Quarterly Market Review and Outlook
Q3 2019 Economic / Market Re-Cap
The U.S. Stock Market (i.e., S&P 500) continued the upward trend of 2019 in the 3rd Quarter albeit at a slower pace than the previous two quarters. The S&P 500 gained a little more than 1.0% in the 3rd Quarter.[i] While the U.S. Stock Market continues to chug along, the rest of the World experienced a decline during the last three months.[ii]
The U.S. Bond Market continues to impress as the Federal Reserve has reversed course from 2018 and lowered interest rates. For 2019, the broad U.S. Bond Market returned 8.3%.[iii] Foreign central banks have kept interest rates low or have initiated their own interest rate cutting program, which has served as a tailwind for the International Bond Market. The Global Bond Market excluding the U.S., is up around 9.0% in 2019.[iv]
Taken as a whole, investors should have very little to complain about so far in 2019 as the vast majority of asset classes are experiencing solid returns after a tough 2018.
As always the million dollar question is, how long will it continue?
Q4 2019 & Beyond Outlook
Interest Rate & Federal Reserve Update
After increasing interest rates multiple times in 2018, Federal Reserve Chair Jerome Powell and his brain trust have solidly reversed course in 2019 by cutting interest rates twice. The latest iteration occurred in September, when the Federal Reserve lowered interest rates by 0.25%.[v] This move was well telegraphed in advance so market reaction was fairly benign.
Many investors, economists and market participants are debating whether interest rate cuts are warranted. As usual, the answer is not a simple one. Depending upon your point-of-view, interest rate cuts are not currently warranted due to low inflation and positive economic growth. The counter to that argument is that the economy is slowing due to ongoing Chinese-U.S. trade tensions and the emergence of an inverted yield (in spite of the recent interest rate cuts, the yield curve remains inverted).[vi]
The Federal Reserve is left playing a dangerous game of chicken. If they do not lower interest rates, then some market participants and investors are likely to overact, increasing the probability of a significant market decline. If they do lower interest rates, then they reduce their ammo supply to fight a truly unexpected, significant economic event.
Whichever side of the equation you fall, it appears almost certain that the Federal Reserve will again lower interest rates at their October meeting. Currently, the Fed Funds Futures is pricing in a 93% probability of a 0.25% interest rate cut in October,[vii] with the likelihood of an additional decease at the December meeting.[viii] Assuming both of the interest rate decreases occur, the Federal Reserve will have undone everything they did in 2018.
One topic we often discuss with clients in relation to interest rates and the Federal Reserve is inflation. The conversation is fairly simple: why aren’t we seeing inflation if the Federal Reserve/U.S. Treasury has dumped so much liquidity into the economic system? One relatively simple explanation is that in the aftermath of the 2008-2009 Financial Crisis, regulations required banks to maintain larger excess reserves. Currently, there is $1.4 trillion of excess reserves in the banking system.[ix] Said plainly, a large portion of the money dumped into the economic system remained in the banks via regulation from those that injected the money.
We would anticipate greater degrees of inflation, and potential economic expansion, if these excess reserves immediately flooded the U.S. economy. However, we’d suggest that the probability of that is low in absence of a significant political/regulatory shift. Thus, we’d anticipate inflation remaining subdued for the time being, which means that the Federal Reserve has some leeway in keeping interest rates low for the time being.
Global Stock Market Conditions
As mentioned above, both U.S. stock markets and Global stock markets have experienced robust gains so far in 2019. In spite of the positive returns, if you turn on the nightly news or check out financial news websites, you’d think that you’d be well advised to prepare for an imminent disaster! Such is life when we live in a 24-hour news environment.
We continue to preach that historically the primary driver of a Bear Market (a 20%+ decline) is a recession. Historically, the stock market does not blow up because of Twitter, a newspaper article, impeachment, Middle Eastern turmoil or anything else that changes the headlines on a day-to-day basis. Generally, the stock market is highly connected to the economy and the profitability of companies.
First, let’s look at the profitability of companies that reported earnings during the 3rd Quarter. Of the companies that make up the S&P 500, 74% reported earnings above analyst estimates.[x] To provide some context, that compares favorable against the long-term average of 65% beating estimates.[xi] To be fair, this is backwards looking data, but generally speaking companies do not go from profitability to deficit overnight. Bear markets are always a possibility, but it appears currently that the prospect for a major stock market breakdown (20%+ decline) in the immediate future are below average.
We would continue to suggest that it is prudent to remain vigilant of market volatility. One topic that we have not previously discussed at length is investors’ increased reliance on computers and algorithms to make trade decisions. Some of the latest trends in money management include minimum volatility and momentum investment strategies. While these strategies certainly have a place that we find useful it is important to remember nothing is perfect.
Without getting into the dorky technicalities, these investment strategies make investment decisions based upon a set of predetermined rules or criteria rather than human input. The relevance of this topic is that algorithms and computers can accelerate trading during periods of volatility. If the design is to prevent/decrease the scale of loses, then the algorithms execute sell orders. More sell orders equals falling stock prices. Thus, selling begets selling. This is simply to serve as a reminder that there are multiple moving parts that occur every day within financial markets that go beyond politics or the news cycle.
