In this Q2 recap: stocks rise, fall, and then soar, as the Federal Reserve shifts its thinking and new chapters unfold in the ongoing U.S.-China trade dispute.
THE QUARTER IN BRIEF
The S&P 500 certainly rollercoastered during the second quarter of 2019, but it also gained 3.8% across those three months. U.S.-China trade negotiations unwound, but as the quarter ended, they showed signs of resuming. The Federal Reserve grew dovish. Yields on longer-term Treasury notes dipped and so did mortgage rates. Consumers were confident, and consumer spending stayed strong. Mixed data emerged from the housing sector. Gold outperformed oil as well as many other commodities. The Brexit was delayed, and central banks in other countries elected to lower benchmark interest rates.1
DOMESTIC ECONOMIC HEALTH
On May 5, President Trump announced that U.S. tariffs of 10% on $200 billion of Chinese products would rise to 25% and that virtually all other imports coming to the U.S. from China would “shortly” face tariffs. China retaliated, declaring that it would hike tariffs already imposed on $60 billion worth of American products effective June 1. The trade talks between officials from the world’s two largest economies then hit a six-week standstill. On June 29, however, President Trump announced at the Group of 20 summit in Japan that formal bilateral trade negotiations would soon resume and that the U.S. would hold off on tariffs slated for another $300 billion in Chinese goods.2,3
The other big story of the quarter was the change of outlook at the Federal Reserve. The central bank did not adjust rates up or down during Q2, but its June policy statement noted that Fed officials would “act as appropriate” to try and sustain economic growth. The latest dot-plot, gathering opinions from Fed officials on where interest rates might be in the near future, showed nothing like consensus.4
The quarter ended with most futures traders believing that the Fed would make some kind of rate adjustment as soon as July. Perhaps the Fed was also revising its expectations in light of declining inflation. The May Consumer Price Index showed just a 1.7% annualized advance. Back in May 2018, inflation was running at a yearly pace of 2.8%.4,5
Some other indicators pointed to a soft patch in the economy in the spring, perhaps nothing more. The Department of Labor reported 205,000 net new jobs in April, but only 90,000 net new jobs in May; unemployment did remain at 3.6% in both months, with the U-6 jobless rate, including the underemployed, actually descending from 7.3% to 7.1%. The prime gauge of U.S. manufacturing health – the Institute for Supply Management Purchasing Managers Index – dropped notably to 52.8 in April, then declined to a 12-month low of 52.1 in May.6,7
Even so, consumer spending remained solid. Personal spending improved 0.5% in May, building on the 0.3% April gain. Retail sales, coincidentally, were also up 0.5% in May and 0.3% in April. Personal incomes rose 0.5% in both months. A lagging indicator worth noting: as the quarter ended, the Bureau of Economic Analysis affirmed that the economy grew 3.1% during Q1.6,8
Key consumer confidence indexes stayed at high levels. The Conference Board’s consumer confidence index was at 129.2 in April, then at 134.1 in May and 121.5 in June. The University of Michigan’s consumer sentiment index hit an 8-month peak of 100.0 in May and ended the quarter at 98.2. 9,10
GLOBAL ECONOMIC HEALTH
The Fed was not the only central bank reconsidering monetary policy during Q2. Policymakers in Australia, Chile, India, New Zealand, and Russia all cut interest rates after May 1 in an effort to stimulate their respective economies. Globally speaking, that constituted the most easing seen since the first half of 2016. Markets in Europe benefited from comments by Mario Draghi, President of the European Central Bank. Draghi said that he was prepared to loosen monetary reins in order to stimulate lethargic European Union country economies.11,12
