Most equity and bond markets around the globe rallied into the second quarter with the U.S. markets leading the way.1 This resulted in U.S. indices being positive for the second quarter, led by the S&P 500 index, +4.3%, followed by the Russell Midcap index, +4.1%, and Russell 2000 index (small cap), +2.1%.2 During the quarter, it was announced that U.S. and China trade talks had stalled and President Trump was implementing a 25% tariff on $250 billion of imported goods.3 President Trump also banned U.S. companies from supplying communication equipment to the Chinese company, Huawei.4 As a result, U.S. equity markets declined 6% in May.5 Meanwhile, the 10 Year U.S. Treasury Bond rallied with its yield dropping by 0.50% to 2.0%.6 With slowing global economic growth, the Federal Reserve has indicated that it may cut interest rates by year’s end.7 With this expected interest rate cut, the U.S. equity markets have rallied back in June, ending the quarter about where they started.8 Outside the U.S., the equity markets were mixed with the MSCI EAFE index (Europe, Japan) positive at 3.7%9sup>, which primarily reflected the news that the U.K. Brexit deal deadline had been pushed out to October and that of U.K. Prime Minister Theresa May’s resignation.10 MSCI Emerging Markets were slightly positive for the quarter, +0.56%,11 as markets ex China are benefitting from the U.S./China trade war12 and Saudi Arabia was added to the emerging markets index.13
The U.S. markets flipped back and forth between cyclicals and defensives during the second quarter14 due to a combination of mixed news from stronger than expected first-quarter earnings and GDP growth to the trade wars and then the potential cut by the Federal Reserve in interest rates.15 The strongest performing sectors were Financial Services and Technology while Energy and Health Care lagged.16 In the Financial Services sector, REITs continue to perform well17 as we believe investors seek higher yields. The Technology sector continues to report strong earnings, but there is rising concern with the largest tech companies about potential regulation to reduce their monopolistic hold.18 Meanwhile, the Health Care sector overall continues to report strong numbers, but there is concern with the upcoming 2020 U.S. elections about potential changes to drug pricing and health care for all.19 Energy lagged during the quarter as oil prices retreated after a good run in the first quarter.20
While we are seeing gyrations in the market and the popular press describing a potential impending recession, the U.S. economy is not showing evidence of that yet. The economic data is slowing, but still relatively strong with low unemployment and high consumer confidence levels.21
Interest Rates and the Federal Reserve
The 10 year U.S. Treasury declined over the quarter by 0.5% to 2.0%. This is down from the high of 3.2% in November 2018,22 a fairly significant roundtrip in interest rates over the last two years. As a result of the interest rate declines, longer maturity bonds have rallied with the Barclays Bond Aggregate, +3.1% for the quarter.23
The yield curve, which shows the yields of different maturity Treasury bonds, is inverted on the short end of the curve (i.e. 3 month through 12 months).24 Historically, the yield curve has inverted a year or so before a recession, but in this case we may see pressure from the bond markets compelling the Fed to cut rates.
The expectation going into 2019 was that the Federal Reserve was going to raise interest rates three times over the course of the year; now, the expectation according to Fed futures is that there is a 90% chance of two rate cuts by the end of the year.25 Fed Chairman Powell indicated at the June meeting that a rate cut could be on the table, which helped cause the rally in the equity markets.26 We believe the Fed is in a tough spot given its mandate of full employment and inflation at 2%, but with the potential for a weakening global economy due to the trade wars the Fed does not want to be behind the curve.
After a strong first quarter when the Chinese government implemented its stimulus program27sup>, the markets in the second quarter declined on weaker manufacturing data as well as loss of confidence as a result of the trade war between the U.S. and China.28 At this point, it is uncertain when the trade war between the U.S. and China will be resolved, but both sides are motivated to find a solution. The biggest issues currently relate to intellectual property and Huawei.29 We still believe that there will be resolution this year, but exact timing is difficult to predict. This will weigh on companies as they adjust manufacturing and other resources and will most likely result in periods of market volatility.
The price of oil made a roundtrip during the quarter ending at $59/barrel relative to the $60 barrel at the end of March.30 Energy companies continue to struggle to find the right supply and demand balance and earnings are relatively weak across the sector.
Gold rallied during the quarter and reached $1,400/oz., which is the highest level since 2013.31 It appears that the rally has occurred as bond yields decline, trade war concerns ramp up and investors flock to safe-haven assets.
In the U.S. we have seen a hot initial public offering (IPO) market in which a number of venture capital “unicorns” have gone public during the first and second quarter. During the second quarter alone we have seen Uber, Zoom, Pinterest, Beyond Meat and Slack go public.32 The stock performance has varied widely between the companies and we are watching to see who the big winners will be.
While the markets were more volatile during the quarter as anticipated, we expected some of it to come from earnings weakness and not necessarily trade talks breaking down. After a very strong first quarter, investors were looking for a reason for the markets to correct. Investors are now to trying to measure how much the trade war will impact earnings for the remainder of the year. Currently, FactSet has second-quarter earnings declining by 2.6% with more declines in the second half.33 If the U.S. and China reach a trade deal and the Federal Reserve cuts rates, we could see a continuation of the rally. If not, the likelihood of more volatility exists. Overall, we remain cautiously positive on the U.S. economy and expect that other parts of the world may be more impacted.