The Economy is not the Stock Market
Stock markets have rallied sharply from the bear market lows reached in late March. Astoundingly, the fastest 30% sell-off ever for the S&P 500 Index was followed by the strongest monthly return in over 33 years, soaring 12.7% in April. This incredible performance occurred while market participants have absorbed a deluge of grim economic data, including the highest unemployment rate since the Great Depression, the highest 8 weekly jobless claims ever recorded, and a wave of companies reporting depressingly low earnings and eliminating future guidance, with a significant uptick in companies filing for chapter 11 bankruptcy. GDP growth rates in the first quarter were sharply negative and estimates for the second quarter are expected to slide even further. It is shocking to many that global stock markets have rebounded so swiftly even as many economies have plunged into recession.
How can a stock market legitimately rise even as an economy falls? To answer this, it is informative to recall the situation at market lows and what has occurred in the seven weeks since.
In March, it was not known if COVID-19 was containable, if millions of patients would overwhelm the health care system, or if the Federal government would be able to respond, given intense partisan bickering and mixed messaging on the severity of the threat posed by the virus. It was unclear if shelter-in-place orders would be effective or how long they would last. Also unclear was the potential impact on the labor market, consumption, and production. The uncertainty was rampant and was reflected in depressed stock markets, as investors sold indiscriminately amid the confusion on how to appropriately value future company earnings.
As the past seven weeks unfolded, significant developments indicated that the worst-case scenarios feared in March had become increasingly unlikely, which supported a meaningful stock market rally. We learned that the social distancing shutdown would be temporary, and that activity would increase as economies slowly reopened. Markets are forward-looking and the prospects for business is considerably better than two months ago. We note:
- Shelter-in-place emergency measures slowed the virus’ spread and many countries are past peak outbreak.
- Countries and regions are reopening. Strategies differ by geography; ultimately some will be seen as successful and others as a failure, but experimentation is necessary as policymakers balance the speed of reopening with public health.
- The employment situation is much worse than feared in March, but there is hope that it is temporary. According to the Bureau of Labor Statistics April jobs report, of the 23.1 million unemployed persons in April, 18.1 million believed they were only temporarily laid off, while the number of permanent jobs lost increased by 544,000 to 2.0 million.
- The US Federal Government came together to pass bipartisan, greatly needed stimulus programs, boosting unemployment benefits, extending lifelines to businesses, and injecting money directly into the bank accounts. However, the aid will not last forever and likely more will be needed soon to continue to prop up household and business balance sheets.
- The US Federal Reserve slashed interest rates to zero, launched the largest monetary stimulus initiative in history, and took the unprecedented step of buying corporate bonds, including junk bonds. This injected much needed liquidity into the financial system and allowed companies with access to financial markets the ability to “weather the storm” by borrowing money at relatively low interest rates.
- The EU and other major international economies launched monetary and fiscal stimulus packages as well, but none came close the size and scope of the US. This could explain why international stock markets have not rebounded as strongly as the US.
Despite the hope-inspiring developments cited above, we still live amidst a public health threat and a deep recession. Huge questions remain, including whether a second wave of the virus will occur, what shape the recovery will take, and if stimulus measures will be effective. However, those who wait for certainty on these issues before investing likely will be forced to buy assets at much higher valuations. Investors are best served by adhering to their long-term objectives and remaining committed to appropriate asset allocations. Within the stock market, we recommend that investors focus on quality and those companies that are best able to recover their earnings. We reiterate our view from the beginning of the COVID-19 scare, written in our February 11 blog:
“We expect there will be winning and losing sectors and companies, which could provide an opportunity for active portfolio management to help mitigate portfolio risk and increase returns. The longer the pandemic takes to resolve, the greater the negative impact will be to industries such as travel, autos, oil, some luxury goods, and commodities. Companies with supply chain disruptions should be monitored closely for downward earnings revisions. We recommend caution in “buying the dip” in these industries until the magnitude of the global economic impact is better understood.”
Thus far, this approach has been successful, and we think this trend will continue until the end of the pandemic is in sight. Until then, stay disciplined, vigilant, and most importantly, safe.
