Second Quarter Recap
The first half of 2019 closed in strong fashion, with U.S. and international stocks generating positive returns, and the S&P 500 index hitting an all-time high to close the quarter. Stock market gains were driven by strong consumer spending in the face of trade uncertainty. Also helping out stocks is the promise of easy monetary policy from the Federal Reserve through the rest of the year.
U.S. mid cap stocks have been one of the strongest performing areas of the market, spurred higher by improved earnings and increasing merger and acquisition activity. Emerging market stocks have enjoyed strong returns of 10.8%, YTD, but have lagged U.S. markets as trade war concerns continue to linger over share prices within countries like China, India, and Mexico.
Bond investments have performed well, particularly in longer maturity holdings, as fears of economic slowdown and the Fed’s newfound willingness to cut interest rates has pushed yields lower and prices higher.
With the exception of some brief volatility in May, as President Trump threatened further tariffs against China, then Mexico, the path higher for stocks this year has seen fairly smooth sailing. The outlook for future growth does suggest a balanced approach to managing return and risk. The uncertainty over higher tariffs has caused a number of gauges for global growth to turn lower. Global manufacturing data has entered contraction territory for the first time in over five years. Balancing the risk of slower manufacturing data is a strong consumer. The jobs market is very strong while the housing market, a key driver in consumer confidence, has rebounded due to falling mortgage rates.
A respite in trade threats has allowed for markets to resume their upward trend, but volatility could return with the push of a ‘send tweet’ button from the President’s Twitter account. Given that global economic data has weakened, and market returns have been so strong through the first half of the year, we would caution investors to not be surprised if volatility resurfaces in the summer. Though it would unlikely lead to a recession in the near-term, given that the consumer is in strong shape, it bears watching due to the strong performance across stock markets through the first half of the year.
The U.S. Outlook – Consumers, Corporations, Politicians
In our last quarterly outlook, we highlighted the general strength of the U.S. consumer with respect to increasing net worth and low, overall debt costs. Data released since the end of last quarter continues to underscore a healthy consumer, given the following data points:
Employment has increased by an average of 192,000 jobs over the last 12 months, while the unemployment rate remains at a 50-year low.
Hourly earnings are increasing at an average rate of 3.1%, the fastest growth in 10 years.
Credit delinquencies remain subdued in spite of rising interest rates over the last two years
On the final point, we closely monitor credit trends as the ripple effect of defaults and tighter lending has major ramifications for the U.S. economy. So far, we have not seen worrisome signs from the household credit data, which was a pre-cursor to the last crisis. In the chart below, you can observe that in 2006 and 2007, before the economy entered a recession and stocks began to roll over and enter a bear market, household credit delinquencies started moving higher. That has not occurred in the current environment in spite of Federal Reserve raising interest rates.
Nor have default rates among businesses started to increase, as they did during the 2008 crisis and prior to the 2001 and 1990 recessions. Interest rates have moved higher, from 0.0% to 2.5%, but still remain low in a historical context. The Fed’s pause on rate hikes, and potential shift to cut rates has kept pressure from building within speculative areas of the credit market due to restrictive interest costs.
Looking forward, it’s possible that companies do start to face some pressure as a result of weakening global trade and tariff uncertainty. Corporate sentiment has shifted lower over the last few months, with the Institute for Supply Management reporting that its widely followed manufacturing new orders survey hit 50.0%. This represents a decline from prior readings and just above what would be considered contraction territory. From the survey, “Respondents expressed concern about U.S-China trade turbulence, potential Mexico trade actions and the global economy.” Various quotes from within the survey noted that the potential increase in tariffs on China and Mexico were causing havoc in supply chain forecasting and forward earnings guidance.
We are typically loath to get overly concerned about geo-political sparring as it rarely feeds into the long-term return prospects for stocks. Think about how many ‘crises’ there have been over the last 10 years that have had minimal impact on the U.S. market’s returns – EU budget crises, the U.S. debt ceiling showdown, Russia invading Ukraine, the Greek debt crisis, war in Syria and Yemen, Brexit, etc. These have caused brief bouts of volatility at times but not affected the longer-run trajectory of stocks. However, the U.S. continually threatening major trading partners with impromptu tariff hikes, undermines forward guidance for corporate earnings and shakes confidence in future stock returns. JP Morgan estimates that if the U.S. implements its full threat of tariffs on China and on Mexico, it would reduce S&P 500 earnings by around $13.00, or an earnings drop of 8.0%.
Considering that valuations would also move lower as investor sentiment would sour, and companies would likely aggressively lower guidance to take their lumps in the process, the potential bear case for stocks could be a 15-20% decline if the full complement of tariffs against China and Mexico is pursued.
