One may be surprised to learn that the Standard & Poor’s 500 Stock Index is entering the fourth quarter of 2019 with a +20.55% gain for the year — its best performance since 1997. Further, the advance this year has materialized concurrently, with both bonds and commodities that have experienced considerable rallies. It is not often that we witness increases in historically safe assets like U.S. Treasury bonds alongside a riskier asset class like U.S. stocks.
Major U.S. markets ended the quarter mostly higher despite mixed economic data and the persistence of trade tensions. In the U.S., the Dow Jones finished up 1.83% while the S&P 500 was up 1.70% and the NASDAQ up 0.18%. Once again, the U.S. outperformed global peers as the dollar continued to strengthen. The MSCI EAFE (Europe, Australasia and Far East) finished the quarter down 1.00% while the MSCI Emerging Market Index ended down 4.16%.
The Fixed Income markets had a wild quarter, which saw interest rate volatility spike. August saw the ten-year bond temporarily trade lower than the two-year bond (aka “inversion”) while all Treasury maturities ended the quarter with lower yields. As expected, the U.S. Federal Reserve cut interest rates twice during the quarter for the first time since 2008. The result saw the Bloomberg Barclays Aggregate rise by 2.27%, while municipals advanced by 1.58% and high yield sold off by 0.67%.
Commodities were mixed over the quarter as crude oil sold off 7.13% while gold finished the quarter up 5.20%
We enter the fourth quarter with more questions than answers as it pertains to the path of both the economy and the financial markets. As the global slowdown, trade fears, Brexit concerns, and unrest in Hong Kong continued to weigh on sentiment, two new developments made news in September: 1) the Fed fought an unexpected liquidity imbalance in the money markets, and 2) the House of Representatives announced an impeachment inquiry.
While the imbalance in the money markets (caused by a mismatch between overnight funding supply and demand) lasted only a couple of days, it did bring up memories of 2008 when this phenomenon was a regular occurrence. We do not believe this is a risk.
The impeachment inquiry, on the other hand, will likely last months, which will prevent both the House and Senate from moving forward on new legislation. While the likelihood of impeachment by the House is currently high (71% as of 10/7/2019 according to PredictIt.org), the likelihood of the Senate convicting President Trump remains low (18% as of 10/7/2019 according to PredictIt). If these predictions remain steady, we feel that the likelihood of the impeachment proceedings adversely affecting the economy should remain low.
Similar to earlier bouts with volatility, recent data has pundits questioning U.S. growth and renewing calls for a recession. The principal weak spot in the global economy continues to be manufacturing. That being said, data can be misleading as the recent reading of 47.8 merely means that 47.8% of respondents to the Institute of Supply Management (ISM) reported growth in their sector. Markets generally want to see more than 50% of respondents reporting.
While we believe the ISM manufacturing survey is important psychologically, we also acknowledge that manufacturing is a small percentage of the overall U.S. economy (11.3% according to the most recent data from the World Bank) and much lower than some of our global peers (China = 29.4%; Germany = 20.8%). Services, on the other hand, represents more than 70% of our economy and, while slowing, continues to expand. A reading below 50 for the service sector would be a more ominous sign regarding the economy.
We view the recent soft patch in the economy similarly to that of 2012 and 2016 and believe it to be cyclical weakness within a secular bull market. We believe the economic expansion is intact, supported by dovish central banks and a healthy consumer. The result should support moderate risk-taking even as recent events reinforce our desire for a greater focus on portfolio resilience.
We believe the Fed will continue to cut rates, but a prolonged period of easing is less likely as the current supply chain disruption is proving to hurt industrial capacity, which could create higher inflation regardless of slower growth. This could complicate policy moving forward, as controlling inflation is a part of the Fed’s mandate.
Globally, central banks have pivoted to looser monetary policies, which will continue to prove that monetary strategies are fungible. The farther rates sink globally, the farther they will decline in the U.S. The result has created a conundrum where more than 25% ($15 trillion) of global bonds now trade with a negative yield. While we believe this will continue to put pressure on interest rates, we would be surprised to see U.S. bonds trading below 0%. Rather we believe this phenomenon will keep a ceiling on rates and hence believe U.S. bonds can be used as a source of protection in the case of further economic weakening.
Thus far in 2019, the Fed pivot to a looser policy has been a tailwind for equities, but much of the advance has been driven by multiple expansion (rising price to earnings ratios). For the markets to continue to grow, we believe earnings growth will be crucial. Wall Street consensus is that there will be earnings growth of 10% in 2020, which would support a continuation of this year’s market rally. As we move through the quarter, we will be listening to corporate guidance as ultimately, the value of a stock depends on the outlook for earnings.
The current investment environment provides an occasion to reiterate investment observations:
- The services sector of the U.S. economy is more important than manufacturing sectors.
- U.S. markets remain in a secular bull market, which continues to reward long-term investors who benefit from staying invested over time. Cyclical soft patches will occur.
- Headlines remain a distraction that should generally be downplayed. Emotions should be suppressed as long-term objectives and risk tolerance should guide your investment decisions.
- Market corrections, like those experienced in May and August, are normal. These corrections ultimately are opportunities to buy risk assets at lower prices.
- Fixed income investments provide a hedge to equity risk.
Again, we would like to thank you for your relationship and interest in following our thoughts. We encourage you to contact your portfolio manager with any investment questions, concerns, or perspectives as 2019 continues to unfold.
You may reach us at 610-975-4300, or email email@example.com.
Mr. Heckscher is Senior Vice President, Director of Fixed Income, and Chief Investment Officer of Pennsylvania Trust.
Disclosure: This Commentary represents a review of topics of possible interest to Pennsylvania Trust’s clients and is not personalized investment advice. It contains Pennsylvania Trust’s opinions, which may change following the date of publication. Information obtained from third-party sources is assumed to be reliable but is not guaranteed. No outcome — including performance — is guaranteed, due to various uncertainties and risks. This document is not a recommendation of any particular investment. Investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Past performance is no guarantee of future results.