Economic and Financial Market Outlook 2020 Q2
Remarkable developments occurred in the first quarter of 2020: the worst pandemic in over a century spread around the globe at alarming speed, policymakers responded with unprecedented monetary and fiscal stimulus, and national, state, and local governments effectively shut down the global economy in the interest of public health. Equity and credit markets responded with incredible volatility. While the selloff in the S&P 500 Index reached a low on March 23, dropping 35.4% intraday below the February 19 high, the US benchmark index also made historically fast gains, including the strongest one-week advance since March 2009. Of the 22 trading days in March, 21 saw stock market moves of at least 1.0%. When all was said and done, the S&P 500 and Dow Jones Industrial Average each incurred their worst first quarter ever. The bond market also saw unprecedented volatility, with 10-year US Treasury bond yields plummeting from 1.92% to a low of 0.50%, while high yield bonds, measured by the iShares High Yield Corporate Bond ETF (HYG), plunged over 30%. Looking ahead, our outlook is essentially unchanged from the March 20 update: “Stopping the Coronavirus: Putting the Brakes on the Economy.” We maintain that for stability to return to markets, investors need greater visibility regarding COVID-19 and its impact on the economy. At this stage, we can provide some updates to the key questions, but a lack of definitive answers continues to cloud the investment landscape:
- How much of the country will be affected by the virus, and how long before we start to see a decline in active cases and fatalities?
COVID-19 has already impacted every US state and over 180 countries with varying ferocity. Globally, new cases are still growing and the timing and severity of peak intensity in the US and abroad remains uncertain. It is somewhat encouraging, however, that a few countries have reported infection rate declines and several more have reported a deceleration in the number of daily new cases.
- How restrictive will the national, state, and local policymakers be in shutting down the economy in the interests of public health? How successful will the restrictions be in containing the virus?
The White House has recommended all Americans to stay home and 41 states have issued orders to shelter in place except for essential activities. Although these steps thankfully appear to be reducing the spread, in our view, the widespread “stay at home” orders have caused the US to enter recession of unknown duration and turmoil. In the week ending March 28, 5.8 million people applied for unemployment insurance following 2.9 million the week before (the previous highest single-week totaled 695,000 in 1982).
- When will there be a return to near-normal activity, and will the mass amounts of unemployed workers be able to resume their jobs?
We don’t know how long it will take until the number of active cases is low enough to resume normal activity, or frankly, at what that level is. What we do know is that the longer we remain in some form of lockdown, the more severe the disruption will be to economic activity and the rehiring process.
- How successful will the healthcare industry be in developing a vaccine or other remedies and how long before distribution is permitted? Will hospitals be properly equipped to treat the virus? Will the testing process be adequately advanced?
There is still a long way to go, but progress has been made in addressing shortages of necessary supplies and protective equipment. There have been promising headlines about potential therapeutic advances, but experts warn that an available vaccine will require months more of development. Based on the experience of other countries, the stay at home orders will lift long before we see a vaccine or cure.
- How quickly and how successful will the national government be in countering the economic impact of their public health measures on citizens, small businesses, and corporations?
Congress and the White House have taken a bipartisan, “whatever it takes” approach to stabilizing the economy, already passing $2 trillion in relief measures, the largest stimulus package in history. Even so, it is not clear whether the initiatives will be effective or if another rescue package will be needed to further protect against economic malaise.
- Will policymakers be able to effectively deal with liquidity problems in financial markets?
The Federal Reserve has acted stronger and quicker than in 2008, dropping the Federal Funds rate to zero and offering up to $4 trillion in asset purchases to keep financial markets functioning. The usefulness of this massive undertaking is unknown as there has never been such a crisis nor such a response. Through these actions, however, the key policymakers have demonstrated that they are 100% committed to combating a credit crunch.
- What will be the impact on corporate profits and stock buybacks, which totaled $700 billion last year? How will investors react to the threat of dividend cuts, bailouts, and bankruptcies?
The exact effect on corporate profits is yet unknown, though we know for certain that the impact will be strongly negative. Factset consensus estimates expect a decline of -4.5% in S&P 500 earnings for 2020, though this number includes outdated forecasts as many research houses have yet to update their projections to reflect current conditions. Goldman Sachs has attempted to produce relevant estimates, and now expect 2020 full-year S&P 500 profits to fall 33%. Companies especially hurt by the virus are expected to cut their dividends in the second quarter, including 21 in the S&P 500, and many more share repurchase plans have been suspended.
We normally view bonds as a stable, income-generating asset. US Treasuries remain very safe, though their yields dropped to record lows in the first quarter. Corporate and municipal bonds have not been a good income source due to low yields and now we see increased credit risk during these trying economic times. We recommend holding to maturity high-quality bonds, which should still provide portfolio stability, whereas lower-quality bonds have been severely punished during the crisis. In addition, we recommend staying short-term in duration, as reaching for yield by going further out in duration will lock in yields for years near record lows.
The situation remains in flux and new information emerges hourly. We are encouraged by some recent developments but clearly do not have the answers to know when the crisis will pass. Investors must accept that there is an abnormally large range of possible short-term outcomes and they should monitor closely developments and the changing probability of various scenarios.
We will get through this eventually. May all our readers stay healthy, safe, and in good spirits!
