“The second cup of coffee is never as good as the first.”
Most coffee drinkers agree with our 26th president on this point. At more than 10 years, we’ve now surpassed the longest Post WW2 economic recovery on record thanks in part to the jolt of caffeine from extraordinary Fed monetary policy measures. Without a doubt, 0% interest rates and multiple rounds of QE from 2008-2015 prevented the U.S. tipping from recession into depression. After three years of “rate normalization,” renewed rate cuts could begin at the July 31st Fed meeting; however, this second serving of Fed rate cuts is unlikely to provide the same boost to the U.S. economy as previous cycles. In this edition of Market Monthly, we provide an update on some of the issues and concerns that continue to impact market expectations before reviewing first-half market performance and previewing our second half outlook.
A Mid-Cycle Slowdown?
Understanding where we are in the economic cycle frames our discussion around the economy, Fed, interest rates, trade and markets. July marked the 121st month of U.S. economic expansion, a new longevity record. The red bar in the chart below provides context for this expansion relative to others since WW2.
Though we remain in a record long economic recovery, an argument could be made that we may be in a midcycle slowdown. The chart below illustrates the growth trajectory of previous economic expansions (shorter duration/faster growth) compared to (in red) the current expansion (longer duration/slower growth). Previous short-term, “boom bust” cycles with a fully armed Fed have in recent years yielded to “lower for longer” cycles with fewer arrows in the Feds quiver to make meaningful economic impact.
Economic Review and Preview:
Q2 GDP: The first estimate of Q2 GDP to be released on July 26th is likely to be lower than Q1’s 3.1% growth rate. At press time, the Atlanta Fed GDPNow forecast and the New York Fed Nowcast foresee 1.6% and 1.4% GDP growth respectively for Q2. We anticipate the data to reflect a return to consumer strength from Q1’s weak showing with a reversal of the one-off positive impacts from inventory, trade surplus and government spending. GDP growth of 1.5% or more will support the consensus .25% rate cut whereas anything below 1.5% increases the possibility of a full .5% rate cut.
U.S. Consumer Sentiment: Near-record low unemployment and record-high stock prices continue to be the catalysts behind consumer optimism. Consumer spending is the cornerstone behind U.S. economic growth and stability comprising almost 70% of GDP. Unemployment would not pose a concern unless it increased by at least .33% or until wage growth spiked to at least 4%. Historically, either of these conditions preceded a recession, but for now, these risks are not present.
Global Business Sentiment: The global Purchasing Managers Index (PMI) remains under pressure with the U.S. expanding but much of the developed world contracting. Trade uncertainty remains a primary concern for corporate decision-makers abroad and is impacting investing decisions. A rebound in the U.S. Philadelphia and Empire manufacturing indices are encouraging signs for business activity, but more proof is needed to call this a turning point.
PMI surveys provide a glimpse of businesses attitudes toward the economy but serve as a leading indicator to future earnings trends. In the coming weeks, we will train our sights on Q4 earnings estimates for potential impact on 2019 revisions.
Trade Wars: Prior to last month’s G20 meeting between Trump and Xi in Japan we suggested: “A trade truce (de-escalation) is more likely than a trade deal in the near-term.” A truce, remains our base case but also our best-case near-term scenario. The path to any trade deal is bumpy and becomes more complicated the closer we get to the 2020 elections. A final deal necessarily involves broader scale geopolitical obstacles illustrated by recent protests in Hong Kong, Chinese military training adjacent to Taiwan and tensions with Iran in the Strait of Hormuz energy-shipping channel.
Supply Chain Disruption: Supply chains trace the source of physical and human capital throughout the production process leading to the sale of final goods. The potential for negative tariff spillover effects on manufacturers with supply chains linked to Chinese suppliers has restrained corporate spending. There is mounting evidence of businesses (i.e., Apple, Crocs, Cummins, GoPro) willing to reconfigure their manufacturing supply chains away from high-cost suppliers in China toward low-cost locations like Vietnam, Malaysia, Thailand and India. In other words, businesses are becoming impatient waiting for a trade deal and are putting their money where their mouth is. This is an encouraging early sign of momentum for business spending.
Takeaway: For now, we remain in a steady state of low growth, low interest rates and low inflation, which has supported risk assets up to now. Time will tell if we are late cycle or simply in a midcycle slowdown. An inverted yield curve is flashing an early warning sign, but other recession indicators remain benign leading us to a cautiously realistic outlook with some help from a friendly Fed.
