Following December’s sharp decline and Q1’s subsequent rebound, the markets’ Q2 performance was V-shaped, but it ended remarkably—the S&P500 approached 3,000, while the NASDAQ smashed through the 8,000 mark. The first-quarter rebound in both stocks and bonds continued through April, died in May, then picked up in June to end with another positive quarter.
Economic signals continue to project slow, steady growth in the U.S., not a recession or hyperinflation, and a steady growth environment will bode well for equities. Meanwhile, forecasts continue to swirl concerning interest rates—will the Fed actually lower rates?
Let’s review Q2’s performance and current key indicators while we look forward into the rest of 2019.
BONDS & FALLING INTEREST RATES
In their June meeting, the Federal Reserve Bank (Fed) did not increase rates and discussed cutting rates before 2019’s end,1 if warranted by economic data. This triggered a bond rally.
Bond prices rose during the quarter and pushed down existing bond rates. The 10-year Treasury fell from 2.41% on March 28 to 2.0% on June 28, a whopping 17% decrease. Global bond prices rose, supporting lower rates by the end of June. As of Q2’s end, long-term fixed income was up 3.1%, high yields rose 2.5%, and emerging market bonds rose 3.8%.2
The Fed’s next rate move is unclear. Many economists believe a rate cut is imminent, and the futures markets agree—they’re forecasting a “most likely” chance of rates lowering twice before year’s end. However, the Fed is taking a more relaxed stance and holding their cards close. We’ll hear more in their scheduled end-of-July meeting.
With bond prices now high and rates shrinking, total return from bond funds will be close to the yield moving forward. Higher yielding bonds will do well until the next recession starts and credit risk becomes an issue.
Global flows into U.S. bonds will continue while U.S. rates are positive, net of inflation. This imbalance in global rates will continue to keep pressure on commodity prices and favor bonds and stocks. Low interest rates could also portend the next recession and credit cycle.
We believe the recent bond market changes will provide a more stable backdrop and better risk-return conditions for the overall bond market. Target returns should be easier to achieve in a flat-rate environment, while bond income is critical for yield and investor spending needs.
We continue to enjoy the benefits of a long economic expansion in the U.S., and key indicators point toward a trajectory of continued expansion into 2020. Relatively strong consumer spending and good earnings reports are positive indicators for our economy’s performance through 2019 and into 2020.
Possible falling rates and the flattening yield curve are of importance. Full employment and low wage growth are prompting the Fed to move cautiously with previously planned rate hikes. Interest rate increases, if sustained, could cut our economic growth rate quickly.
In Q2, the yield curve remained very flat and was even slightly inverted during the quarter.
The Yield Curve–Recession Connection
When the two-year T-bill is higher than the 10-year note, we call this an inverted yield curve. The importance? Historically, inverted yield curves have signaled a recession.
Since 1962, when the yield curve has been inverted, a recession has followed seven to 19 months later—on all but one occasion. This lengthy foreshadowing timespan makes it difficult to predict a downturn’s start. The curve oscillated between flat and inverted during the last quarter, and it remains significantly flatter than in 2013. It’s too early to tell if this is an early warning signal of a recession.
Inflation remains close to the Fed’s 2% target rate. The core PCE (Personal Consumption Expenditures) supports this. A measure of consumer goods and services price changes, the PCE can reveal consumer buying habits and point toward inflation or deflation. The PCE recently rose 0.2% month over month and 1.6% year over year,3 meaning goods in the PCE are 1.6% more costly than the same month last year. Economically, this means we are not imminently headed toward hyperinflation or recession.
Trade Wars & Brexit
Trade wars and Brexit dominated headlines last quarter and created short-term volatility despite Brexit’s modest impact on the U.S. economy. However, June closed with renewed optimism in the U.S. tariff scuffles with both Mexico and China following President Trump’s outreach to Chinese President Jinping and his softening stance with Mexico.
Oil Distribution Disruption
Attacks on oil ships in the Strait of Hormuz led to sharp price increases and volatility in energy. This narrow and dangerous waterway between the Persian Gulf and the Gulf of Oman is where 30% of the world’s oil shipping passes. Any long-term disruption to this distribution could be a major economic issue, not only for world oil markets but also consumers.
EQUITIES IN 2019
After May’s dip, stock prices climbed sharply to finish Q2 near all-time highs. As of Q2’s end, even with a mid-quarter dip, many regions and asset classes ended with strong positive gains.2 The S&P 500 rose 4.3%, and despite our 10-year bull market, S&P500 forward P/E ratios closed at a 16.8, only slightly higher than the 25-year average of 16.2, suggesting these equities are not over-valued. Latin America (4.6%), Europe (5.0%), and the Pacific Rim (2.5%) also posted nice positive gains.
While some of Asia was negatively impacted by the U.S.–China trade wars, emerging markets rose 2.0% and ended the quarter with a particularly bright outlook. For example, India’s blue chips rose 7.3%. Oil was negatively impacted by the aforementioned shipping attacks, and energy ended the quarter at –4.9%.
The second quarter’s V-shaped rise–fall–recover pattern is one we may see repeated due to increased volatility near the markets’ peaks. As interest rates fall back toward zero again, value stocks that pay a large dividend should see increased demand. The absence of a recession will warrant a short-term bias for U.S. over foreign stocks, while long term, lower foreign-stock valuations may be attractive when comparing price appreciation potential. A solid trade deal with China will help emerging markets in Asia and the Pacific Rim.
It is normal to see more volatile stock prices and lower average-price increases near the top of a market. In the absence of a near-term recession, we should see at least average market returns for 2019 and 2020.
We publish these insights quarterly for our clients, with further detail on specific asset classes. Our personalized investment management strategy is built around each client’s personal Financial Plan and Investment Policy Statement. We review both as we make changes to each client’s portfolio, working to ensure their investments match their personal risk tolerance, return goals, and tax picture.
We welcome the opportunity to talk about how we might help you plan, build, and preserve your wealth.
Read more about our Investment Policy Committee.
Categories: Market Commentary, Market Forecast
2Data in this section are sourced from: https://www.morningstar.com/markets.html; Bloomberg Institutional Portal, dated 7/1/2019; JP Morgan Guide to the Markets, data as of June 30, 2019; and MSCI.com.
3Source: LPL Daily Market Update, published June 28, 2019
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline.
Stock investing involves risk including loss of principal.