Stopping the Coronavirus: Putting the Brakes on the Economy
As the world confronts the unprecedented threat of the coronavirus (COVID-19) outbreak, Marietta’s Economic & Financial Market Outlook must be completely overhauled. The difficulty in providing a useful and specific update is that these are uncharted waters with no equivalent historical references. Any current forecast contains assumptions that could be outdated in hours, as economic and medical data rapidly update and stimulus measures are announced. Amid this uncertainty, our focus is on the major questions that need to be addressed before markets stabilize:
- How much of the country will be affected by the virus, and how long before we start to see a decline in active cases?
- How restrictive will the national, state, and local policymakers be in shutting down the economy in the interests of public health? How successful will the restrictions be in containing the virus?
- How successful will the healthcare industry be in developing a vaccine and how long before the testing process permits distribution?
- How quickly and how successful will the national government be in countering the economic impact of their public health measures on citizens, small businesses, and corporations?
- What will be the impact on corporate profits and the threat of dividend cuts, bailouts, and bankruptcies?
- Will policymakers be able to deal with liquidity problems in financial markets?
The task of investors is not to press forward with rigid statistical predictions regarding GDP and the S&P 500 Index. In other words, this is a time to avoid being locked into an inflexible strategy. Rather, investors must accept that there is an abnormally large range of possible outcomes and they should monitor closely developments and the changing probability of various scenarios.
Despite the cloud of uncertainty, we offer several observations…
The news is likely to get worse before it gets better. However, at some point the panic will subside. For a stock market recovery to begin, investors need more certainty on two fronts:
- that COVID-19 won’t overwhelm the US healthcare system.
- that economic fallout will not spiral into a deep, long-lasting recession.
We think the recovery will begin well before the virus is eradicated. The country has mobilized to fight a war against COVID-19. In this vein, stock markets will rise when we see a turn of fortune and start winning the war. Fortunately, there is a roadmap to stopping the acceleration of new cases and relieving pressure on the healthcare system. The strategy is twofold: mass testing and physical isolation. This has worked in other countries that have passed the worst of the spread of new cases. There is a downside, however: isolation causes a severe decline in economic activity. Policymakers have made the rare decision to sacrifice economic growth in order to protect the public health. Short-term volatility in financial markets will occur due to the efficacy of policies aimed at lowering the strain on the healthcare system, both to the upside and the downside.
The immediate financial impact of mass isolation is drastic. For a recovery to begin, investors need assurance that these short-term economic consequences do not balloon to become a more pronounced structural decline. Federal Reserve action has been a good start but will not be enough. To stem the tide of this calamity, fiscal stimulus must occur on two levels: individuals need money to live and businesses need access to capital to survive. The US consumer has been the beating heart of the global economy. Yet a recent survey revealed that 69% of Americans have less than $1,000 in savings and 45% of Americans have no savings at all. People living paycheck to paycheck need relief, as they cannot work due to mass closures and thus are not receiving paychecks. In addition, small businesses have shuttered their doors, yet still have bills to pay. With no customers, they need access to capital to survive. A large fiscal package targeted at small businesses and individual families would go a long way to help people get through this difficult situation and would give investors confidence that the economy will avoid a huge spike in unemployment, bankruptcies, and other disastrous impacts of recession.
We, as a country, will overcome the threat of COVID-19 and get back on our collective feet. Investors should keep in mind their time horizon, as long-term returns have been very positive following past selloffs of this magnitude. Portfolios should be monitored carefully to ensure that they will continue to meet income needs and capital preservation goals. Proactive investors should consider taking steps to position the portfolio for a post-corona world while avoiding those industries likely to exhibit lingering problems due to the global response. Stay calm and stay healthy friends.
Does the Coronavirus Change the Outlook?
During a very eventful start to 2020, the world’s attention has been set on the serious and significant spread of the Coronavirus. A contagious, life-threatening respiratory disease, it has infected nearly 50,000 people worldwide and has killed over 1,000 people, the majority in mainland China. While our focus here is the potential economic and financial market impact of the Coronavirus, we do not want to leave unacknowledged the reality that humans are suffering. Our hearts go out to the families and loved ones who have been affected by this tragedy.
Even disease experts acknowledge that it is irresponsible to make a forecast on how long the outbreak will last, how far it will spread, and what the ultimate economic impact will be. What we do know is the Coronavirus is serious enough that a few large Chinese cities are on lockdown, some companies with factories in Wuhan are suspending operations, and several countries are enforcing travel bans to and from China. When the world’s second largest economy undergoes a disruption of this magnitude, global growth will slow. The degree to which this will impact US growth will depend on unknown future developments.