With that being said, we continue to suggest that the stock market is not at an insanely overbought level. In fact, several of our trusted data sources suggest that the stock market may even be slightly undervalued.[xii][xiii]
Global Economic Environment/Trade Dispute Update
If companies continue to appear to be profitable, then we should turn our attention to the economy in order to get a gauge on the prospects of a recession/Bear market.
The Federal Reserve Bank of Atlanta’s current projections for U.S. economic growth in the 3rd Quarter is 1.8%.[xiv] Not the growth that we experienced in Q1 or Q2, but certainly not recessionary. We will receive the initial estimate on October 30th.[xv]
There are some data points that suggest that the U.S. economy may be slowing. The ISM Manufacturing Index declined to 47.8 in September (any number under 50 signals contraction).[xvi] Said simply, this report suggests that the manufacturing sector of the U.S. economy is contracting or is in a recession. Before that scares everyone, we’d point out that manufacturing only makes up about 10% of economic production in the U.S.[xvii] Further, most economists blame manufacturing slowdowns on Chinese-U.S. trade tensions, a tight labor market and increased automation.
Unfortunately, the picture that is often painted within the media is one on either end of the spectrum. Either things have to be horrible or perfect. We know through our own lives that reality typically resides somewhere in between. It is unusual for life to be either completely, unbearably horrible or absolutely perfect. The same applies to economic analysis. We’d suggest that the reality is that the U.S. economy is not at the brink of collapse, but it is slowing from previous quarters for multiple reasons.
Beyond the U.S. shores, the picture does get a little bleaker. Especially in Europe, where Brexit is close to a train wreck and the German economy is staring down the barrel of a recession.[xviii] The U.K. and Germany are two of the significant economic powers in Europe. Both falling into recession would be less than ideal.
The biggest global economic news story continues to be the ongoing trade war between the U.S. and China. Obviously, it is borderline impossible to predict a specific outcome. We think that it is fair to say that both countries are being impacted by the ongoing trade dispute. As we mentioned in our previous newsletter, businesses are moving away from China to seek cheaper labor amid increased tariff costs. The optimistic viewpoint is that if a trade deal is implemented, then we’d anticipate the potential for further economic growth and market gains to be significant.
There are always fireworks in the geopolitical arena. The most prominent geopolitical event in the 3rd Quarter was probably news of House Democrats opening a probe into a phone call between President Trump and Ukrainian President Zelensky.
The idea that Democrats may try to find reason to initiate impeachment proceedings against President Trump is nothing new. Instead of looking into the political chess match, we will focus on the potential impact upon the financial markets. Granted we don’t have a lot of historical data to assess (Nixon and Clinton-we are not going to count Andrew Johnson). In both instances, the stock market did experience a period of decline during the lead up to Nixon’s resignation and Clinton’s impeachment. However, the declines were both fairly limited.
Further, the U.S. economy was in the midst of a recession during Nixon’s investigation and resignation. Whereas in 1998, the U.S. economy was in full blown expansion mode. From our perspective, this small sample size drives home the notion that while impeachment proceedings could cause some short-term volatility it is unlikely to cause a full blown stock market crash or recession. Finally, we remind folks that for President Trump to be removed from Office, the Senate (Republican controlled) would have to vote to convict on a 2/3s majority. This seems highly unlikely based solely upon the transcript of a phone call.
There will always be optimists and pessimists. We like to think of ourselves as realists. The reality is that there are events to be excited about and cautious about.
We should be excited that financial markets have produced solid returns this year. We should be excited that the U.S. economy continues to chug along. We should be excited about low interest rates serving as a tailwind to the home buying industry.
We need to be cautious of a slowing economy. We need to be cautious if companies begin to report earnings that are less than stellar. We need to be cautious of trade disputes and impeachments.
However, the reality is that most of that stuff has little bearing upon the long-term success or failures of our financial goals. The reality is that we all need to spend more time focusing on things that we can control:
- How much money do we contribute towards our financial goals?
- How much money do we spend to maintain our lifestyle?
- Is our job/business running as efficiently as possible?
- Is our family/business going to be protected should something unexpected happen?
We have control and influence over these things and we are here to serve clients in assessing those questions.
Finally, we’d bring back that age-old reality that having all of your eggs in one basket is not the best strategy. We believe that a prudent investment strategy includes all asset classes (i.e., stocks, bonds, alternatives and cash). The reality is we need some money in stocks, bonds, alternatives and cash almost all of the time.
Stick to reality, you’ll maintain a higher degree of sanity. Well, maybe…
Thank you for your continued trust and confidence.
We hope that everyone has a great rest of 2019!
[v] “Transcript of Chair Powell’s Press Conference”. September 18, 2019. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20190918.pdf
[ix] Wesbury, Brian S. & Stein, Robert. “Monday Morning Outlook: Repo Turmoil”. First Trust Advisors. September 30, 2019.
[x] Aurelio, David. “This Week in Earnings: Aggregate Estimates and Revisions”. Proprietary Research from Refinitiv. September 20, 2019.
[xi] Aurelio, David. “This Week in Earnings: Aggregate Estimates and Revisions”. Proprietary Research from Refinitiv. September 20, 2019.
[xiii] Brinker, Bob. “Bob Brinker’s Marketimer”. Volume 34, Number 10. October 4, 2019.
[xviii] “The Kiplinger Letter”. Volume 96, Number 36. September 6, 2019.