EQM Capital LLC 3Q 2019 Market Review – Will the Trade War Trigger Recession?

Posted on Oct 10, 2019

Market Eked Out a Positive Return

Despite negative headwinds in the third quarter such as trade wars, an inverted yield curve, and now Presidential impeachment hearings, the U.S. market has held up pretty well this year, ending a tumultuous quarter with the S&P 500 Index up 1.7% and the Dow Jones Industrial Average up 1.8%.  The S&P 500 Index was up more than 20% YTD through September, but it has not exactly been smooth sailing. 

Yield Curve Inversion

On August 5th, the market recorded its worst loss of the year amid worries about the health of the global economy, trading down 3% in one day.  The yield curve inverted, with the 2-year Treasury yield trading higher than its 10-year counterpart.  Historically, that has been predictive of a recession, so it caused panic in the market. 

While the sell-off was short-lived, as the yield curve inversion only temporary, uncertainty surrounding U.S.-China trade negotiations continues to contribute to market volatility. The Fed cut interest rates for the second time this year in September, which helped sooth seasick investors but the market’s risk appetite is showing signs of caution. Value stocks outpaced their growth peers in the third quarter and low volatility funds are seeing healthy inflows. 

Market Sentiment Mixed Heading Into the End of the Year

Going into the end of the year, market sentiment remains mixed even though historically the S&P 500 rises on average 4.3% in the fourth quarter. Even though the Fed and other central banks appear committed to keeping rates low, there are some cracks emerging in the economy.  The latest manufacturing and employment data missed expectations. Trade delegations are due to meet on October 10, but there is not a lot of optimism about a deal. 

The other unknown is corporate earnings, particularly those exposed to the trade tariffs.  Earnings for companies in the S&P 500 that generate more than 50% of their sales from overseas markets are expected to fall 10.7% in the third quarter compared to last year according to FactSet.  While expectations for S&P 500 firms that generate the majority of revenue from the U.S. are essentially flat over last year. 

The trade war, a strong U.S. dollar, and a weaker global economy have hurt U.S. manufacturing, exports, farming, and curbed business investment.  The good news is that analysts appear optimistic that earnings will rebound next year, as rate cuts take effect and trade talks make progress. The Fed is expected to cut rates again in the fourth quarter and it is not alone.  According to JP Morgan, after 16 central banks lowered rates in the third quarter, at least 24 more are expected to slash rates in the fourth quarter. 

Bad News is Good News

We are in an odd “bad news is good news” scenario at the moment.  Each bad piece of news on the economic front, increases the likelihood that central bank saviors will step in and bolster the market.  Currently, the CME FedWatch Tool is pricing in an 88% probability that the Fed will cut rates another 25 bps in October and the majority expect another rate cut in December as well.

While lower rates and fiscal stimulus should keep the bull market going a little longer and stave off a near-term recession, central banks are running out of ammunition and could use some progress on the trade front as well. 

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