Stocks and Bonds Reflect Diverging Views
Despite several unfavorable global trade developments and continued concerns over domestic and international economic data, equity markets continued to advance with the S&P 500 Index registering its best first-half performance since 1997. Equity investors seem willing to overlook the economic slowdown and near-term trade tensions given expectations for future interest rate cuts by the Federal Reserve as well as anticipation of a delayed, but still positive outcome on the U.S.-China trade dispute.
Keeping with the recent trend, U.S. stocks outpaced both global and international equity indices with the S&P 500 Index advancing by 3.8%. Global stocks (MSCI All-Country World Index) posted a positive return of 3.4%, and international stocks (MSCI EAFE Index) rose by 2.5%.
Similar to the first quarter, bond performance was propelled by another sharp drop in interest rates. The Barclays U.S. Aggregate Bond Index advanced by 3.1% in the second quarter, bringing the year-to-date return close to 6%. Benign inflation readings and declining interest rates have resulted in fixed income returns that exceeded our expectations for the first half of 2019. However, for these performance results to continue at the same pace in the second half of the year, interest rates would need to fall to levels not registered since data started being recorded in the early 1960s. While that outcome is possible, it’s not one we want to adopt as our base case assumption.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
After a surprisingly strong 3.1% GDP growth rate in the first quarter, the U.S. economy showed signs of a deceleration in the second quarter. Weak global growth and the confidence-shaking trade battle between the U.S. and China are the main contributors to the moderation in economic activity. Evidence of the broad-based economic deterioration has been reflected in weak manufacturing data, declining factory orders, as well as jobs gains and consumer retail sales that have generally fallen short of expectations.
Hopes and expectations are firmly centered on the Federal Reserve acting to reignite a slowing U.S. economy through monetary policy changes or more specifically, lowering interest rates. Time will tell how the Federal Reserve responds to economic conditions, but just as important is how participants in the real economy react to potential policy changes.
An alleviation of political policy uncertainties and geopolitical headwinds that are clouding business leaders’ ability to plan would also help to boost confidence levels and facilitate economic growth.
A mid-point equity allocation was maintained for the entirety of the second quarter. A few adjustments were made within equity allocations during the quarter. Large cap value exposure was slightly reduced in favor of large cap growth equities in order to more evenly balance the mix between those two categories. In addition, a few individual positions were eliminated due to prices reaching our fair value estimates. These holdings were replaced with positions where we have a more optimistic view on future upside potential.
After adding to our core bond holdings in the first quarter, no major changes were made to fixed income allocations this quarter. Given the significant drop in interest rates and less enticing bond yields, we are in the process of consolidating some fixed income exposure into ultra-short-term bonds that could be utilized as a funding source for more attractive opportunities outside of low-yielding core bonds.
Portfolio returns were bolstered by a continuation of the equity market rally and broad-based strength within the fixed income segments of portfolios.
While our fixed income strategies performed well in the quarter, most did not keep pace with longer duration bond proxies such as the Barclays U.S. Aggregate Bond Index. Our fixed income approach results in higher income levels and less interest rate risk than intermediate or long maturity bond strategies. However, periods of rapid and dramatic interest rate declines are not as beneficial for our fixed income positioning as it is for longer maturity bonds which are more sensitive to interest rate movements.
It’s difficult to recall a time when the stock market and the bond market reflected such different views of the world. The S&P 500 Index has advanced 26% from the low registered in the fourth quarter of 2018 and ended the second quarter perched near all-time highs. Equity investors seem confident that accommodative monetary policy from the Fed and other global central banks will extend the economic expansion and support equity valuations. A positive and timely resolution to various trade disputes is also a key component of the bulls’ thesis.
Judging by their actions, bond investors have a downright pessimistic and gloomy view of the economic landscape. The ravenous demand for U.S. Treasury bonds has driven yields down to three-year lows. Outside of the U.S., many international bonds offer investors record low yields with a significant proportion of global bonds trading with yields firmly in negative territory. Bond investors seem convinced that the growth slowdown will persist, that inflation will be subdued in perpetuity, and that trade wars won’t be resolved anytime soon.
Not surprisingly, our view is more balanced. The equity market rally that kicked off in late December has been driven by anticipation of a trade deal with China and interest rate cuts from the Fed. Positive outcomes on these fronts seem to be largely priced in given the march to new all-time highs. If the conclusions don’t meet investors’ expectations, stocks are certainly susceptible to a decline in the near-term. However, we don’t see an overly compelling case to get more conservative than our current midpoint equity stance. Equity valuations are fair to moderately attractive against the backdrop of an ultra-low interest rate environment which translates into more valuable corporate earnings and stock dividend yields that are often higher than the income opportunities in many segments of the fixed income markets.
Difference of Opinions
The chart below illustrates the divergent views among stock and bond investors that we discussed above. The domestic stock market (S&P 500 Index; black line) has rallied sharply over the past six months, reflecting the bullish views of equity investors. Conversely, bond yields (10-year U.S. Treasury yield; blue line) have fallen from roughly 2.75% to 2% during the same time period, reflecting the preference for safe-haven assets and the bleak views of fixed income investors.
Sources: Zacks Advisor Tools, FRED (Federal Reserve Economic Data).
Markets Focus on China, but Deeper Trade Ties with Canada and Mexico
In late May, President Trump caught investors off-guard with an announcement of tariffs on all goods coming into the U.S. from Mexico due to the ongoing immigration dispute with our neighbor to the south. These tariffs were originally slated to start at 5% and then increase monthly until they reached 25%. While the U.S. and Mexico reached a deal several weeks later that avoided the implementation of tariffs, investors remained concerned that tensions may heat up again in the future. In addition to the recent conflict with Mexico, the revised U.S.-Mexico-Canada trade agreement (USMCA) is still awaiting ratification by Congress.
While trade negotiations with China receive most of the media attention, our trade relationship with our North American neighbors has a much larger potential impact on the U.S. economy. As illustrated in the chart below, our combined imports from Canada and Mexico are greater than what we import from China. On the export side of the equation, the amount of goods we send to Canada and Mexico dwarfs our exports to China.
Sources: U.S. Census Bureau, Wells Fargo Investment Institute, May 16, 2019. Chart shows 2018 goods trade between the U.S., Canada, and Mexico, as well as between the U.S. and China (for reference). “Chart of the Week” 5/29/19 Wells Fargo Investment Institute.
Long in the Tooth?
In July, the current economic expansion has officially become the longest expansion in history. This naturally prompts investors to question how much longer it can last. However, another factor that should be considered is how shallow this expansion has been as measured by cumulative GDP growth (chart on the right; light blue line). Many investors would argue that this is relevant because the tepid growth environment has prevented many of these excesses that typically end economic cycles.
Sources: BEA, NBER, J.P. Morgan Asset Management. *Chart assumes current expansion started in July 2009 and continued through June 2019, lasting 120 months so far. Data for length of economic expansions and recessions obtained from the National Bureau of Economic Research (NBER). These data can be found at www.nber.org/cycles/ and reflect information through June 2019. Past performance is not a reliable indicator of current and future results.
Guide to the Markets – U.S. Data are as of June 30, 2019.
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