Fed to Recaffeinate:
The Fed has loudly telegraphed and is widely expected to cut rates at the July 31st meeting for the first time since 2008. Minutes from the June Fed meeting reveal that weak economic growth from abroad, persistent below target inflation and continuing trade concerns have elevated downside risks to their outlook. In our view:
- A .25% rate cut (75% probability) would be a life jacket to markets as an insurance policy supporting risk assets. Stocks have already priced this in.
- A .5% rate cut (25% probability) would be a lifeboat to boost the economy extending the 11-year expansion. This could give stocks a short-term bump but would also express conviction by the Fed.
Takeaway: We anticipate renewed Fed rate cuts at the July 31st meeting for the first time in 11 years but think it is unlikely to provide the same economic boost as previous cycles. The most likely outcome will be a continuance of the U.S. expansion keeping the global economy from tipping toward recession. We think a rate cut would provide near-term market insurance and buy time for organic economic improvement in the months ahead, but the Fed cannot do this alone. We expect other global central banks to follow suit and remain hopeful an eventual trade deal could help put in a floor on global growth concerns.
First Half Review, a Bull Market in Everything:
Equity Review: U.S. markets led the way in the first half with their best start since 1997. Earnings have been flat, yet markets have seen valuations grow beyond their 5- and 10-year averages thanks to an accommodative Fed. In the U.S., growth, defensive and low-volatility stocks outperformed value stocks as is typical during periods of weak economic growth. A trade deal could cause a mean reversion trade to favor value, but that remains elusive for now. International stocks have also performed well with Eurozone equities leading the way. For the quarter, pockets of weakness showed particularly in China and the United Kingdom due to uncertainty regarding trade and Brexit.
A strong/stable dollar had little impact on returns in the first half, but we expect a weaker dollar could provide an additional source of returns for U.S. investors in the second half of 2019.
- Lower rates have supported the PE expansion trade, but earnings must carry the burden to support further gains.
- Companies are beating previously downgraded estimates, but trends remain flat.
- In the S&P 500, companies generating over 50% of their business in the U.S. have performed significantly better than those more dependent on overseas business.
- Short term, U.S. Markets are fully valued and could encounter consolidation after earnings season.
- We have a bullseye on upcoming Q3 and Q4 earnings revisions to reassess our outlook.
- A trade truce is baked into current prices but a trade deal is not.
Bond Review: A first glance at the chart below for YTD bond returns confirm our observation above of a bull market in everything. As the Fed paused in March and pivoted in June to a lower rate forecast, yields have fallen and boosted the price of all assets.
So far in 2019, the higher the risk the higher the return for bond investors. Q1 was a story of a return to credit risk in areas like high-yield and emerging-market debt from an oversold December 2018 condition. Q2 was a story of falling long-term yields after the June Fed meeting, supporting the case for interest rate risk. This is displayed in the chart below.
- Fed rate cuts could flatten the yield curve going forward, a welcome sign.
- Low default rates continue to support corporate bonds as a way to generate yield.
- Any weakening of the dollar supports emerging market debt.
- Municipal bond supply constraints support current municipal bond valuations.
- With “equity like” returns for the first half, we expect a “keep your coupon” best-case scenario for the balance of 2019.
Asset Allocation Review: The chart below illustrates hypothetical asset allocation performance for the last year across multiple asset mixes. Three-month and one-year performance is largely flat across the entire spectrum of possible asset allocation objectives due to stock and bond performance being relatively equal. For equity performance, we utilize a 70% U.S. / 30% international blend to reduce portfolio and currency volatility.
This illustration portrays benchmark allocation performance as a high-level guidepost of how different asset allocation blends have performed and does not account for differences in allocations over time, manager selection, cash flows or taxes.
- At 121 months, the U.S. recovery is the longest on record.
- At an annualized GDP growth rate of 1.8%, the growth rate ranks among the lowest on record.
- Consumer trends remain positive buoyed by low unemployment and record-high stock prices.
- Business trends remain challenged with trade the pivot point between global expansion and contraction.
- A trade truce is our best base case in the near-term, but a trade deal would stimulate the global economy.
- The Fed has signaled a July 31st rate cut, which should support the recent market rally at a .25% cut but stimulate markets and the economy at a .5% rate cut.
- Equity markets are off to one of the best starts in years but need earnings follow-through to justify valuations beyond current levels.
- Bond markets have enjoyed “equity like” returns so far in 2019 with the balance of the year returns more constrained.
Jeff Terrell, CFA Chief Wealth Market Strategist
BB&T Wealth Portfolio Management Team
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors
The Morningstar indexes are unmanaged, weighted indexes of stocks and bonds providing a broad indicator of price movements. Individual investors cannot directly purchase an index.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.