— 2019 Q2 Update —
SUMMARY & HIGHLIGHTS
We are experiencing a variety of conditions making for a complex market analysis for the second quarter comprised of some very bullish indicators as well as some very bearish ones.
These were some of the situations impacting this quarter:
- G-20 summit meeting between President Trump and President Xi had a positive conclusion.
- The yield curve is still inverted at the 3-month Treasury bill and 10-year Treasury bond maturities.
- The Federal Reserve is taking a dovish stance on policy.
- Conflict with Iran is causing anxiety in the markets.
- Low inflation combined with extended growth puts the Federal Reserve in a tricky situation.
Please read on for a detailed market analysis and in-depth explanation of these indicators and the effects they have on the economy.
QUARTERLY MARKET ANALYSIS
Half of 2019 is in the books and investors that have been in domestic equities for the past 6 months should have a smile on their face. After S&P 500 investors experienced a 13.07% arithmetic return and a 6.68% standard deviation in quarter one of 2019, those same investors saw an arithmetic return of 4.58% and annualized standard deviation of 5.79% in quarter two of 2019. The market would return 17.49% if quarter 2 returns were extrapolated over four consecutive quarters, which is hardly anything to scoff at. However, this return wasn’t close to quarter one’s return and some investors may question why. What were the main differences between the two quarter’s that caused such a discrepancy in returns and will that discrepancy disappear or will the returns diverge even further from quarter one? In order to answer these questions, we need to understand the structural changes in the economy during quarter two because the returns and volatility tend to be simply a derivative of those structural changes.
In comparison to quarter one, the second quarter of 2019 was defined by low market volatility, relatively low stock market returns, trade-war escalation, trade-war de-escalation, extended yield curve inversion (3-month Treasury bill yield minus the 10-year Treasury bond yield), a dovish Federal Reserve (Fed), lower global growth estimates by the International Monetary Fund, and political conflict in Iran. An important structural signal the economy has shown in 2019 is lower average inflation when compared to 2018 based on annualized monthly CPI numbers (a common proxy used to measure inflation). As of May 1st, 2019 (latest data available) the average annualized CPI for 2019, or inflation rate, is 1.8% versus 2018’s 2.4% inflation average.
Source: Federal Reserve Bank of St. Louis
The CPI is an important metric because according to the Fed’s website, their three main goals are: “maximum sustainable employment, stable prices, and moderate long-term interest rates.” The Fed has the first two of these three mandates under control, with the latter being elusive since quantitative easing. According to the Federal Reserve bank of St. Louis, the civilian unemployment rate is at 3.6% which is the lowest that indicator has been since August of 1969 which satisfies their mandate of “maximum sustainable employment”. Even though employment is doing remarkably well, the Fed is having a difficult time raising inflation to their target level of 2%. To raise the inflation rate the Fed typically uses monetary policy to lower interest rates in an attempt to jump start the economy and lead to higher inflation. However, one of the main problems the Fed is running into is the interest rate floor. We have already experienced the longest bull market in US history and we still have low inflation, which means that the Fed is in the quandary of having to lower interest rates during the longest bull market in history instead of the Fed raising interest rates during a bull economy to lower inflation, which has been the normal routine of the past. This goes directly against their third mandate of keeping “moderate long-term interest rates.”
This interest rate, growth, and inflation conundrum is an interesting problem because it is unique. Unfortunately, it is a problem that could ultimately lead to negative consequences in the long term. One of the consequences of extremely low interest rates is that fixed income money managers have a difficult time finding the yield that they need in order for them to provide adequate returns for their investors. This issue for fixed income money managers creates a market for financial engineers to create complex products that produce the yield these money managers are searching for. These complex products may create unknown risks within the financial system and can create a contagion effect that can jeopardize the entire financial system, circa subprime mortgage and collateralized debt obligations in 2008. Another long-term consequence of extremely low interest rates during the tail end of the longest bull market in history is the lack of tools the Fed will have if we go into recession. The Fed normally lowers short term interest rates extremely fast during a recession in order to jumpstart the economy and there is essentially a floor interest rate at 0%, therefore, they cannot use this tool forever because interest rates cannot go down forever. This is like a doctor having only a few charges on a defibrillator and using all the charges on a healthy person before a heart attack. Once the heart attack (recession) actually happens, it can be much more difficult to save the person’s life (jump start the economy). Getting away from the analogy, another problem with falling into a recession during this economic climate is we’re already in a low inflationary environment which means we will risk falling into a deflationary environment that can cause a negative feedback loop likely further damaging the American economy.
The trade-war escalated in May when talks fell apart between China and the United States. According to the South China Morning Post, “The Trump administration accused the Chinese side of backtracking on key legal commitments on issues such as market access, intellectual property protection, and forced technology transfers. The Chinese side accused the US of repeatedly changing their demands.” After that news came to light, it was clear that the trade war was escalating. According to Michael Penn of Aljazeera, “Trump more than doubled import tariffs on $200bn worth of Chinese goods to 25 percent in May. He has also threatened to impose tariffs on another $325bn of goods, covering nearly all the remaining Chinese imports into the US, including consumer products such as mobile phones, computers and clothing.” An increase in tariffs from the current levels will likely increase headwinds for global growth. According to Michael Penn, “Economists, including International Monetary Fund (IMF) Managing Director Christine Lagarde, have warned that global economic growth could suffer if the trade war is not resolved soon. Earlier this month, the IMF said current and threatened US-China tariffs could cut 2020 global gross domestic product (GDP) by 0.5 percent, or about $455bn - a loss larger than G20 member South Africa's annual economic output.”
