Island Light Quarterly Commentary (Jul 2019)
“A lot of people get so enmeshed in the markets that they lose their perspective. “― Martin Schwartz
We are now halfway through 2019, the stock market has delivered great performance, and the S&P 500 is flirting with record highs, up nearly 20% since the end of 2018. But let’s not lose our perspective; recall that this performance is coming off last year’s dreadful fourth quarter when the market was nearly in bear market territory, down 13.5%. It appears that the root causes of the increase in equity markets comes from 1) a reversion to the mean, or a positive rebound after an oversold fourth quarter, 2) expectations of an interest rate cut (or two) by the Federal Reserve in response to weaker-than-forecast economic growth, and 3) expectations of a drop in trade tensions as the US steps back from President Trumps ill-considered tariffs. We’ll see whether this investor optimism remains in place for the rest of the year.
US equity markets returned 4.3% for the quarter ended June 30 and 18.5% for the year-to-date. Growth stocks outperformed value stocks by more than 5% (Russell 1000 Growth, YTD 21.5%; Russell 1000 Value, YTD 16.2%) and smaller stocks underperformed large cap stocks by 1.9% (Russell 2000, YTD 17.0%, Russell 1000, YTD 18.8%). By any measure, these are very good returns, but the year-to-date numbers mask increased volatility during the year. Most of us forget that the US equity market dropped more than 6% in May before rising more than 7% in June and that January’s 8% return followed a 9% drop in December. We suspect that a lot of this volatility can be traced to headline news; tariffs are on one week, off the next; war with Iran is coming one week and doesn’t come the next. We recommend ignoring the headlines, keeping your perspective, and remaining on plan.
International equity returns also outperformed their long-term averages and expectations in the first half of 2019. The MSCI EAFE index returned 14.0% for the year-to-date and 3.7% in the second quarter. This follows a 13.8% loss in 2018. The dollar has been flat for the year, neither detracting from nor adding to ex-US returns. Emerging markets performed slightly under their developed market counterparts year-to-date as the MSCI Emerging Markets index rose 10.6% for the year and 0.6% for the second quarter. Fears of the impact of US tariffs on Mexico and China were a major contributor to 2019 volatility.
A surprising drop in US interest rates contributed to a decent rise of 6.1% in the US bond market year-to-date (Bloomberg BarCap US Aggregate Bond index.) The 10-Year US Treasury yield dropped from 2.69% on December 31, 2018 to 2.00% on June 28, 2019 (Fed Reserve Bank of St Louis). Bond prices move in inverse proportion to their yields. The decline in bond yields in the US can most likely be attributed to a decline in yields in German and Japanese government bonds below zero, an expectation of a slowing US economy in the second half of the year and in 2020, and the continuing expectation of low US inflation. Market expectations on a Fed funds rate cut in July are high. There is also a better-than-average possibility of a second rate cut in October as the Federal Reserve tries to increase inflation to their desired 2.0% target. In corporate bond news, credit spreads declined 30 basis points to 1.2% at the end of June (ICE BAML US Corporate Master Option- Adjusted Spread.)
We are now witnessing the effect of uncertainties related to international trade policy in the indexes of manufacturing productivity. The major export markets of Germany, Korea, Canada and Taiwan, for example, have all suffered a drop in the PMI (Purchasing Managers Index for manufacturing) below 50, indicating a deceleration in the sector. In 2017 and 2018, global PMI was much higher. A decline in the manufacturing index is an early indicator of economic slowdown. Global PMI for the services sector, which is a much larger component of global GDP, remains above 50 but has declined markedly since the beginning of 2018.
The world still has an enormous amount of liquidity in place, despite US monetary policies to ‘normalize’ (reduce) the Fed’s balance sheet. The total assets of the Federal Reserve now stand at $3.8 Trillion from $4.5 Trillion in early 2015 and $0.8 Trillion in December 2007. We expect the Fed to drop interest rates in the face of economic uncertainty. The European Central Bank, also awash in liquidity, announced that it would hold its balance sheet constant at around €2.5Trillion in December of 2018. Partly in response to and partly because of a dramatic slowdown, the German 10-year Bund yield went negative again to its lowest level ever (-0.33%) on June 30 from +0.24% at the beginning of the year. The Japanese 10-year Govt Bond yield dropped to -0.16% from 0.01% on December 31 even as the Bank of Japan retains its asset purchase program. The global weakness in yield and inflation is occurring despite the enormous liquidity in the market.
Is anything cheap anymore? The increase in the price of everything securities-related in 2019 make financial assets look less attractive than six months ago. While most of the major strategists that we pay attention to do not expect the US to sink into recession in the next two years, it is pretty clear that the risk of recession is higher than it has been We expect GDP growth to slow to a range between 1.8% and 2.3%, continuing the Goldilocks economy (neither too hot nor too cold) of the last decade. This slow growth is OK for equity markets, but we have to pay attention to recessionary indicators in the global economy that could weaken markets from these levels.
With bond yields at 2.0% today and the S&P paying a dividend of 2.1%, US equities look attractive relative to US fixed income. The forward-looking PE ratio for the US equity market is 16.7, modestly higher than its 25-year average and certainly within a reasonable valuation range. International equities look comparatively attractive on a valuation basis (forward PE of 13.2 and dividend yield of 3.5% (MSCI ACWI exUS). If the dollar weakens, as it should if interest rates move towards parity with the rest of the world, a currency lift would further aid overseas investments. Offsetting the valuation trade-off is the fact that the US economy has, time and again, shown its resiliency in the face of a wall of worry. Low expectations set a low bar, and US stocks could certainly further surprise to the upside.
In the face of this equity market uncertainty, we look to retain a neutral outlook for the rest of the year and will likely rebalance to our target equity/fixed income allocations. Ex-US investments may be somewhat more attractive on a valuation basis, but overseas economic growth is weak. Trade policy remains a big uncertainty and we do not expect to see any clarity until after the next election. Markets hate uncertainty and volatility in the markets is highly correlated to these trade on/ trade off discussions. In fixed income, we will probably move to a more neutral benchmark-relative weighting. In the long term, fixed income helps to insure against equity loss; as uncertainty in the direction of equity markets increase, we want to keep that insurance component in perspective.
We look forward to your helpful comments and suggestions.
Matthew V. Pierce, President