with better-than-expected second-quarter corporate earnings to propel the S&P 500 to new all-time highs in July. Also helping markets rally was anticipation of the first interest rate cut by the Federal Reserve since 2008, which became reality on July 31st when the FOMC cut the Fed Funds Rate by 25 basis points.
But that strong start to the quarter was quickly undone in early August thanks to increased tariffs between the U.S. and China (the trade truce was short-lived), uncertainty over future Fed policy, and concerning signals from the bond market regarding economic growth and inflation.
The U.S.-China trade truce that was agreed to in late June didn’t last much more than a month as President Trump announced new 10% tariffs on $300 billion worth of Chinese imports on August 1st, citing a failure by the Chinese to fulfill promises to increase purchases of U.S. agricultural products. Then, in late August, China retaliated by levying various new tariffs on $75 billion worth of U.S. imports, and President Trump immediately responded by increasing existing tariffs on all $550 billion of Chinese imports. The tariff tit-for-tat weighed on markets throughout August.
Also pressuring stocks in August was uncertainty regarding U.S. monetary policy. As mentioned, the Fed cut interest rates by 25 basis points on July 31st, but they did not definitively signal more rate cuts were coming, and disappointment from that lack of clear guidance, combined with growing worries over future economic growth, added to the volatility in August.
Finally, a closely watched part of the U.S. Treasury yield curve, the “10s-2s spread,” inverted (meaning that yields on shorter-term notes exceeded those of longer-term notes) for the first time since 2007. This signal has historically preceded a recession by an average of 18 months, although admittedly, it’s not a perfect indicator. Regardless, seeing this signal for the first time in over a decade led to a deterioration in investor sentiment and added to the August volatility.
Despite this trifecta of headwinds, markets again showed impressive resilience in the final month of the quarter, just as they did in the second quarter of 2019.
Early in September, there was improvement in U.S.-China trade relations as President Trump authorized a short delay on the implementation of some of the recently announced tariff increases, and both the U.S. and China agreed to face-to-face meetings in October in another attempt to end the now 18-plus-month trade war.
Additionally, the Federal Reserve cut interest rates for a second time on September 18th and clearly signaled more willingness for future cuts if conditions warranted further action.
Finally, after a brief period of being inverted, the yield curve normalized in early September in part due to better-than-expected U.S. economic data and subsequently easing concerns of a future recession.
Due to the improving market fundamentals listed above, the S&P 500 rebounded solidly in September and came close to matching July’s all-time highs, although the initiation of an impeachment investigation by the House of Representatives on President Trump caused a modest pullback late in the month.
In sum, the volatility we witnessed in the third quarter, which remains historically typical, was not surprising due to the numerous macroeconomic uncertainties facing this market and the economy.
But the third quarter was also a reminder that volatility does not automatically mean poor performance. Resilient corporate earnings, stable U.S. economic growth and an accommodative Federal Reserve combined with rising optimism towards U.S.-China trade to offset the volatility and deliver another quarter of positive returns.
Third Quarter Performance Review – Defensive Sectors Outperform
Major index returns were somewhat mixed in the third quarter as three of the four major indices, the S&P 500, Nasdaq 100 and Dow Jones Industrial Average, finished the quarter with positive returns, while the Russell 2000 saw negative returns. That mixed performance largely reflected the deterioration in U.S.-China trade relations and rising concerns about global economic growth.
By market capitalization, large caps once again outperformed small caps, which is a continuation of the trend witnessed in the second quarter. Large-cap outperformance was partially due to investors reacting to rising future recession fears, as large caps are historically less sensitive to a slowing economy. From an investment style standpoint, growth outperformed value due to strength in consumer sectors, industrials and large-cap tech.
On a sector level, eight of the 11 S&P 500 Index sectors finished the third quarter with positive returns. But in a departure from the first two quarters of 2019, traditional defensive stock sectors with high dividend yields (like utilities and REITS) handily outperformed. Falling Treasury yields and concerns about future economic growth fueled the outperformance of these higher-yielding sectors.
