The third quarter presented some choppiness in the global markets, with concerns over a global slow down and the escalating U.S./ China trade war.i In August, these concerns reached a peak with all stock markets down and a flight to safety into Treasury bonds, bond proxy stocks such as utilities, REITs and consumer staples stocks, as well as secular growth stocks.ii The 10-year U.S. Treasury bond yield went from 2% to 1.4% during the month.iii In September, we saw a reversal. The stock markets rallied back while the bond markets sold off. The 10 year U.S. Treasury ended the quarter at 1.7% and the U.S. stock markets were generally positive with the S&P 500 leading the way up 1.7%, the Russell Mid Cap index up 1.2%, while the Russell Small Cap index was down 2.4%.iv The international indices, MSCI EAFE, reported down 1.1% and the MSCI Emerging Market index was down 4.3% for the quarter.v Year-todate every major asset class is reporting positive returns.vi
The U.S. equity markets were led by large cap stocks during the quarter, then mid cap stocks and finally small cap stocks.vii With low interest rates, investors flocked to stocks with defensive characteristics such as bond proxy stocks that have higher dividend yields, and secular growth stocks that offer the potential for higher returns.viii By the end of August, there was a historically large difference in the performance of the Russell 1000 Growth and the Russell 1000 Value indices with growth significantly outperforming value.ix In September, interest rates reversed course after declining to the lowest yields in three years.x Concurrently, there was a Six Sigma outperformance in deeper value and extremely out of favor stocks like energy and financial stocks, while the fastest growing stocks declined. By the end of the third quarter we saw performance even out.xi For the quarter, the bond proxy sectors such as utilities, REITs and consumer staples outperformed along with technology.xii Even after a huge rally, energy was still down for the quarter as well as health care.xiii
The U.S./China trade war has continued for a year with back-and-forth implementation of tariffs on imported goods along with other restrictive measures. There has been some hope of reaching an agreement by year-end, but it is still very uncertain at this point.xiv The uncertainty is weighing on the Chinese economy as they are seeing a contraction in factory orders and GDP growth.xv Consumer spending has slowed, but is still growing at decent rates.xvi In order to counteract the slowing economy the Chinese government has implemented a number of stimulus measures including reducing the reserve rate, so banks have more capital to lend out, and reducing taxes.xvii Despite the difficult picture in China, the local Chinese stock market, Shenzen A shares are up 23% for the year.xviii
Europe is also facing an economic contraction. Europe’s largest economy, Germany, has seen its Production Manufacturing Index (PMI) fall into contraction level as exports to China have declined.xix The U.K., still struggling with Brexit, had extended the deadline to October 31st.xx Even with Boris Johnson taking over as Prime Minister it has not helped in resolving the issues and the deadline may have to be extended again.xxi Italy is facing its own economic and political troubles.xxii The European Central Bank (ECB) has already reduced interest rates and has started a new quantitative easing (QE) program to help prevent a full-on recession.xxiii
Interest rates, yield curve, and Federal Reserve
The 10-year U.S. Treasury yield has declined from 3.2% in November 2018 down to 1.4% in August, and back to 1.7% by quarter end.xxiv We believe it has been a big change in interest rates over a very short period of time. As a result, the yield curve, which shows the yields of Treasury bonds at different maturities, has become inverted with the shorter term rates higher than the longer term rates.xxv Yield curve inversion has historically been a precursor to a recession by 12 to 15 months.xxvi However, yields on government debt in Germany and Japan are negative, so U.S. Treasury bonds with a positive yield look attractive.xxvii It may mean that buyers of U.S. Treasuries have forced the yields down. The Federal Reserve is now forced to help prevent a recession, and as such steepened the yield curve by cutting short-term rates.xxviii The Fed cut the rates by 0.25% in July and September with the market expecting further cuts by year-end.xxix
The price per barrel has stayed relatively flat over the quarter, but we saw a spike in oil prices in September.xxx Drones took out oil production facilities in Saudi Arabia, which caused the government to initially say that production for half the oil would be out for several weeks. xxxi Two days later Saudi Arabia said it could bring oil back much faster and the price stabilized.xxxii U.S. energy companies got a pop in stock prices on the news, but they are still negative for the year. xxxiii Saudi Arabia’s Aramco, its oil production company, is planning on an IPO in the next few months.xxxiv
Gold reached new levels during the quarter to over $1,500/oz.xxxv In our opinion, there has been more interest in gold as investors worry about the economy and look for a safe haven asset.
The 2019 IPO market has been hot as many of the unicorns, or companies with private valuations of $1 billion or greater, have come to the public markets.xxxvi One that is generating a lot of controversy is WeWork, an office sharing company. Controversy surrounds what the right valuation is and whether there has been self-dealing with the CEO.xxxvii The CEO, Adam Neumann, has been forced out and the IPO has been delayed.xxxviii Airbnb, another highly anticipated IPO, is expected to come to the IPO market in 2020.xxxix
While the markets remain choppy given the headlines around the trade wars, global economic slowing, Brexit, the U.S. elections, and proposed Presidential impeachment, the U.S. consumer has been resilient. With low interest rates, home sales have been strong and the employment picture has remained robust.xl In addition, companies have a lot of cash on their balance sheet and continue to buy back shares.xli We are cautious as we move later in the year, largely due to whether a trade deal will be reached and whether the slow down elsewhere will affect the U.S. economy. After having positive performance for most of the year we expect some consolidation in the markets.
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