EQM Capital LLC 2Q 2019 Market Review – Will Slow and Steady Win the Race?

Posted on Aug 29, 2019

Markets Sold Off in May, but Rallied in June

The U.S. stock market sits at record highs as the May market selloff, its worst May since 2010, gave way to a sharp market rally in the month of June.  The S&P 500 posted a strong 7.1% monthly return and is now up 18.5% for the year.

Growth continues to outpace value YTD, with the S&P 500 Growth Index up 20.2% versus the 16.7% return of the S&P 500 Value Index. Large caps continue to outperform small cap peers YTD, helped by a weaker dollar, with the Russell 2000 TR Index up 17%. 

Recent market gains have been fueled by investor optimism that the U.S. and China will reach a trade deal, and that central banks will step in with rate cuts if global economies falter and avoid a recession.

Slower Economic Growth and Tariff Impacts Spurring Fed to Lower Interest Rates

Tariffs, which drive up the cost of U.S. goods, have taken their toll on the U.S. corporate earnings from retail, housing, materials, consumer electronics, and autos, as the U.S. and China have placed billions of dollars of punitive tariffs on each countries’ imports.

There are indications of economic slowing not only in the U.S., but in the global economy as well. U.S. job growth slowed sharply in May, adding only 75k jobs, and wages rose less than expected.  This has put pressure on the Federal Reserve to cut interest rates this year. 

While the Fed kept interest rates unchanged in June, Fed chair Jerome Powell opened the door for future rate cuts, saying that the “case for somewhat more accommodative policy has strengthened.”  But shortly thereafter, comments from St. Louis Fed President, James Bullard, dampened hopes that the magnitude of the next rate cut would be half-a-percent. 

At quarter end, Fed Fund Futures were pricing in an 84.5% probability the Fed will cut interest rates in July. 

Anticipation that the Fed will lower interest rates in order to prevent an economic recession caused markets to rally in June. Furthermore, investors are hopeful that the US and China will broker a trade deal before the July 6th deadline when new 25% tariffs are scheduled to be implemented.

Here is what that scenario looks like, and it is not pretty!

Further helping market sentiment in June was the announcement by European Central Bank President Mario Draghi that their central bank planned to roll out fiscal stimulus in July, signaling that central banks still have some fiscal ammo left to help combat slower global growth.

Is Crypto the New Gold?

Besides stocks and bonds, gold and cryptocurrency assets have also been big beneficiaries of the trend toward lower rates, rising tariffs, and heating geopolitical tensions. These factors undermine the U.S. dollar, and gold and now cryptocurrencies, represent the ultimate “anti-dollar” trade.  Gold futures rallied 8% in June and Bitcoin was up a staggering 42% for the month. 

The rally in cryptocurrencies was also spurred by announcements, such as Facebook’s announcement that it was launching its own coin named “Libra”, furthering the view that cryptocurrencies and blockchain are becoming institutional vehicles. 

Economic Slowdown or Recession?

Six months ago, the market was bracing itself for interest rate increases. Now the Fed, faced with the result of slower global growth abroad and the impact of the trade war at home, has done a complete 180.  Investors now anticipate at least two interest rate cuts this year and a weaker dollar environment.

While recession risk is rising, lower interest rates, which tend to stimulate corporate borrowing and business investment, should help counter these negatives. A trade deal would also significantly relieve economic pressure as well. 

Much has been made of the inverted yield curve this year, as historically, when rates on short-term term investments like 3-month T-bills are higher than rates on longer-term investments, like 10-year Treasury bonds, a recession has often followed within 12-18 months.  This concern references Duke University finance professor Campbell Harvey’s 1986 research work linking yield-curve inversions to recessions.

In a 1986 dissertation, economist Campbell Harvey identified an economic indicator that would precede the next seven recessions. That indicator is known as “a yield curve inversion.” Courtesy of Campbell Harvey

Will Slow and Steady Win the Race?

But complicating matters this time, is that other traditional warning signs of recession, such as rising unemployment, waning spending and confidence, and missed earnings are not flashing red this time. 

One key factor favoring continued economic expansion it that the pace of growth has been slower than its predecessors.  There are few signs of “over-exuberance” such as asset bubbles, and inflation has been quite muted despite record low unemployment and strong job creation. 

There is an old cliché that “economic cycles do not die of old age.”  Still, some people worry that recession is right around the corner, merely because we have not had a recession in a while.  To the extent those fears weigh negatively on consumer and business confidence, the fear of recession could end up being a self-fulfilling prophecy.

With the market sitting at new highs and the economy in its longest ever economic expansion of 121 months, investors appear to be confident, at least for now, that Fed action in the form of lower rates and an end to the trade wars can keep the slow growth economy going and the bull market running. 

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