The response of financial markets has been mixed. Taking into account this problematic outlook, commodity prices have fallen. Year to date, WTI crude oil has plummeted -17.5%, copper -8.4%, and iron ore -10.8%. Likewise, the economy-sensitive S&P 500 energy and materials sectors have dropped -10.1% and -2.2% respectively, and emerging market stock markets, measured by the iShares MSCI Emerging Markets ETF, the EEM, have dropped -3.4%. On the other hand, the S&P 500 Index as a whole has continued its upward march, rising 3.2%, with technology, communication services, and utilities outperforming.
Marietta’s most recent Economic and Financial Market Outlook (January 10) was modestly optimistic based on cooling trade tensions, easy monetary policy, a strong US consumer, a return to corporate profit gains, and a global growth rebound that would reduce recession fears. Thus far, these core fundamentals remain unchanged: trade tensions continue to diminish, monetary policy remains supportive of growth, corporate earnings are still expected to rise, and US consumer spending has been relatively unimpeded by the Coronavirus. We no longer project a global growth rebound, but we continue to think that recession fears will stay low, provided a significant outbreak does not reach US shores. Thus, our outlook is relatively intact and supports the case for higher global stock markets.
We expect there will be winning and losing sectors and companies, which could provide an opportunity for active portfolio management to help mitigate portfolio risk and increase returns. The longer the pandemic takes to resolve, the greater the negative impact will be to industries such as travel, autos, oil, some luxury goods, and commodities. Companies with supply chain disruptions should be monitored closely for downward earnings revisions. We recommend caution in “buying the dip” in these industries until the magnitude of the global economic impact is better understood. Even if the virus is contained quickly, companies should be reevaluated in the context of a slower than expected global economy. We will be tracking developments closely, especially regarding a potential disruption to US consumer spending. We all wish for a swift end to this serious threat.
Economic and Financial Market Outlook 2020 Q1
We begin the new decade riding a historic economic expansion that enters its 11th year. 2019 saw global stocks post significant gains and bond markets rally for most of the year as the dominant obstacles retreated or moved closer to resolution. At this point, our economic and financial outlook for the coming year remains modestly optimistic:
- Tensions are cooling in the US/China trade war
- Global central banks have taken steps to ease monetary policy
- Global growth is poised to rebound, reducing fears of US or worldwide recession
- The indefatigable American consumer persists as a bulwark supporting the global economy
Our optimism is tempered by the likelihood that a reversal of any of these factors would lead to market declines. We also expect the coming year to bring greater volatility, although absent any fundamental deterioration of these factors, we would view any pullbacks as buying opportunities. With the potential for pitfalls, it is especially important for investors to monitor economic reports for any signs of weakening and be prepared to make quick adjustments or maintain more balanced portfolios.
In the US, the economy demonstrated its resilience with the previous quarter projected to grow 1.8%. Despite predictions from pundits that the trade war would lead to recession, the economy withstood the negative impact on the manufacturing sector from the tariffs. Indeed, the ISM Report on Business showed US manufacturing contracting in 5 consecutive months to end the year. However, service activity remained robust with PMI readings solidly expanding. The scorching labor market has shown no sign of slowdown and headlines the positive case for the US economy. The US added on average 177,000 jobs per month in 2019 and job growth accelerated into the end of the year. Unemployment is the lowest it has been in 50 years and wages are growing about 3%. The Federal Reserve restored accommodative monetary policy with three quarter-point rate cuts in 2019 and Chair Powell has signaled that it would take a significant increase in inflation or economic activity to force rate hikes. We expect the newly-dovish Fed and the strong consumer will prevent the US from slipping into recession, but we are hesitant to anticipate a new upward cycle of growth. We forecast that the US economy will maintain its 2019 pace of about 2% in 2020, with inflation hovering around 1.9% – 2.0% and unemployment holding steady.
How will U.S. stocks follow up its tremendous performance in 2019? The S&P 500 finished the year up 31.5%. However, earnings growth will probably come in negative in 2019 after the final tally. That means that the stock gains further stretched P/E multiples to the limits of what could be called fairly valued. It is difficult to imagine further advances without a pickup in corporate earnings. While the resilient economy will bring a return to earnings growth, profit estimates for this year have fallen from double digits to about 9%-10% improvement over last year’s numbers. However, higher labor costs, continued effects of remaining tariffs, and uncertainty from the upcoming election will skew the risks to this forecast to the downside. With already high multiples on stocks, our conclusion is that broad indexes will track or slightly lag earnings growth and finish the year about 6%-9% higher. In this middling environment, investors should focus on sectors and companies that benefit from secular trends that are sheltered from economic headwinds.