Sector laggards, meanwhile, were the same as the second quarter. The energy sector experienced negative returns again thanks to further declines in the price of oil and the healthcare sector was pressured by continued political risks via increasing calls for the expansion of government healthcare programs, dubbed “Medicare for all,” and consistent, yet so far unsuccessful efforts by the government to lower the cost of prescription drugs.
|US Equity Indexes||Q3 Return||YTD Return|
|DJ Industrial Average||1.83%||17.51%|
|S&P MidCap 400||-0.09%||17.87%|
Looking internationally, foreign markets saw negative returns in the third quarter thanks primarily to concerns about global economic growth. Foreign developed markets declined but relatively outperformed emerging markets due to the European Central Bank cutting interest rates and restarting its quantitative easing (QE) program for the first time since September of 2018. Emerging markets, meanwhile, saw moderate declines thanks to concerns about global economic growth, combined with pressures from a stronger U.S. dollar.
|International Equity Indexes||Q3 Return||YTD Return|
|MSCI EAFE TR USD (Foreign Developed)||-1.00%||13.35%|
|MSCI EM TR USD (Emerging Markets)||-4.10%||6.23%|
|MSCI ACWI Ex USA TR USD (Foreign Dev & EM)||-1.70%||12.06%|
Commodities again experienced mixed returns as gold continued to surge and hit fresh multi-year highs while oil declined. Gold rallied in the third quarter thanks to global central bank rate cuts (the Fed and European Central Bank) and an increase in geopolitical tensions (especially with respect to the U.S. and Iran). Meanwhile, oil was volatile last quarter as short-lived geopolitically driven rallies related to the bombing of a Saudi Arabian oil production facility were offset by rising concerns over slowing global economic growth reducing future energy demand.
|Commodity Indexes||Q3 Return||YTD Return|
|S&P GSCI (Broad-Based Commodities)||-4.18%||8.61%|
|S&P GSCI Crude Oil||-6.93%||18.15%|
|GLD Gold Price||4.26%||14.53%|
Switching to fixed income markets, bonds were broadly higher in the third quarter, as we’d expect given global rate cuts, rising concerns about future economic growth, and still subdued inflation readings. The leading benchmark for bonds (Bloomberg Barclays US Aggregate Bond Index) experienced solidly higher returns for the fourth straight quarter.
Looking deeper into the fixed income markets, longer-duration bonds once again outperformed those with shorter durations, which is a continuation of what we observed in the first half of 2019 and reflective of a market that is responding to the recent rate cuts and threats of potentially slowing economic growth.
Corporate bonds saw solidly positive returns in the third quarter, although investment-grade bonds handily outperformed high-yield bonds, and that move to higher-quality corporate debt also underscored concerns about future economic growth and corporate earnings.
|US Bond Indexes||Q3 Return||YTD Return|
|BBgBarc US Agg Bond||2.27%||8.52%|
|BBgBarc US T-Bill 1-3 Mon||0.54%||1.76%|
|ICE US T-Bond 7-10 Year||2.72%||9.85%|
|BBgBarc US MBS (Mortgage-backed)||1.37%||5.60%|
|BBgBarc US Corporate Invest Grade||3.05%||13.20%|
|BBgBarc US Corporate High Yield||1.33%||11.41%|
Fourth Quarter Market Outlook
Once again, the S&P 500 successfully weathered an increase in volatility this past quarter, as positive current economic fundamentals, interest rate cuts, better-than-expected corporate earnings and renewed hope for resolution on U.S.-China trade helped the S&P 500 maintain strong year-to-date gains.
However, the increase in volatility we saw in May, and again most recently in August, is an important reminder that while markets remain broadly resilient, risks to investment portfolios and the economy need to be carefully monitored. There are still multiple unknowns currently facing investors as we begin the final three months of 2019.
Trade, the Economy, and the Fed
First, the ongoing U.S.-China trade war is clearly the most important influence on the markets. And while there has been rising optimism for some sort of temporary resolution, the fact remains that the U.S. and China still have substantial tariffs in place on imports, with more potentially coming in December. Those tariffs continue to be a headwind on global economic growth, and slowing global growth is a risk to markets that we will continue to watch closely.
