QUARTERLY MARKET UPDATE as of October 2019
Equity markets had mixed results in the third quarter. The S & P 500 edged higher gaining 1.7%, while small cap stocks and international equities were both down for the quarter. The S & P was led by the Utilities, Real Estate, and Consumer Staples sectors, while Energy and Healthcare declined. In September there was a sharp divergence between Value and Growth investment styles. Investors rotated out of momentum and growth, shifting focus to the more defensive Value style for the first time in several years. Value stocks outperformed Growth in every market capitalization class by over 2% in the quarter’s final month.
Interest rates continued to decline with the 10-year Treasury ending the quarter at 1.67%, from 2% at the start of the quarter and 3% in last year’s third quarter. The Federal Reserve Bank cut the Federal Funds rate twice during the quarter, and is now at a range of 1.75% to 2.0%. The yield curve remains bumpy with the Fed Funds rate exceeding the 10-year rate. But the curve flattened out somewhat after inverting in the second quarter, as 2-year Treasuries at 1.62% are now slightly lower than the 10-year yield.
The recent impeachment inquiry may increase volatility but will have less of an impact on overall market trends. It is too early to determine an outcome and forecast that would lead to a change in fiscal or monetary policy, and that is what would have a foundational impact on the economy and markets. The turbulence in our nation’s capital does make it less likely we will see bipartisan cooperation on passing legislation on infrastructure anytime soon. As well, the priority is now lower for ratifying the new trade agreement with Mexico and Canada, or revamping drug pricing in the pharmaceutical industry.
Developments in global trade will have a greater impact this quarter. The market has had positive expectations that tariff issues will be worked out, and surprisingly the consumer has not been hit with any meaningful increase in prices. The latest core personal consumption expenditures index at 1.8% is still below the Fed’s target of 2%. Expectations of an increase in inflation would likely be driven more from wages in our tight labor market as the unemployment rate remains at an historical low of 3.7%.
Trade discussions with the Chinese are set to take place this month in Washington. The impact of tariffs on manufacturing activity is evident across the globe. The slowdown is showing up in capital investment decisions which are being placed on hold. The U.S. and EU tariff battles haven’t made any progress yet, and the trade spats between the U.S. and China are having a greater than expected impact in the Eurozone. Globally consumers have pared back on foreign purchases, especially automobiles. This obviously affects Germany more which is highly reliant on the health of their auto industry; their most recent manufacturing index fell to its lowest level in a decade. The GDP for both Germany and the United Kingdom’s is expected to decline in the third quarter, officially putting their economies into a recession.
Offsetting the trade wars are global central bank stimulus efforts, which may boost the economic growth outlook over the next 6 to 12 months. Along with the Fed lowering rates, the European Central Bank cut their deposit rate to commercial banks to a record low of negative 0.5%, and will revamp their quantitative easing (QE) program of buying bonds. Uncertainty on the overall economic impact is high, as the unprecedented negative rates have yet to stimulate the economy. We do expect this will help the housing market both in the U.S. and abroad which will benefit from mortgage rates continuing to decline.
The ultra-low global interest rate environment creates a problem for investors seeking safety and diversification. It becomes hard to rationalize investing in bonds when interest rates are lower than the rate of inflation; and it creates an incentive to seek out higher risk fixed income investments, or replace bonds with stocks. Especially in the EU, a guaranteed loss on a negative rate fixed income investment tends to steer investors back towards equities. With that backdrop we continue to expect investors will remain over weighted in equities. The greater economic stability and higher growth rates in the U.S. will continue to attract global investors.
Growth in the U.S is expected to slow to 1.9% in the third and fourth quarter, and 2% for the year per the latest Atlanta Fed’s GDPNow forecast. This is not as robust as the past two years but still much better than most developed markets. Annual spending trends for the U.S. consumer remain strong and are the main force sustaining our economy. However, we will be watching future spending reports closely to see if there will be any follow through from lasts months report which came in less than expected, although income levels exceeded expectations due to an increase in employee compensation.
If positive developments on trade occur, we expect to increase our Asian international equity weighting. Otherwise we will continue to trim our exposure to stocks that exceed our fair value, and see improved relative performance from adding reasonably priced “value” stocks paying dividends, over momentum stocks.