It was another roller-coaster ride of a week; one in which the most recent of market stress seemed to be attempting to mend. In fact, until Friday, the market was up a little more than 1% and the VIX, a widely watched measure of market volatility was beginning to appear calm. Investors appeared optimistic that Fed Chair Jay Powell would deliver a dovish and re-assuring tone during his speech in Jackson Hole, WY. In fact, most believe he delivered what the market was looking for: a conciliatory tone acknowledging that global economic conditions have continued to weaken since the late-July cut and monetary policy increasingly looks out of sync with the global situation specifically citing escalating trade friction.
If you watch the news today, it is almost certain you will learn the yield curve inverted (the 2yr/10yr spread) this morning for the first time since 2007. This will probably result in a challenging market experience today (and perhaps days ahead). You will also hear inversion – a condition where short term interest rates are higher than longer term rates – is significant because it sports a strong track record for correctly signaling that an economic recession develops at some point in the not distant future. With the curve flattening for the better part of 18 months, and some maturities first inverting earlier this year, we’ve discussed why we too believe the curve slope is relevant and worth monitoring. We do not dismiss the condition as insignificant; it signals that a policy mistake is being made and damage to the economy is building. It is evidence that monetary policy is too tight for the current economic situation as a whole and will become restrictive. The ongoing friction between the US and China over trade is part of that restrictive cocktail, and the Fed should not delay in responding further via additional rate cuts in the months ahead.
Almost as quick as the calendar flipped to August, the market’s backdrop and investor sentiment was altered. Just two weeks ago, the Fed made good on months of more dovish rhetoric by cutting its target for short-term interest rates by a quarter of one percent (25 bps). While some watchers were pining for a more aggressive move, the adjustment seemed all that was warranted given a stock market near all-time highs, low levels of unemployment, and trade talks between the US and China that were reportedly making progress following a late-June G20 meeting between Trump and Xi. But with a newspaper article and harsh tweet from Trump that fresh additional tariffs would be levied against China, the Fed’s easing move suddenly felt inadequate and behind the curve. Tensions between the US and China are again heightened, and some are calling the process of negotiation all but collapsed as China allowed their currency to depreciate in retaliation and appears to be slow-walking/stalling the process. They in no way seem urgent to strike a deal even as their economy is showing signs of stress as a result of tariffs. Chinese leaders instead appear of the perspective that in the “long-game”, a weakened global and US economy hurts Trump’s chance of re-election in 2020 – and their odds of a more favorable “deal” are higher when considering the stated positions of Democratic party hopefuls.
After beginning July with a strong posture, markets seem to be pausing to catch a breath. Domestic equities slipped -1.2% during the week ending July 19, effectively halving the month-to-date performance. It is challenging to point to any single factor or headline, but perhaps most notable is the reality that corporate earnings being reported for the 2Q period are soft. When combined with the reality that the market as a whole is up handsomely YTD despite what seems to be persistent negative headlines (be it trade, geopolitical tension, yield curve inversion, etc), it’s not hard to understand why the investment community’s prevailing sentiment is that the good times will not last.
With the exception of May, 2019 is probably surprising most everyone in the investing community in quite positive fashion. Despite the realities that both economic and corporate earnings data appear to be in a trend of slowing, AND continued tariff/trade and political uncertainty both the S&P500 and Dow busted through respective round-number levels of 3,000 and 27,000 last week. So far in July, the S&P500 is up another +2.1% bringing the YTD climb to more than 20%. About 86% of the S&P500 constituents trading above their 50-day moving average. In the short-run, this probably means the market is overbought and due for a pause – that idea is also significant when one considers we are entering what is traditionally a weaker seasonal period. But more important is the message it tells about momentum present under the surface. Interestingly, all of this has happened at the same time the yield curve has remained troublingly flat (or inverted depending on the maturities inspected).