Turning to the economy, the outlook remains uncertain. Currently, U.S. economic growth is solid and the envy of the world’s developed economies. And, accommodative policy by the Federal Reserve will continue to support that growth. However, Fed rate cuts don’t bring guarantees of sustained periods of economic growth, and the ongoing U.S.-China trade war, combined with tariffs on European imports, heightens the risk of an economic slowdown. Fortunately, the U.S. consumer remains confident and their wages are rising, key factors in heading off any threat of a near-term recession.
Peaking Stock Market – an October Surprise?
While October is historically a frightening month for investors (1907 panic, Crash of 1929, and Black Monday in 1987), the period from October through January generally serves as the best time of the year for stocks. 2018 was an exception as the Federal Reserve raised interest rates despite growing evidence of economic sluggishness.
Judged from a historic perspective, the market was in a topping process when three or more of the above conditions were present. A recession has occurred within 12 months when four or more conditions were present. Currently, we are not seeing the warning signs necessary to act as a “call to action” to become more cautious with our stock allocation. Indeed, the recent inverted yield curve condition between the 2-yr. Treasury bond and the 10-yr. Treasury bond, a harbinger of past recessions, has now returned to a non-inverted status.
International stocks, while underperforming their U.S. counterparts again this year, have still registered solid returns despite slowing economies, negative interest rates, and political instability. As international markets are trading at historical discounts to their norms and their economies are flush with liquidity, we believe that it’s still prudent for clients to allocate a portion of their stock allocations to foreign investments.
As interest rates have fallen so dramatically this year, bonds are extremely expensive when compared to stocks. Within bond allocations, we maintain our focus on owning quality bonds in client portfolios to hedge against potential stock market risk. This risk could take the form of negative developments in global trade disputes as well as downward revisions in corporate earnings’ forecasts for 2020.
Finally, both domestic and geopolitical dramas require close watching over the coming months. Domestically, the impeachment inquiry of President Trump has the potential to weigh on investor sentiment, while internationally U.S.-Iran tensions are as high as they’ve been in years, and any conflict between the U.S. and Iran will almost certainly be a negative for stocks, broadly speaking.
Bottom line, U.S. markets were resilient in the third quarter and the performance of most markets year to date remains impressive. However, our experience has taught us that while markets may be resilient, risks still need to be monitored closely, and so we will continue to do so as we have all year.
What happens next with the U.S.-China trade war (will there be a trade truce?), Federal Reserve policy (will the Fed cut rates again in 2019?), and future economic growth (does the yield curve invert again?) will likely determine whether markets maintain, and potentially add to, year-to-date gains—or whether we see similar bouts of volatility like we did in May and August of this year.
We understand that markets always face uncertainties at the start of a new quarter, and we are committed to monitoring these situations and their impact on the markets and your portfolio. Positively, current corporate and economic fundamentals remain solid, and it is those factors that determine the longer-term path of markets, not the latest political drama or salvo in the U.S.-China trade war. Patience has always been rewarded in the stock market, and pullbacks should be seen as opportunities to add to holdings.
At McKinley Carter Wealth Services, we understand that volatility, regardless of the cause, can be unnerving, even if it is historically typical. That’s why we remain committed to helping you navigate this ever-changing market environment, with a focused eye on ensuring we continue to make progress on achieving your long-term investment goals.
Our years of experience in all types of markets (calm and volatile) have taught us that successful investing remains a marathon, not a sprint. Therefore, it remains critical to stay invested, remain patient, and stick to a plan. That’s why we’ve worked diligently with you to establish a personal allocation target based on your financial position, risk tolerance, and investment time horizon.
The strong YTD market performance notwithstanding, we remain vigilant in monitoring risks to portfolios and the economy, and we thank you for your ongoing confidence and trust. Rest assured that our entire team will remain dedicated to helping you successfully navigate this market environment.
Please do not hesitate to contact us with any questions, comments, or to schedule a review.