The Brexit was delayed. After an acrimonious spring in Parliament that saw no progress toward ratifying a new trade pact between the United Kingdom and the European Union, the E.U. postponed the Brexit deadline until October 31. Prime Minister Theresa May announced that she would resign, and based on election results, either current U.K. foreign secretary Jeremy Hunt or prior U.K. foreign secretary Boris Johnson will replace her later this month. Johnson, widely considered the favorite, has told the media that while he does not want the U.K. to leave the E.U. without a deal, the U.K. would do well to prepare “confidently and seriously” for that possibility.13,14
Gains were numerous in the quarter, with Argentina’s Merval recording the largest at 26.02%. There was one other double-digit Q2 advance: Russia’s Micex added 10.97%. Germany’s DAX improved by 8.58%; Brazil’s Bovespa rose 6.97%. Other gains of note: France’s CAC 40, 4.58%; the Euro Stoxx 50, 3.64%; the MSCI World, 3.35%; India’s Sensex, 3.04%; Canada’s TSX Composite, 1.74%; Japan’s Nikkei 225, 1.42%.15,16
The quarterly retreats included the 0.31% loss for the MSCI Emerging Markets benchmark, the 0.34% retreat for Spain’s IBEX, and the 0.61% decline of China’s Shanghai Composite.15,16
Examining second-quarter commodities performance, palladium had the best quarter among the metals, rising 18.23%. Wheat finished first among the key crops, up 12.22%. Ethanol topped the energy futures, advancing 8.74%. Coffee rose 12.06%; corn, 9.51%; gold, 8.63%. Gold ended Q2 at a price of $1,412.50 on the New York Mercantile Exchange. RBOB gasoline added 4.56% of value in Q2, and silver rose 1.25% to a NYMEX value of $15.27 on June 28.17,18
There were also copious losses in the quarter. Some were minor: soybeans declined 0.36%; the U.S. Dollar Index, 0.61%; platinum, 0.98%; West Texas Intermediate crude, 2.16%. WTI crude settled at $58.20 per barrel on June 28 after a 9.07% June surge. Copper fell 6.06%; cotton, 17.86%; natural gas, 18.70%.17,18
Home loans grew cheaper in Q2, and home buying picked up as the quarter drew to a close. The National Association of Realtors noted a 2.5% increase for existing home sales in May; although, the annualized sales pace was still 1.1% beneath year-ago levels. May was the fifteenth straight month showing a year-over-year decline. (April had seen a retreat of 0.4%.) New home sales, which make up only about 10% of the U.S. residential real estate market, were down 3.7% in April and another 7.8% in May. The S&P CoreLogic Case-Shiller 20-City Composite Home Price NSA Index, a lagging indicator, showed a 2.5% yearly gain as of April.6,19
Not that long ago (November), the average interest rate for a 30-year, fixed-rate mortgage was near 5%. Contrast that with where it was as the second quarter ended: 3.73%, according to mortgage reseller Freddie Mac’s June 27 Primary Mortgage Market Survey. Back on March 28, Freddie Mac calculated the average interest rate on a 30-year FRM at 4.06%. As for 15-year, fixed-rate mortgages, their average interest rate went from 3.57% to 3.16% between the March 28 and June 27 surveys.19,20
30-year and 15-year fixed-rate mortgages are conventional home loans generally featuring a limit of $484,350 ($726,525 in high-cost areas) that meet the lending requirements of Fannie Mae and Freddie Mac, but they are not mortgages guaranteed or insured by any government agency. Private mortgage insurance, or PMI, is required for any conventional loan with less than a 20% down payment.
The Census Bureau said that housing starts surged 6.8% in April, then retreated 0.9% a month later. The pace of permits issued for new residential construction improved by 0.2% in April and 0.3% in May.6
LOOKING BACK, LOOKING FORWARD
Time for a look at stock index performance. The S&P 500 gained 3.93% in April, dropped 6.58% in May, and climbed 6.89% in June. It hit a new, all-time peak in intraday trading on June 21: 2,964.03. The benchmark closed the quarter at 2,941.76.1,21
The Dow Jones Industrial Average settled at 26,599.96 on the last trading day of the quarter; the Nasdaq Composite, at 8,006.24. Early in June, the yield on the 10-year Treasury went under 2%, a development that occurred multiple times in that month.22,23
1 MO AGO
1 YR AGO
10 YR TIPS
Sources: tradingview.com, barchart.com, treasury.gov - 6/28/1923,24,25
Indices are unmanaged, do not incur fees or expenses, and cannot be invested into directly. These returns do not include dividends. 10-year TIPS real yield = projected return at maturity given expected inflation.