The global economy, which experienced a synchronized slowdown in 2019, is forecast to recover modestly this year. The International Monetary Fund (IMF) attributes the subdued growth last year primarily to increased tariff barriers and elevated uncertainties surrounding trade and geopolitics. Especially hard hit was capital spending and manufacturing. On the other hand, broad-based monetary stimulus implemented by the world’s leading central banks partially offset these negatives. Heading into 2020, the Phase 1 tariff agreement between the U.S. and China, the USMCA treaty, and greater clarity towards a Brexit solution should improve prospects for capital spending, manufacturing, and trade. Meanwhile, we expect global central bank accommodative policies to continue well into 2020. We echo the IMF global GDP projections of 3.0% in 2019 and 3.4% in 2020, which is still below the 3.8% gain in 2017. Fueled by monetary stimulus, this economic recovery will support higher global equity markets as the fears of recession that rattled financial markets earlier in 2019 diminish.
Our confidence in international stock markets is based primarily on the improved outlook for corporate earnings, subdued inflation, low bond yields, and very attractive valuations. We do not expect developed country economies (notably the Euro Area, Great Britain, Canada, and Australia) to rebound strongly: improved global conditions will likely result in modest GDP growth of only 1-2%. However, even such a mild rebound in output will support earnings growth and a corresponding stock market advance. Companies in developed country economies with strong bottom-up fundamentals will outperform, especially in consumer and technology sectors. The brightest spots in the global economic outlook are the emerging economies. The latest forecast of the IMF foresees a growth pickup from 3.9% in 2019 to 4.6% in 2020, including 5.8% in China and 7.0% in India in 2020. We are also projecting a rebound in Brazil from about 0.7% to 1.5-2.0%. This combined economic advance will come as a boost to emerging markets: over the past 5 years the iShares MSCI Emerging Market ETF (EEM) was up a meager 16.3% in comparison to the 57.4% jump in the S&P 500 Index. Additionally, a stabilization or decline in the dollar, which we consider likely, would be another positive for international markets.
The bond rally of 2019 peaked in September with the 10-year US Treasury rate nearly reaching its all-time low. Bonds yields have come up ever so slightly from their lows as global growth appears to have stabilized. We forecast a slight progression higher for interest rates that will track the pickup in growth. The synchronized efforts of global central banks to ease monetary policy will limit the potential for a significant advance in rates absent an unexpected spike in inflation. High-quality, short duration bonds continue to provide a haven for capital preservation but we caution against reaching too far with lower rated or longer dated bonds as those carry risks that would be better allocated in the equity markets.
Economic and Financial Market Outlook 2019 Q4
The economic and financial market outlook continues to be mixed. It is evident that while global GDP is still expanding, its growth rate is dropping. The US-China Trade War has exacerbated this slowdown, contributing to a global manufacturing contraction. The resulting rise in uncertainty has limited business spending and mired corporate profits, which are expected to decline for a third consecutive quarter. A turnaround could be near, however, with 2020 S&P 500 earnings projected to rise 10.5%. Another positive development is that the world’s major central banks, including the Federal Reserve, have increased monetary stimulus in response to slower growth. Historically, this has been a powerful support for stock markets. We recommend a balanced and flexible approach. Investors should be prepared for developments that alter the market climate quickly, both positively and negatively.
The US economy has enjoyed steady, albeit slowing, growth so far in 2019. Backed by a strong consumer and an outstanding labor market, economic activity has climbed despite a slowdown in trade, agriculture, and manufacturing. Goods-producing industries are in decline and the situation is deteriorating. The September Manufacturing ISM Report on Business composite PMI Index declined for the sixth consecutive month and showed that deliveries, backlogs, new orders, employment, exports, and imports all contracted. While concerning, manufacturing only makes up roughly 11% of GDP while consumption is about 70%. Thus far, the US consumer has remained one of the last strongholds of growth. If household spending can endure the current soft-patch, the global economy may rebound without further damage. If individuals tighten their wallets, however, the situation could spiral into a more serious downturn.
The impressive US stock market advance hit its peak in late July but has been range-bound since. The volatility has had a clear pattern: shaky economic data and negative trade headlines have weighed on the indices, while hopes for a Trade War ceasefire and Federal Reserve rate cuts have pushed equities higher. While much attention is currently preoccupied with these macro considerations, we think that the key to reaching new highs is corporate profits. If investors gain confidence in businesses achieving the expected double-digit earnings growth in 2020, the S&P 500 Index will likely respond with solid gains to end the year. This will not be an easy task, as profits have been slightly negative over the past two quarters and the third quarter numbers are expected to show another consecutive decline. Provided that earnings break out of their slump, the fundamental backdrop is generally supportive of higher stock markets: valuations are reasonable, inflation is low and stable, the Fed is providing monetary stimulus, and bonds and money markets do not provide competitive returns compared with equities.