The trade-war escalation injected quite a bit of uncertainty into the financial markets leading up to the G20 summit where President Trump of the United States and President Xi of China were set to meet to discuss the trade war. According to Rich Miller of Bloomberg, “Trump and Chinese President Xi Jinping decided on Saturday (June, 29th) to resume trade negotiations after a six-week stalemate, with the U.S. agreeing to a temporary freeze on further tariffs on Chinese goods.” We believe this is a clear de-escalation of the trade war and a very bullish sign for equities in quarter three. The original tariffs are still standing which will pose headwinds towards global growth but the markets will likely reprice now that $325bn of new tariffs are not going to be added, as of now.
Another event that has been causing uncertainty in the financial markets is the United States and Iran conflict currently happening. According to CNBC, “Tensions between the United States and Iran escalated rapidly after an American drone was shot down by Iranian forces in the Middle East on Thursday — but experts are not expecting it to lead to an outright military conflict.” Even though the probability of a war happening appears to be low, there is a much higher probability of smaller military conflicts happening. According to the New York Times, “Trump approved military strikes against Iranian targets, but later withdrew from launching the planned attacks.” Iran controls a large portion of the world’s oil supply, and any disruption to the supply of oil will have ripple effects throughout the economy. According to OPEC at the end of 2017, “81.89% of the worlds proven oil reserves are located in OPEC Member Countries, with Iran controlling 12.8% of that supply.” This is a significant supply of oil and if Iran’s economy is materially damaged by war or US sanctions it will likely add more headwind to a global economy that is already climbing an uphill battle for growth. However, the main reason this didn’t cause a lot of turmoil in the financial markets in quarter two is because not much actually transpired as a result of these tensions. There was a lot of uncertainty without much action. Extended uncertainty puts investors in a tough situation because they cannot update their views on the markets without adding in extreme speculation. Volatility truly takes rise once new information comes to light and differs from what is currently priced into the markets. Therefore, if a large event suddenly happened that wasn’t already priced into the market, the markets would experience volatility in an attempt to correct the previous mispricing.
In aggregate, these different indicators paint an extremely complex picture. The picture is complex because some of these indicators are extremely bullish signs, such as the Federal Reserve taking a dovish policy stance and the de-escalation of the trade-war; and some are extremely bearish sign, such as extended yield curve inversion and tensions in the Middle East with Iran This complexity is why it is important to separate the structural endogenous indicators from the derivative indicators in order to clear the view.
Essentially, which indicators are “cause” and which indicators are “effects”. In the “cause” bucket, we have trade-war escalation, trade-war de-escalation, dovish Federal Reserve, and political conflict in Iran. In the “effect” bucket, we have low market volatility, low stock market returns. There are also second derivative indicators that react based on the “effect” bucket, such as the lower inflation number in 2019 versus 2018. Lastly, the hybrid indicator that has pieces of structural, first derivative, and second derivative aspects is the yield curve. The yield curve changes at different tenors based on different factors. Monetary policy influences the shorter maturity end the most and the farther the yield curve goes out the more it is usually influenced by investor’s long term expectations of the markets. Therefore, the yield curve will react to expected growth in the economy, expected/actual inflation, unemployment, investor’s preferred holding periods, and countless other factors.
Astute readers might realize the disconnect between the cause and effect here. At first glance it would appear that these causes would cause extreme volatility in the equity markets, which is something we didn’t have in quarter two. Part of the reason for this disconnect is that the markets have been in a quasi-purgatory state, waiting for answers to these structural issues.
There are a few big questions that are yet to be completely answered, such as:
- Will the US-China trade war be resolved?
- Will the United States go to war with Iran or put economic sanctions on them?
- Will the Federal Reserve actually lower interest rates in July?
We will not have the answers to these questions until the events actually happen. This type of uncertainty is why it is important to regularly review your portfolio allocation with your financial advisor. If you have gone awhile without rebalancing your portfolio or updating the strategic asset allocation assigned to your portfolio, you might be taking on unwanted risks that do not fit your true risk profile. As these unanswered questions get answered the market will react accordingly and you want to make sure you understand the intrinsic risks you are taking on as well as the potential rewards you can receive for assuming those risks. Along with understanding the risks, it is important to understand how your portfolio has shifted since the last time it was rebalanced. Equities have greatly outperformed in 2019 and if your portfolio hasn’t been rebalanced during the latest bull run, it is possible your portfolio is overweight equities. The tandem of understanding your strategic asset allocation and how it has shifted over time can give you the necessary tools to withstand the changes in financial markets.
Sources:
https://www.opec.org/opec_web/en/data_graphs/330.htm
https://www.federalreserve.gov/
The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of The Lincoln Investment Companies. The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss. The Federal Reserve System (the Fed) is the central banking system of the United States and controls the Federal Funds Rate (aka Fed Rate), an important benchmark in financial markets used to influence the supply of money in the U.S. economy. S&P 500 Index is an index of 500 of the largest exchange-traded stocks in the US from a broad range of industries whose collective performance mirrors the overall stock market. Investors cannot invest directly in an index. Inflation is the rise in the prices of goods and services, as happens when spending increases relative to the supply of goods on the market. Moderate inflation is a common result of economic growth. A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession. Deflation is the decline in the prices of goods and services. Generally, the economic effects of deflation are the opposite of those produced by inflation, with two notable exceptions: (1) prices that increase with inflation do not necessarily decrease with deflation; (2) while inflation may or may not stimulate output and employment, marked deflation has always affected both negatively. The International Monetary Fund is an international organization that was initiated in 1944 at the Bretton Woods Conference and formally created in 1945 by 29 member countries. Consumer Price Index (CPI) measures prices of a fixed basket of goods bought by a typical consumer, widely used as a cost-of-living benchmark, and uses January 1982 as the base year.