All in all, it was quite a quarter, with stocks getting as much of a lift from Federal Reserve policy moves and White House tweets as from earnings. As Q3 starts, traders are wondering if a rate cut and a U.S.-China trade deal are in store for the summer; there is also some ambiguity about the economy’s momentum. Companies are expected to start reporting second-quarter earnings in mid-July.
U.S. ECONOMIC EXPANSION MAKES HISTORY
The economic cycle is going into its 11th year in July but is still not displaying late-cycle characteristics, such as high inflation or elevated interest rates, even though wage pressures have accelerated in response to labor market tightness. Domestic sectors, primarily those centered around personal consumption, continue to spur growth. Economic expansion is on the cusp of making history to become the longest since 1854.
While we anticipate a marked slowdown in growth in the second quarter, economic conditions nevertheless remain solid and consumer spending to remain a dominant growth engine. We estimate the unemployment rate will move lower by the end of the year and the pace of core PCE inflation will firm, rising closer to the Fed 2% target. Based on the forecast compiled by the Bloomberg, annual economic growth will likely decelerate from the stellar pace reached in 2018, but it should remain above potential.
Smart policy execution by the Fed and no further escalation of trade tensions should enable that growth to extend well into record territory.
U.S. GROWTH OUTLOOK CENTERS ON CONSUMERS
The latest signs on U.S. growth are uninspiring, albeit good enough for the Fed to remain on hold. Growth remains choppy -- retail sales have whipsawed in recent months. Consumers will once again shoulder the burden, as they have done for a substantial share of the current cycle. With growth prospects centered on consumers, economic developments will increasingly depend on spending, income or hiring momentum.
Labor markets remain tight, despite the May payrolls stumble. Nonetheless, rattled economic confidence on the back of trade-related uncertainties appears to be resulting in a cautious approach to hiring across the private sector.
U.S. INFLATION REMAINS TEPID, WILL RISE AGAIN AS WAGES GAIN
The Fed's preferred gauge of inflation, the core PCE deflator showed signs of a revival at the start of the second quarter. However, it will be a tough task for the Fed to continue to attribute weakness in inflation to transitory factors as the latest CPI reading showed the monthly pace of core inflation extending its tepid streak despite normalization in apparel and airfares.
We expect firmer inflation to reassert itself over the medium term as labor conditions continue to tighten. However, a strong dollar will serve as a deflationary downdraft, offsetting the upward pressure from labor.
FEDERAL RESERVE TO CUT RATES
The market consensus now projects the Fed to execute 50 bps of rate cuts by year-end in an attempt to reduce inversion pressures on the yield curve, and to avoid policy in a manner contrary to the increasing dovishness among other major foreign central banks. Economic conditions have not changed appreciably and the U.S. is still poised to book above-trend growth this year but market conditions have.
Fed officials have reduced their estimates of the neutral fed funds rate and neutral unemployment rate, and as a result need to moderately trim rates in response to inflation undershoot. As such, in our view, the rate reductions should be considered a modest recalibration, not the onset of an easing cycle.
INVESTMENT THEMES DURING Q2 2019
Lowered Earnings and Tough Comps May Lead to Sideways Market
The S&P 500's 2019 EPS forecast is now almost $10 below its January level, and tough comparisons to extraordinary strong 2018 growth allow stocks to give fundamental weakness a pass until closer to 4Q. Earnings estimate declines have stopped, though it's too early to tell if this will lead to recovery or is merely the eye of the storm. Wait and see seems to be the right strategy for now – no risk on or off.
ANNUAL-FORECAST DECLINES PAUSED IN 2Q
The cascade of decline in 2019 and 2020 annual earnings estimates have stopped in the second quarter, though it's still too early to tell if this is stabilization that will lead to an uptrend or is merely a pause. In either case, the growth forecast is about $10/share lower than it was to start the year.