The international outlook is clouded by the slowing global economy and ongoing trade tensions. China is suffering from the onslaught of US tariffs and will need significant stimulus to maintain its target GDP growth rate of above 6%. We expect the Chinese government will continue to take proactive steps to boost the economy. There is some evidence that monetary and fiscal stimulus may already be working: consumer spending and the service sector remain strong and the slowdown in manufacturing is showing early signs of a potential bottom. In comparison, the euro area is expected to confront a sharp slowdown in 2020, with Germany and Italy flirting with recession. Already, demand for goods and services is falling at the fastest pace in six years. The European Central Bank continues to do “whatever it takes” to get growth and inflation back on track, announcing in September an interest rate cut and agreement to restart its quantitative easing program. Curiously, policymakers so far have been reluctant to address aggressively the downturn with fiscal stimulus despite negative borrowing rates. The ongoing Brexit stalemate adds additional uncertainty to the region.
The positive case for international stock markets seemingly depends on a breakthrough in trade negotiations as well as a continuation of accommodative central bank policies. Global central banks will continue to ease, providing a positive backdrop for global equities. However, the near-term prospects for the US-China trade negotiations are not encouraging and the timing of an eventual agreement will be difficult to predict. We recommend exercising patience, diligently reviewing any ongoing developments. For long-term investors, international stocks present an opportunity for diversification and potential growth at substantially lower valuations than US equities. Our approach takes a bottom-up view to evaluate companies on a fundamental basis, emphasizing strong relative earnings momentum and/or recession resistant characteristics.
Bond yields fell further in the third quarter, with US 30-year and 10-year treasuries dropping to record low yields in September. Reflecting our mixed outlook, we think bond yields are likely to remain low and range-bound until a clear narrative takes shape. Money market funds have become relatively attractive and offer similar yields and additional liquidity. Higher cash-equivalent positions are currently warranted with potential future volatility on the horizon. With greater flexibility and lower interest rate exposure, investors with elevated cash positions will have the ability to return to equity and fixed-income norms while maintaining downside protection in the event of an improving outlook.
On Wednesday, the Dow Jones Industrial Average fell a numbing 800 points and the S&P 500 Index dropped 3%. The financial media attributed the declines to an “inverted yield curve” in the US Treasury bond market. Historians quickly pointed out that such an inversion preceded each of the last six US recessions, alarming investors across the globe.
During normal economic expansions, yields for longer-dated bonds are higher than shorter-dated bonds because longer time periods carry more interest rate risk. An inverted yield curve occurs when the yields of shorter-maturity US Treasuries, such as 90-day or 2-year notes, are higher than longer-maturity 10- or 30-year bonds. Historically an inversion has occurred for several reasons, but four of the last six inversions included a booming economy, rising inflation, and the Federal Reserve raising short rates in order to curb future inflation. This is not the case with the current inversion. Since October 1 last year, 10-year Treasury yields have plummeted from 3.22% to 1.53%, and 30-year Treasury yields have reached all-time lows, whereas short-term rates are little changed from 10 months ago. A variety of reasons have been put forward to explain this phenomenon, but it is worth noting that it is a global as well as US situation. Currently, an unprecedented $15 trillion of sovereign bonds are trading with negative yields.
Should investors be alarmed and implement strong defensive strategies? The yield curve inversion historically has been a long-leading indicator of recessions. Past recessions, however, have arrived on average 21 months later and never earlier than 8 months following 2-year/10-year inversions. Further, the stock market during the last three inversions (1988, 1998, 2005) has risen 36.7%, 43.2%, and 28.8% respectively during the interval between the inversion and the subsequent market peak. Nor is it the case that a recession is unavoidable. There are opportunities for governments here and abroad to take corrective actions to restore confidence. This includes a meaningful thawing of US/China trade tensions as well as the adoption of stimulative fiscal and monetary policies around the world. For example, we are confident that the Fed will respond in September with another rate cut, and possibly a third in October or December, which may well reverse the inversion.
The inverted yield curve complicates an already cloudy economic outlook. Clearly the global economy is slowing, but there continues to be impressive strength in consumer spending, rising wages, and lofty small business sentiment. On the other hand, as we have pointed out in our most recent Outlook, conflicting data regarding the US economy is concerning, especially the sharp drop in bond yields. Consequently, we continue to recommend that investors placing importance on preservation of capital remain cautious and flexible.
