The three months ended June 30, 2019 were marked by volatility in equity markets and a significant decline in worldwide interest rates. The S&P 500 was down 3% for the quarter at its low but finished up 4.3% for the entire time period. The yield of the 10-Year U.S. Treasury dropped to 2.0% while many European interest rates broke below zero. Building on the first quarter returns, our accounts delivered significant positive performance in 2Q19.
The current environment is analogous to a boxing match. In one corner, wearing red trunks (and scaring everyone) is the challenger, a combination of weakening economic activity and trade tensions between the United States and China (and perhaps other countries). The challenger has been landing a lot of punches lately:
He is very effective overseas particularly in Europe and Japan. In contrast, payroll growth in the United States rebounded to 224,000 after a May reading of 72,000. The trade war has been a split decision. In other words, after breaking off negotiations and raising tariffs on select Chinese imports to 25%, President Trump agreed to a truce. For an unspecified time tariffs on additional Chinese goods are suspended and negotiations are implied to resume. The policy uncertainty remains a weight on the global outlook but a pause in tensions propelled U.S equities higher.
Wearing green trunks (and at this moment looking like he outweighs his opponent) is the reigning champion, monetary policy (i.e. interest rates). It is really a team effort with central banks including heavy weights like the Federal Reserve, European Central Bank and the People’s Bank of China in the corner together. Chairman Powell delivered an uppercut when he stated that the Fed “will act as appropriate to sustain the expansion.” This has been interpreted as an American version of ECB head Mario Draghi’s 2012 decisive quote “whatever it takes.” The ECB used a hook by signaling rate cuts and unorthodox policies. The punch landed as German 10-Year yields are now negative and Greek sovereign debt is trading at yields equivalent to the U.S. With an estimated $13 trillion of negative yielding assets looking for better returns, this is a powerful stimulant for financial markets.
So far, the defending champion is winning as measured by the S&P 500 hitting new highs and total returns for fixed income benchmarks at mid-single digit levels. However, we are only in Round 6 of the year. None of the trade issues are resolved, and we are only a Tweet away from being reminded. That said, President Trump knows that a healthy economy is critical to his reelection chances. The economic soft patch will show up as earnings disappointments, particularly in the more cyclical segments of the market. Our portfolio is significantly underweighted these areas (Materials, Energy, Industrials, and Financials) to mitigate earnings risk. Most importantly, the benefits of another global easing cycle have to a large degree been discounted in asset prices. Take a look at the moves in Bitcoin and gold prices to see how this tide of liquidity has been anticipated. Specific to stocks, the S&P 500’s price to earnings ratio has increased significantly despite downward revisions to earnings expectations:
Expect the second half of this year to be challenging. However, central banks’ pivot to easing goes a long way in avoiding a recession. Remember that there is a reason why the phrase “don’t fight the Fed” was coined. We are on the lookout for green shoots to economic activity but it seems early. In the meantime, our focus remains on secular growth properties.
Apologies for the prize fighting parallel. We do not equate investing to any sport nor are we particular fans of the ring. However, the analogy rings true, and we hope that the reader finds it less tedious than some of the stuff that we need to digest. Please enjoy some good beach reading this summer.