EXPECTATIONS FOR 2019 S&P 500 EPS GROWTH
In the short run, 2019 forecasts bottomed in mid-April and 2020 estimates stopped falling by early May. The S&P 500 is expected to post EPS growth of just below 5% this year vs. estimates of 8% at the start of the year. Forecasts for 11% growth in 2020 are largely unchanged.
TOUGH COMPS VS. 2018
Decoding earnings trends is extremely challenging considering difficult comparisons on the top and bottom line. Earnings rose 27% year-over-year for the first three quarters of 2018, so very difficult comparisons for the S&P 500 remain a challenge to faster growth until at least 4Q. Revenue comparisons are also tough, with respective 7.6%, 8.5% and 7.6% gains in 1Q18-3Q18, the fastest three-quarter stretch since 2011.
SOME BRIGHT SPOTS
Near-term earnings trends are clearly weak, but the market's 2019 advance implies stocks continue to anticipate profit improvement later this year and in 2020. Adjusted net income is expected to reverse weakness as comparisons ease, with consensus growth of 7.7% in 4Q and 11% in 2020.
STRONG 1Q GDP FIGURES
1Q real GDP growth topped the highest estimate in the consensus of economists, accelerating to 3.2% from 2.2% in the prior quarter. While this is encouraging news at face value, particularly given the growth concerns that rattled economic sentiment around the end of the year, a closer review exposes a much more sluggish underlying profile.
Much of what made 1Q GDP look great could make 2Q GDP look considerably weaker -- namely an unaddressed inventory overhang.
Anticipating an escalation in trade tensions toward the end of last year, producers amplified their supply chains by rushing goods into the U.S. (widening the trade gap) and stockpiling supplies (building inventory stockpiles). Now that trade talks appear to be moving in a more favorable direction, producers are reversing course and trying to normalize their operating conditions. This is resulting in depressed production (evident in weak manufacturing payrolls). Yet it also materializes in a collapse in imports during 1Q, creating the temporary appearance of a narrowing trade gap.
1Q results depicted an unusual composition of growth, including weak consumer spending and outsized contributions from net trade and inventories. As a result, neither the profile nor the pace of growth should be viewed as setting the tone for the remainder of the year.
VALUATIONS FOR VOLATILITY AND MOMENTUM STOCKS APPEAR STRETCHED
Volatility returns continue to lead 2019 returns among the major factor groups. Historically, late-cycle returns have favored stability toward the end, but the Fed’s pause and resilience in job markets data trends to date offer a relative strength for offensive factor tilts: namely volatility and, more recently, momentum.
Their strength comes amid an ever-widening divergence in valuations. The spreads, or difference between valuations of the highest vs. lowest rankings within factors, have widened for most groups, but most heavily for volatility and momentum. Measured by median price-to-book for the top vs. bottom rankings of respective factors, the largest spreads between ranks relative to recent history have been persistent for the highest- vs. lowest-volatility names (orange line). More recently, spreads have widened for momentum stocks (blue line).
DIVERSIFICATION INTO LESS-DEMANDING VALUATION AREAS MAKES SENSE
Risk-on is gaining legs as the valuations for volatility and momentum stocks continue to pick up ground. Relative to recent history, average valuation spreads within the volatility factor are positive for the first time this cycle. Valuation spreads for momentum exposure are moving toward cycle highs.
While valuations aren't necessarily a risk and could very well persist in their trajectory, the YTD market rebound has already priced in a lot of economic upside in our view. Prudence may be warranted, focusing on areas that offer diversification with less-demanding valuations.
The IC is currently evaluating replacing single factor ETFs with multi-factor strategies within the TFA portfolios.
PREFERENCE FOR U.S. EQUITIES
Until policy problems like global trade friction and Brexit begin showing signs of resolution, U.S. stocks will likely keep outperforming their global counterparts. Currently, U.S. stocks have above average valuations, but also slightly faster earnings growth, higher margins, and higher ROE than the rest of the world. As a relatively isolated economy, with the world's reserve currency, the U.S. also offers safety in times of heightened policy uncertainty.