Quote of the day: “If you’re not confused by the outlook, you just aren’t paying attention.” -Steve Liesman, CNBC
Economic and Financial Market Outlook 2019 Q3
The US and Global stock markets are enjoying a banner year. The S&P 500 Index rocketed +18.5% in the first six months of 2019 (the best first half since 1997), which included +7.1% in June (the strongest June since 1938). International equities have also enjoyed substantial gains: the MSCI All-Country World ex-US Index (ACWX) has climbed +13.4% this year. What lies ahead after such lofty returns? Despite the remarkable first half, we consider the outlook to be mixed, reflecting widely divergent views on three critical issues:
- Tariffs and trade wars
- Synchronized global central bank stimulus
- Slowing US and international economic and corporate profits
Since the Trump administration levied tariffs on Chinese goods over one year ago, sharp stock market swings have occurred regularly. When tensions rose, most indices sold off in response, such as in the fourth quarter of 2018 and May 2019 when the MSCI All-Country World Index (ACWI) retreated -12.7% and -7.3% respectively. In contrast, reports of negotiation progress and easing tensions led to meaningful relief rallies in January and June. The clock is running out on accomplishing a productive agreement; the negative effects of tariffs are already biting into profits and eroding business confidence and capital expenditures. Both sides have stated a desire to reach a deal but have found it difficult to compromise on major issues. At this point, it is difficult to predict any specific outcome with a high degree of confidence. Consequently, our recommendation to investors is to avoid strategies based upon a very positive or very negative scenario.
With respect to central banks, their policies wield powerful influence on a country’s economy, currency, and financial markets. Over the past year, many of the key banks have increasingly indicated concerns for slow growth and below-target inflation and have stated that they are prepared, if needed, to provide stimulus. This is now the case in the European Union, Japan, India, Australia, most of South America, and, significantly, the US and China. The Federal Reserve is widely expected to reduce its target interest rate in July for the first time since 2007, and many investors anticipate multiple rate cuts later this year. Historically, central bank rate cuts have provided powerful economic stimulus that has boosted flagging equity markets. If the Fed balks, global stock prices almost assuredly will respond negatively. Further complicating matters, monetary policy will be influenced by trade considerations. For example, the economic gains achieved through a US-China resolution will reduce pressure to cut rates. As we see it, future Fed action is as enigmatic as future trade conditions and prudent investors should maintain a position of flexibility and data-dependency.
Source: Council on Foreign Relations, Global Monetary Policy Tracker, June 2019 (-6.68, Easing), accessed July 10, 2019. Data Sources: Bloomberg, IMF, Council on Foreign Relations
The International Monetary Fund and other forecasters currently expect global growth to deteriorate for the remainder of this year. The world’s two largest economies, the US and China, have the greatest potential to turn around the projected weakness. The US is slowing and risks continuing down this path, with negative consequences for corporate earnings, without some stabilizing monetary and/or fiscal stimulus. However, we do not anticipate a recession and the most probable scenario includes a pickup in corporate profits by year-end. China’s GDP has been decelerating for 15 years from the double-digit rates of the mid-2000’s to 6.5% in 2018, and the government is determined to hold the line at 6.0%. Government officials have already adopted numerous policies to reverse a slumping economy, which was apparent even before tariffs were enacted, with uncertain result. Since these two countries account for about 40% of global GDP growth, their success will determine whether the world’s economic situation will flourish or languish.
The US stock market will continue to benefit from a variety of supports. Stock buybacks and merger and acquisition activity show few signs of letting up. The bond market does not offer attractive returns to draw investors out of equities. Many common stocks provide dividend yields in excess of bonds and money market funds and some investors, especially retirees, depend on stocks to provide essential growth of principal to fund withdrawals. This is not to denigrate bonds, which remain useful to investors desiring to dampen portfolio volatility and reduce their allocation to equities.
In summary, we see many positive economic factors that run concurrent with rising risks and negative data. Moreover, key determinants cannot be easily predicted at this time. In a market expected to remain highly volatile with the distinct possibility, if not probability, of a correction sometime this year, we suggest that investors give careful consideration to their equity ratios.
As Trade Tensions Heat Up, Market Outlook Cools Down
Earlier this year, our Global Economic and Financial Market Outlook was favorable based on expectations of a trade agreement with China, a more accommodative Federal Reserve policy, a stronger than anticipated global economy, and surprisingly upbeat corporate earnings. Since the end of April, the positive case for global and US economies has weakened resulting in a 6.0% pullback in both the S&P 500 and the MSCI All-Country World ex-US Index (ACWX). The outlook has become increasingly uncertain and a higher level of caution is warranted for stock investors.
The key negative development in May was a breakdown in trade negotiations and increased tariffs between the US and China. At this point it seems to us that the two sides are becoming further entrenched and we think an imminent resolution is unlikely. The impact of the escalating trade war will be negative for global and US growth and individual company earnings. Since there is no modern-day precedent of a major trade war between the world’s two leading economies, it is impossible to estimate the magnitude of the negative impact with any confidence. [Update: new tariffs on Mexico were announced Thursday night, which underscores this administration’s commitment to tariffs as a policy tool. This also reinforces the level of uncertainty and the fact that circumstances can change at any moment.]