Global equity markets are enjoying a swift recovery following their “distracting” adjustment last month. The S&P500 is up +5% over the first 10 trading days in June (thru 6/14), even as the trade dispute between the US and China is yet to show tangible signs of renewed repair. For the most part, improvement is being attributed to a more accommodating tone developing from Federal Reserve officials as they communicate their thoughts on the path of monetary policy and appear tipping their hat to a yield curve that is now inverted across some key maturities. The inversion in shorter-dated maturities is long thought a message that monetary policy is too tight for the economic conditions and outlook. It is in that regard that weaker economic data is now the market’s counter-intuitive friend. Just as strong economic data suggests to the Fed that tighter monetary policy is appropriate to keep the threat of inflation at bay, weaker data gives the Fed support to shift to an easier and more accommodating monetary policy even though the economic cycle is long. Bad news is good.
With just four trading days remaining for May, the “rear-view mirror-ists” will be quick to say investors should have expected the noticeable pullback coming (nevermind that the month of May was firmly positive in each of the last 5 years). The S&P500 is off -3.9% with most attributing the decline to renewed tension between the US and China over trade-related policy and the fact is that until recently, most investors anticipated a trade agreement was not just close, but a virtual certainty in early 2019. Combined with a US Fed that now seems firmly on hold from any additional interest rate hikes this year, the stock market enjoyed support. While the Fed still appears content with its patient posture (very important), a truce between the US and China on trade is no longer in clear sight. Interesting is that smaller-size companies which are often believed to be more insulated from the dynamics over global trade and should in theory experience less influence from tension are actually faring noticeable worse in this latest war of words. But more telling perhaps is that international equities and those domiciled in Asia especially are really getting crunched compared to US domiciled companies.
Following one of the best four-month stretches for equity markets in recent memory, the month of May is proving more challenging with the S&P500 experiencing its worst week of the year. Despite a better than expected quarter of economic growth during the 1Q and earnings that are not as soft as feared, optimistic sentiment of investors that propelled the markets to swift recovery is now deteriorating due to escalating tension between the US and China in its ongoing trade negotiation. The US view is that China backed away/recanted from prior commitments and broke the deal. As a result, the S&P500 suffered a setback of -2.1% last week even despite a late-day rise on Friday (perhaps a show of optimism that drama between the US/China might progress over the weekend). That trade-related uncertainty and market pressure looks set to continue into a new week on headlines that discussions over the weekend made little progress and actually seem to be moving further apart. Abroad, international equities and emerging markets in particular are being punished more acutely as evidenced by the MSCI EM index forfeiting -4.5% last week.
It should be news to no one at this point that 2019 is off to a fantastic start – at least for investors who continued to “stand in the pocket” despite getting repeatedly knocked down during 4Q’18. As many market participants believed at the time, the reaction by the financial markets to perceived slowing of economic growth that was anticipated (and is playing out) during the 1Q was overdone. But in fairness to investors, perceived Government missteps (or perhaps more fairly described as inflexibility) both on monetary policy evolution (Fed tightening) and Trade (US-China) made it hard to maintain confidence in officials being able to do the right thing for the US economy in the face of persistent international economic weakness and uncertainty. Since that time, sentiment on both items has turned more favorable, leading to a swift recovery for domestic equities. Investors also find themselves questioning whether they have been too pessimistic over international economic and financial market prospects. Significant economic, regulatory, and political uncertainties hampered international investing success for much of this 10-year cycle, but lesser acknowledged is how much has been done to improve monetary policy transmission in support of the banking system and economic growth. This sets international markets for potential out-performance especially when considering valuations overseas are more attractive than domestic on a number of measures and the currencies are cheap relative to USD.
The 1st Quarter concluded with each month firmly in positive territory and a cumulative advance for the S&P500 of +13.6% – a sharp reversal from the experience suffered closing out 2018. Interesting fact: since 1950 there are only 19 examples of the S&P500 starting a year with positive performance in January, February, and March and returns over the following 9 months historically came in above average (though mid-year corrections were just as likely). The early year improvement has been most attributed to a decidedly more deal-seeking tone on the issue of US-China trade and a US Federal Reserve that now appears firmly on break from any additional interest rate hikes or incrementally tighter monetary policies. While those developments are welcomed, the forward-looking message to be gleaned is far less clear. In recent weeks for instance, smaller-size companies along with transportation and industrial sectors have been laggards. Too, it is widely expected that the US economy has entered a decidedly more sluggish period of economic growth and safe-haven bond yields have drifted lower; a condition usually accompanied by a risk-off mood and caution.