U.S. stocks trade with less sensitivity to global macro factors than global counterparts and may continue to benefit from the lack of policy clarity. Approximately 20% of U.S. GDP growth comes from international trade, thus the U.S. economy is relatively insulated from global trade policy uncertainty; particularly in comparison with trade titans like China and Europe (where 36% and 63% of growth is trade-related, respectively).
BOUNCE BACK WITH FED SUPPORT
Market sentiment has shifted increasingly toward interest-rate cuts, possibly early in the second half of this year. The current implied probability of rate cut in July meeting stands at 80%. Despite this high probability figure, we are more careful and expect many Fed members to resist easing policy for two main reasons: One, mounting evidence that tight labor market is finally driving acceleration in wage pressures will help to soften policy makers’ concerns over persistently low inflation. Two, market interest rates are already low, so the economic benefit of rate cuts may be minimal, and instead merely contribute to financial stability risks. That said, a material escalation of trade tensions for example, across-the-board tariffs on China and/or Mexico would necessitate counter-action from the Fed.
RECAP OF JUNE FOMC DECISION: NO RATE CHANGE, FED TURNS DOVISH
The Fed statement was incrementally more dovish by downgrading the growth assessment from “solid” to “moderate” and acknowledging increased uncertainty. The operative “patient” language describing future interest-rate changes was dropped in favor of “closely monitor/will act as appropriate” -- thereby putting even greater emphasis on data dependence ahead of the July and September meetings.
The dot plot showed about half of meeting participants leaning toward a cumulative 25-50 bps of cuts over the next two years, markedly less than what markets were starting to price in. So the committee became more dovish, but appears resistant to the notion of substantial “insurance cuts.” FOMC members voted 9-1 to hold the federal funds rate steady at 2.25%-2.50%. St. Louis Fed President James Bullard was the lone dissenter, preferring to decrease the target rate by 25 bps.
FED DROPS ‘PATIENT’, BUT JULY RATE CUT NOT A SURE THING
The Fed’s dovish stance continued at their June meeting, but policy makers avoided signaling a July interest-rate cut, which many market participants and forecasters had anticipated. The dot plot shows policy makers almost evenly split on the direction of rates later this year.
We maintain the view that if economic data firm somewhat and trade tensions cool, the Fed may avoid embarking on insurance cuts, or at the very least will deliver far less accommodation than what markets have started to price in. Hence, we are not completely on board with the market consensus, which is pricing in 100% July rate cut probability.
Some of this material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. The information herein has been derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results. Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. This material represents an assessment of the market environment at a specific point in time and is not intended to be a forecast of future events, or a guarantee of future results. MarketingPro, Inc. is not affiliated with any person or firm that may be providing this information to you. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a competent professional.
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Investments are not insured by the FDIC, not deposits of, obligations of, or guaranteed by the bank or its affiliates, and are subject to investment risk including
possible loss of principal. I recommend consistency in this disclosure across all print marketing pieces.
This material was prepared by MarketingPro, Inc., and does not necessarily represent the views of the presenting party, nor their affiliates. The information herein has been
derived from sources believed to be accurate. Please note - investing involves risk, and past performance is no guarantee of future results. Investments will fluctuate and
when redeemed may be worth more or less than when originally invested. This information should not be construed as investment, tax or legal advice and may not be
relied on for the purpose of avoiding any Federal tax penalty. This is neither a solicitation nor recommendation to purchase or sell any investment or insurance product
or service, and should not be relied upon as such. All market indices discussed are unmanaged and are not illustrative of any particular investment. Indices do not incur
management fees, costs and expenses, and cannot be invested into directly. All economic and performance data is historical and not indicative of future results.
Additional risks are associated with international investing, such as currency fluctuations, political and economic instability and differences in accounting standards. These
risks are often heightened for investments in emerging marketsThis material represents an assessment of the market environment at a specific point in time and is not
intended to be a forecast of future events, or a guarantee of future results. MarketingPro, Inc. is not affiliated with any person or firm that may be providing this information
to you. The publisher is not engaged in rendering legal, accounting or other professional services. If assistance is needed, the reader is advised to engage the services of a