We emphasize that many of the positives that drove the market higher earlier this year remain in effect. The Federal Reserve and other key central banks have turned more supportive. Business and consumer confidence remain high, with unemployment, inflation, and interest rates surprisingly low. Corporate profits have continued to surprise Wall Street analysts to the upside; 2019 full-year S&P 500 earnings and revenues are expected to rise around 5.0%. Stock buybacks are on a record pace and valuations are relatively low, further supporting equity markets. At this point, we continue to expect the US to avoid an economic and/or profits recession.
On balance, it is prudent for investors to be cautious and stay vigilant and flexible.
Economic and Financial Market Outlook 2019 Q2
Despite the current deceleration in global and US economic growth, we think the outlook for the world’s key stock markets is modestly positive.
- We anticipate a second-half acceleration for most advanced and emerging economies and, despite recent soft data, we reiterate our forecast for 3.4% global GDP growth in 2019.
- US stock markets will benefit from economic stabilization, a supportive Federal Reserve, and low inflation and interest rates.
- The Chinese economy and stock market will improve in response to stimulus measures and could further gain from a US tariff resolution. Europe’s challenges will persist.
- Risks remain apparent but should be weighed against a solid environment for potential stock market gains.
- We categorize our outlook as “modestly positive”: the balance of encouraging factors and visible risks tilts moderately in favor of sustained equity investment. Excessively positive or negative fundamental scenarios are based on unlikely developments.
The US economy has decelerated from last year’s robust growth. GDP growth peaked at 4.2% in the second quarter of 2018 and sequentially dropped to 3.4% and 2.2% in the third and fourth quarters. Current estimates for the first quarter indicate a third consecutive slowdown. A major fear of some investors is that this trend will continue until the US economy enters recession. We reject this view and confirm our position that a growth rebound will occur, potentially as soon as this quarter. Though we are unlikely to see GDP growth greater than last year’s 3.0%, we project that steady growth this year of 2.0%-2.5% will be enough to maintain a strong labor market, healthy consumer spending, and improved manufacturing demand. Indeed, the April 4 weekly jobless claims hit a 49-year low.
The US stock market has recovered as focus has shifted beyond recent weakness, with the S&P 500 Index soaring 13.7% in the first quarter. Despite this considerable surge, investor sentiment is still largely negative, which we consider encouraging. A recent Merrill Lynch Flow Show report tallied nearly $80 billion of outflows from global equities in the first quarter. This indicates that the improving situation is not fully reflected in stock prices. The persistent pessimism could be due to the widely expected earnings decline in the first and possibly second quarters. We anticipate this will be transitory, brought about by unique circumstances including the longest government shutdown in history, a hangover from the fourth quarter market correction, and unusually bad weather. A second half economic acceleration should boost full-year S&P 500 profits, but we are reducing our prior forecast of 7.0-9.0% to around 5.0%. Historically when earnings are muted, the stocks of companies exhibiting above-average growth have outperformed.
Though the economic and profit backdrop has been more challenging, other fundamental positives remain. The Federal Reserve has indicated that they will not raise interest rates again this year. We expect the Fed to be data dependent, including the possibility of lowering interest rates should the economy demand monetary stimulus. Inflation is low and stable and has little prospect of surging upward. Valuations are reasonable and stock buybacks have totaled more than $270 billion already this year, signaling optimism for the rest of 2019.
International stock markets have rebounded from an oversold condition in 2018, though many economic indicators have deteriorated. This upsurge has been fueled by better-than-feared data out of Europe, improved growth prospects in southeast Asia, and optimism for a US-China trade resolution. Already Chinese policy makers have introduced stimulus measures which are making a positive impact, laying the groundwork for a second-half pickup. We are encouraged by recent Purchasing Manager’s Index (PMI) data (see chart) that showed expansion in manufacturing, which motivated J.P. Morgan economists to revise upwards their full-year China GDP estimates to 6.4% from 6.2%. Though this turnaround will also help the situation in Europe, the investment case is weaker there due to uncertainty regarding Brexit, Italy, and the ECB. Growth in the emerging economies is expected to exceed developed economies, with India and Brazil the most attractive for investors.
Bond yields fell further in the first quarter, reflecting weakening economic growth. At this point, we think that yields are unlikely to fall much more, considering our outlook for a second-half pickup. Our view is that now is not the time to lock in current rates on long maturities. Medium to short term bonds can provide flexibility and portfolio stability. On a related note, we would be remiss if we did not include a comment on the yield curve. A yield curve inversion, meaning that it costs more to borrow in the short-term than it does in the longer-term, is considered by many investors to be a recession indicator. This occurred in the first quarter, with the yield on 3-month T-Bills surpassing the 10-year Treasury rate. This may sound concerning, and while it has strong predictive power for coming recessions, its occurrence normally precedes recession by 12-18 months. What’s more, this interim period usually coincides with rising stock markets. This is, however, more evidence that we are in a slowing period and investors should remain attentive to new developments.