We tend to think that President Trump is unlikely to pursue this path, evidenced by his willingness to delay further tariffs with both countries as they came to the bargaining table over the last month. However, where he goes from here depends on what he views as his best campaign platform – an appreciating stock market and stable business outlook or a trade war that plays to his base’s concern over lost jobs and industry (regardless of whether trade deals were directly responsible for this). We tend to think that the stable market and business outlook is better suited for his campaign but are cautious to not predict what he will tweet about next.
In addition to tariffs, the government’s judicial push into the technology industry is giving us some pause with respect to earnings outlook. Growth stocks, primarily driven by technology companies such as Facebook, Amazon, Netflix, and Google (the FANG stocks), have generated substantial returns for investors and have been one of the primary drivers for earnings growth across the market.
Obviously, the earnings growth has been for good reason. The internet of things has shifted consumer and business spending from traditional channels onto mobile platforms and the cloud, with increasing research and development dollars going towards data driven solutions rather than more antiquated approaches. These are long-term secular trends that are unlikely to abate any time soon and continue to merit inclusion in an equity portfolio. However, we are closely monitoring the prospect of the government’s involvement in deciding what type of business is permissible and what requires greater oversight. It may not necessarily be that the government breaks up the big tech giants, or that they stop the growth trends that are occurring within the sector, but their involvement, particularly at a time when margins are high and valuations, relative to history and other sectors of the market, are stretched, may signal tougher sledding ahead.
Fixed Income – Lowering Risk, Lowering Returns
With parts of the economy slowing down as trade uncertainty kicks in, combined with the Fed’s shift towards potentially cutting rates this year, bond yields across the U.S. and developed world have fallen significantly to start the year. The U.S. 10 Year Treasury, which yielded 2.68% to start the year, now yields 2.00%.
Yields in Germany and Japan are now negative while countries with weak fiscal health, such as Spain or Portugal, yield significantly less than the U.S. From our vantage point, fixed income allocations are best to directed towards high quality, short-term U.S. bonds, be in Treasuries, government agency bonds, or corporations with strong credit ratings. If given the choice between owning a 10 Year German Bund, yielding negative 0.30%, or a 2 Year government agency bond in the U.S., yielding around 2.4%, we would gladly take the extra two percentage points and the significant reduction in interest rate risk.
While it might be hard for investors to get enthused about fixed income returns of 2-3%, which is where a lot of short-term, high quality U.S. bonds are trading, in our view it’s better to position for quality and take the available yield, when so much of the global bond market ($13 trillion dollars) is trading at a negative yield.
Within the high yield space, the average bond is trading at a 400 bps spread to U.S. Treasuries, or around a 6% yield. While this is up from the multi-year low levels hit in the summer of last year, it is still low in the context of history and in our view does not adequately compensate for potential credit risk, nor the high correlation to equity markets, which have enjoyed a sizeable run over the last six months.
The historical median yield of high yield bonds is around 8.2% and while corporate yields may stay low for a little while longer, we’d prefer to have an overweight in the safer portion of the credit spectrum. We prefer a lower correlation to equities at this point in the cycle and will consider reallocating into high yield when it trades at or a discount to average historical valuations. In the interim, we will continue to favor short-term, high quality fixed income.
In closing, we see a balance of risk and reward in the market. Economic data has slowed in the U.S. and abroad during the second quarter, but faces the potential for improvement as tariff uncertainty eases, the Federal Reserve tilts towards a more lenient rate policy, and business spending picks up in the back half of the year. The consumer has been very resilient over the last year and is bolstered by a strong job market, rising wages, and improving net worth.
While economic data is likely to remain positive throughout the remainder of 2019, the primary risks revolve around government interference, in the form of trade wars and legislative action against the technology industry. The threat of tariffs against Mexico put much of the business community on edge given the interconnectedness of supply chains between the two countries. Simultaneously, the threat of punitive action against the large tech companies threatens the market leader in share price and earnings growth over the last five years and could reduce forward earnings optimism.
The Federal Reserve’s willingness to keep interest rate policy easy as an ‘insurance’ against potential economic weakness bodes well for the broad environment as it wards off the risk that they will continue hiking rates until something breaks. Beyond the Fed, the majority of signals we look at continue to point to the economic cycle being in the later stages, though not an imminent end. As we navigate the rest of the year and beyond, we continue to implement high quality investment ideas that focus on protection of principal, secure cash flows, and complement balance of return and risk across the portfolio.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data via St Louis Federal Reserve, Morningstar, Eaton Vance, Bloomberg, KKR, Blackstone, and JP Morgan