Investment Overview: 3rd Quarter 2019

November 15, 2019
Frank W. Savage, CFA
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The Economy

The longest expansion in U.S. history continues. Second quarter GDP growth came in at 2.0%, marking an economy that continues its upward trajectory, albeit at a slower-than-optimal pace. The revised number reflects slower growth than the 3.1% realized in the first quarter and the 2.9% growth rate in 2018. Third and fourth quarter GDP growth is estimated to be between 2.0%-2.5%, signaling the continuation of the expansion, despite the negative effect of escalating tariffs.

The saga between the U.S. and China over trade disputes continued to drive market returns throughout the third quarter. Gold prices hit a six-year high in early September, as falling global interest rates and the prospects for decelerating growth intensified and prompted investors to seek the safe-haven asset. In the waning days of September, investors unwound fear-driven trades that roiled markets in August. The positive change in market sentiment to end the quarter was largely attributed to reconciliatory gestures between the two powers.

Investor uncertainty over the true economic impact of U.S./China trade negotiations is likely to persist into the foreseeable future. The manufacturing sector contracted in August for the first time in three years, and is no doubt being weakened by the persistence of tariffs. More troubling than U.S. manufacturing weakness is the manufacturing slowdown in the eurozone. Eurozone manufacturing sentiment is at its weakest in years and the outlook for Germany, the region’s largest economy, is at its worst point in more than a decade.

Although global trade woes continue, other areas of the economy are showing remarkable resilience. August retail sales growth beat expectations by a considerable margin and the unemployment rate remains low and stable. Many economists expect U.S. consumer spending to remain strong, offsetting manufacturing weakness, and ultimately supporting a continued expansion. One area of slight concern is consumer confidence. Although confidence remains high by historical standards, the reading did fall in September by more than economists expected.

The housing market picked up a bit of steam recently after a surprisingly dismal 2019. Low rates are certainly resulting in more market activity and affordability has recently improved. Nevertheless, combined new and existing home sales have gotten back only to where they were at the beginning of 2018.

Along with trade conflicts garnering headlines, so too did geopolitical drama across the globe. Protests in Hong Kong continued for the 16th straight week ahead of the 70th anniversary of the founding of Communist China. The sustained protests have now lasted about twice as long as the 1989 Tiananmen Square protests. The economic and social fallout from the largely leaderless demonstrations remains to be seen.

Iran’s alleged September 14th attack on Saudi oil facilities took out approximately 5% of world oil supply. Consequently, oil futures jumped by the most on record. Easing fears was a statement from the Saudi Kingdom that about 50% of the supply had been quickly restored. In response to rising oil prices, U.S. oil production rose back to a record 12.5 million barrels a day by the end of September, a testament to the shale industry’s ability to ramp up supply when conditions warrant.

In a sign of the times, the U.S. House of Representatives moved ahead with an impeachment inquiry in late September after reports that President Trump withheld aid to Ukraine while he pressed for an investigation of Democratic presidential candidate Joe Biden and his son. The impeachment inquiry avoided a full house vote on opening a probe, a step that has occurred each of the previous three times the House has spearheaded impeachment proceedings. This may signal a lack of House support to pass a resolution.

Interest Rates

Intermediate and longer-term bond prices experienced heightened volatility during the third quarter, but continued upon their second-quarterly rally, as investors oscillated between doubt and acceptance of the continued economic expansion. In August, the 10-year Treasury Note posted its biggest one-month decline since August of 2011. In an about-face, the huge rally was followed by an abrupt selloff in the first two weeks of September. The 10-year Treasury Note finished the month with yet another rally to yield 1.67%, down from 2.01% at the end of the second quarter.

Bond returns have been exceptional this year as bond prices move inversely with interest rates. The broadly-diversified Barclays Capital U.S. Aggregate Index is now up over 10% for the year. Higher-quality bonds outperformed lower-quality bonds as high-yield spreads widened in September.

Still notable is the yield on the 3-month T-Bill, which ended the quarter at 1.82%. This inversion of the yield curve, where shorter maturities offer higher yields than longer issues is often considered as predictive of an oncoming recession. Although a recession does not appear probable over the next several quarters, market participants will closely monitor this inversion for any telltale signs.

The Fed lowered interest rates during its September meeting for the second time in recent months to a range of 1.75%- 2.00% as Fed Chair Powell cited “slower growth abroad and trade policy developments”. The move was widely anticipated. Powell won on a 7-3 vote, the most formal dissent on a policy decision since he became chair in February of 2018. Fed officials appear divided as to whether they will lower rates again this year. Inflation appears well contained but did show a notable uptick at last report with both the Producer Price and Consumer Price Indices up 0.3% for the month. The next Fed meeting is scheduled for October 30th.

