After a brief lull in market activity, stock volatility returned with a vengeance last week as equity markets finished with their worst five-day performance since last December. Monday’s market drop made it six days in a row with losses, and many investors are rightfully scratching their heads wondering what could have changed so much over the course of a week.
As expected, the Federal Reserve cut interest rates by 25 basis points (bps) last week and laid out a path should future rate cuts be needed to respond to slower global growth, reduced business confidence, and a further slump in trade. Our central bank referred to this pre-emptive strike to lower rates as a “mid-cycle adjustment,” and it was widely heralded as an acknowledgment that they likely went too far in raising rates in 2018. Investors clearly wanted a larger rate cut or the promise of future cuts, and initially sold down stocks on their disappointment. However, reflecting on the fact that the last mid-cycle adjustment in the mid-1990s prolonged that economic expansion by several years, investors quickly went about changing their minds, sending the markets higher following last Wednesday’s temper tantrum.
However, before the markets could close out last Thursday with gains, President Trump tweeted that China wasn’t moving fast enough in coming to the table with a trade deal and would impose additional tariffs on another $300 billion of goods starting this September. Oil closed down over 8% that day, amid fears that weaker economic growth from a further slowdown in global trade would lead to reduced demand amid abundant supply. Stock markets also quickly turned lower and turned in their worst weekly performance year-to-date, as the S&P 500 and Nasdaq Indices respectively finished 3% and 4% lower.
Low Interest Rate Environment
After largely ignoring the Fed decision, the 10-year Treasury yield fell on the tariff news by over 20 bps, which was the largest one-week move in more than seven years. At 1.7% on a 10-year Treasury, this level of yield appears quite low — yet remains quite competitive when compared to the negative rates throughout much of Europe; 30-year German bonds trade at prices offering investors less than 0% in yield and there is currently over $14 trillion of bonds globally that trade with a negative yield. Even a 100-year Australian bond maturing in 2117 now offers an annual yield of just over 1% – scant compensation indeed. Can things really be that bad? We doubt it.
Looking through to fundamentals, the U.S. Jobs Report last week revealed the unemployment rate held steady at 3.7% and confirmed that the Fed rate cut of “just” 25 bps was one that fit their view: our U.S. economy is still doing fine, even if it is slowing as some of the economic weakness in Asia and Europe spills over into the U.S. Presently, the market expects a couple more rate cuts in 2019, which we view could be necessary if the trade war gets out of hand or geopolitics with Iran or North Korea flare up. And flare up it has…
China retaliated to President Trump’s tariff threat, announcing it would suspend imports of U.S. agriculture products at state owned enterprises, while simultaneously devaluing its currency – something we at JNBA expected would happen as it looks for an outlet to ease pressure on its economy (a weaker currency helps Chinese exports, which would otherwise be less competitive in the face of tariffs). The U.S. has labeled China a currency manipulator, opening up a new front on the trade war. The prospects of a currency war clearly frighten financial markets because capital is often misallocated and consumers end up paying higher prices for goods and services.
In our view, China appears to be feeling the impact of our tariffs and is getting a bit concerned. In fact, Mexico and Canada both have replaced China as our largest trading partners and global supply chains continue to be revamped. China was already struggling from a pullback in bank credit growth before the change in global trading patterns began to hit its economy, and corporate bankruptcies are on the rise there. Meanwhile, our economy appears far healthier. While U.S. growth was slowing as we entered 2019, that was partially due to the natural fading impact of tax cuts and U.S. fiscal stimulus. A trade fight results in both parties often feeling battered and bruised by the later rounds.
As we extend our aperture, equity markets historically have struggled in the immediate aftermath of additional tariffs, so we do not expect a quick return to record highs unless corporate earnings improve meaningfully or this trade spat appears on its way to being settled, something that no one is expecting right now.
Second-quarter earnings reports have not been great but are still coming in better than expected. U.S. consumers appear healthy, with solid figures in terms of jobs, household wealth, and wage growth. And while trade uncertainty has resulted in a pause on U.S. business investment and hiring decisions, it is not as bad as it is for European companies which tend to rely more on global trade and export-driven revenue (see chart above).
The JNBA View
We have remained underweight in our targeted stock exposure since late last summer. We are hopeful that a trade deal or a more dovish Fed could change sentiment, but for now, slowing economic growth and geopolitics continue to weigh heavily on investor minds and we emphasize patience and caution. Markets were expecting a rate cut, and a series of these could prolong what has now already become the longest economic expansion on record. In fact, Q2 GDP came in better than expected if one looks through the impact from trade and inventory adjustments and solely focuses on underlying consumer demand (which accounts for 70% of our economy). The unemployment rate remains at a 50-year low and a budget deal was passed last week, which was widely ignored but removes some additional uncertainty for investors. However, while the stock market is up nearly 20% from the December 2018 lows, it is still sitting right around its January 2018 levels, thereby validating our underweight position to stocks and overweight position to bonds at JNBA.
Furthermore, we are focused on maintaining a diversified and high-quality income stream in fixed income while we wait for stock valuations to improve or earnings growth to accelerate before changing our stance. We believe we are in a mature bull market but won’t rule out further advances if the Fed’s current easing in interest rates creates a pickup in domestic growth (already mortgage rates have come down meaningfully from last year).
In addition to our defensive stance in bonds (shorter duration), we are favoring cheaper stocks which should offer better yields and more downside protection should the market continue its bumpy path as we continue to exchange barbs with China and the prolonged trade war meanders to its eventual outcome (no one wins a trade war, so at some point a de-escalation should be sought). We will likely not be aggressive in chasing this recent dip but will more gradually take advantage of lower prices should the market continue to drift in that direction, thereby pushing up our prospective estimates of future returns, which at this point still keep us moderated in our behavior.
Due to various factors, including changing market conditions and/or applicable laws, the content may no longer be reflective of current opinions or positions. Moreover, you should not assume that any discussion or information contained in this blog serves as the receipt of, or as a substitute for, personalized investment advice from JNBA Financial Advisors, Inc.
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