Repo markets, or markets where large investors borrow money on a short-term basis (typically overnight), were in disarray in mid-September after outsized corporate obligations and potentially overly stringent liquidity requirements at the Fed temporarily strained funds. The Fed’s subsequent large-scale injection of liquidity via an overnight repurchase-agreement operation quelled fears and brought the repo rate down to the Fed’s target zone. Also, Fed Chair Powell sought to alleviate tensions stating that the recent episode did not have “implications for the broader economy or the economic outlook, nor for our ability to control rates”.

Repo markets are likely to be tested again in the first week of October as banks may refrain from lending at quarter-end to shore up the appearance of their balance sheets.

Treasury yields of selected maturities for recent time periods are displayed below (data from Bloomberg).

  Treasury Bill Treasury Notes & Bonds
  3 mo. 2 yr. 5 yr. 10 yr. 30 yr.
9/30/19 1.82% 1.62% 1.55% 1.67% 2.11%
6/28/19

2.09%

1.76% 1.77% 2.01% 2.53%
9/30/18 2.20% 2.82% 2.95% 3.06% 3.21%

 

The total return numbers for various fixed income indices over the last twelve months are displayed below (data from Bloomberg).

12-Month Returns (as of 9/30/19)
Barclays Capital US Aggregate 10.30% Merrill Lunch US High-Yield 6.34%
Barclays Intermediate Government 7.52% Merrill Lynch US Municipal Index 8.75%
Dow Jones Corporate 14.00% JP Morgan EMBI Global 10.74%

 

Stocks

The stock market posted modest gains in September, rebounding nicely from August losses. The September gains have helped the S&P 500 Index hold on to its biggest year-to-date gain in more than two decades. The S&P 500 is now up 19% year-to-date, it’s best performance since 1997.

As we close the third quarter, markets appear somewhat ambivalent, as participants dissect conflicting economic reports in lockstep with grandiose political headlines. Nevertheless, the S&P 500 is less than two percentage points away from its July 26th all-time high.

The stock market has indeed climbed a “wall of worry”. Global geopolitical events, as opposed to underlying economic conditions, appear to be causing the most angst. Trades tensions and disputes with China and, to a lesser extent, negative interest rates in Europe are causing the most worry.

September witnessed a rare rotation into “value” from “growth” as investors appeared less concerned about recent economic weakness. Many of the hardest-hit sectors in the stock market in August were among the best performers in September. Banks, manufacturers, and energy producers outperformed the broader market this month. Conversely, stocks closely associated with the “momentum” trade were relative losers. In particular, shares of payment stocks including Visa, Mastercard, and PayPal fared the worst.

Investors will be contemplating if this is just a temporary reversal in the months ahead. Although the spread between the trailing price/earnings ratios of growth and value stocks hasn’t been this wide since 2001, investors may be reluctant to part ways with assets that have been winners for years.

Investor sentiment remains firmly with the U.S. relative to its international counterparts. In fact, except for the dot.com bubble period, the U.S. currently has the largest price premium over the eurozone, U.K., Japan and emerging markets since the 1980s. Some are starting to question whether the valuation gap is too large. Supporters of U.S. stocks point to the higher U.S. economic growth rate and quality of earnings. The relative valuation of domestic vs. international stocks again widened in the third quarter with both the MSCI EAFE (developed international) and MSCI EM (emerging markets) Indexes under-performing.

Equity Indices 3rd Quarter 2019
S&P 500 1.70%
Dow Jones Industrial 1.83%
NASDAQ 0.18%
S&P 500 Growth 0.72%
S&P 500 Value 2.83%
Russell 2000 (small-cap) -2.41%
MSCI/EAFE (developed international) -1.00%
MSCI/EM (emerging markets) -4.16%

Given the low interest rate environment and the September rotation into “value”, it’s no surprise that the Utilities, Real Estate, and Consumer Staples sectors were the performance leaders for the quarter with the sectors posting returns of 9.33%, 7.71%, and 6.11%, respectively.

Energy stocks, despite the Saudi oil disruption, continue to face oversupply issues in the face of stagnant global demand. The Energy sector finished the quarter down 6.30%. Despite its defensive characteristics, the Health Care sector continues to battle rising healthcare costs and ever-increasing political scrutiny. The Health Care sector was down 2.25% for the quarter.

Return by Stock Sector 3rd Quarter 2019
1. Utilities 9.33%
2. Real Estate 7.71%
3. Consumer Staples 6.11%
4. Information Technology 3.34%
5. Communication Services 2.22%
6. Financials 2.01%
7. Industrials 0.99%
8. Consumer Discretionary 0.51%
9. Materials -0.12%
10. Health Care -2.25%
11. Energy -6.30%

 

The Investment Overview is published quarterly by the Union Investment Management Group of Union Bank & Trust Company. Please address correspondence to: Union Bank & Trust, Attn: UIMG, PO Box 82535, Lincoln, NE 68501-2535.

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