In the first half of 2019, US equity market performance was remarkably resilient. While uncertainty about the US stance on trade caused periods of significant retracement, by the end of June, investors were responding positively to potential for increased accommodation from the Federal Reserve (the Fed) and indications of progress in trade talks. Additionally, the US stock market, as measured by the Russell 3000, returned 4.1% for Q2 and an impressive 18.71% year-to-date (YTD) return by June 30.
The US stock market started off the year with a bang as the S&P gained 7.9% in January, with stocks rebounding from one of the worst Decembers on record. Subsequent to this snap-back rally, further gains can be attributed to:
- Q1 earnings in line with expectations
- Easing of trade tensions
- Favorable interest rate policy from the Fed
For more details on Q1, see our summary.
2019 Q2 Returns
It’s been a positive year for financial markets with strong gains in riskier assets, such as equities, as well as safer investments, such as government bonds. So far in 2019, US equity markets have led with a return of 18.71% as of June 30, 2019. International developed equities, emerging market equities, and global real estate all reached double-digit returns.
Top Factors Impacting Markets
Tariffs and Trade Uncertainty
While the direct impact of tariffs is difficult to calculate, recent data suggests that trade policy uncertainty has started to dampen economic activity, particularly in the manufacturing sector. This has been reflected in lower business confidence and capital spending, particularly in export-heavy economies. While trade tensions have ebbed and flowed throughout the year, hopes of progress were in play by the end of Q2.
May was a challenging month with stocks declining 6.47% on heightened trade uncertainty. However, by the end of June, markets were responding positively to news that President Trump had canceled plans to impose tariffs on certain goods imported from Mexico after reaching a temporary deal on immigration.
The ever-shifting US and China talks have kept the market on its toes throughout 2019. The dynamic appeared to stabilize after a tentative truce made at the G20 meeting in June, which boosted stock prices into the end of Q2. However, that truce has cooled and the US Administration has imposed additional tariffs on China. China has retaliated with some measures of their own, including a cease of purchase of US agricultural goods and a devaluation of their currency. These geopolitical tensions may continue to create uncertainty throughout the remainder of the year.
The Fed made some adjustments to their policy language at the June committee meeting, downgrading its view of economic activity from “solid” to “moderate.” The move was in response to concerns about US and global economic growth in Q2 2019, due to geopolitical risks and economic data showing signs of deterioration. Another factor was a further inversion of the US Treasury yield curve—a situation in which yields in shorter treasuries exceed those with longer maturities.
The Fed also deleted the word “patient” from the statement, indicating to market participants that the door is open for a potential rate cut this year. Federal Reserve Chairman Jerome Powell said the Fed is “watching risks closely, and will act appropriately to sustain the economic expansion.”’ This has further bolstered investor optimism that the Fed is willing to lower rates if deemed necessary.
The Fed’s language change was constructive for riskier assets, such as equities. (Subsequent to this writing the Fed did ease the Federal Funds rate by 25 basis points, and the market is pricing in 100% probability of an additional ease at the September meeting).
In line with the Fed, major central banks around the world have become more accommodative, keeping borrowing costs low or, in some challenged regions, moving towards more stimulative monetary policies.
US Economic Activity
Though the market was largely focused on trade policy implications and parsing language from the Fed, economic data has been mixed and trending softer into Q2.
Gross Domestic Product
The US Gross Domestic Product (GDP) grew a respectable 3.1% in Q1. Estimates for Q2 GDP are much weaker, ranging from 1.8% to 2.2%.
Employment data remained encouraging despite slowing in June. The unemployment rate remained stable at a 49-year low of 3.6%, while average hourly earnings climbed 3.1% from 2018.
On the less encouraging side, consumer and business confidence indices weakened, and survey data indicated business activity is slowing.
Additionally, in June 2019, the Conference Board’s consumer confidence indicator, largely regarded as an important data point for the United States, fell to its lowest point since September 2017.
International Market Trends
Outside of the United States, geopolitical tensions and softening global trade continued to weigh on growth. Weakness has continued in Japan and Europe, with Germany and Italy having been hit particularly hard. This deceleration of economic momentum in Europe has been reflected in a broad range of indicators, including confidence surveys across the industrial, services, and consumer sectors.
Q1 GDP growth for the Eurozone was an underwhelming 0.4% quarter over quarter, but more concerning was inflation at 1.2%—significantly below the European Central Bank (ECB) target of 2%.
In the Eurozone, a projected small cut in the already-negative central bank deposit rate is indicating that the ECB may be shifting to attempt more accommodation. Mario Draghi, the ECB president, hinted at further monetary policy stimulus, such as new bond purchases, particularly if the inflation outlook fails to improve.
Additional cause for caution in Europe and globally is the still unresolved US threat of tariffs on European car and auto parts. Automobile trade accounts for about 8% of total global trade, so the impact of an escalation in these talks could be seen as a risk to European growth. These talks are tabled for now.
Emerging market equities lagged their developed market counterparts’ so far this year.
Trade weighed on China as the United States increased tariffs on additional goods and labeled Chinese telecom equipment giant Huawei a national security risk, putting heavy restrictions on the business it could conduct in the United States.
In other emerging markets, the US repealed a preferential status from Turkey and India that had previously exempted billions of dollars’ worth of products brought into the United States duty-free.
A strong dollar was an additional headwind to many emerging markets that rely heavily on US dollar-denominated funding for their debts. Countries that have borrowed in dollars generally see their total cost of debt service increase as the dollar strengthens against their local currency.
US Treasury bonds have increased in value during the first half of 2019 due to a combination of several factors:
- Investors turning to safe assets like treasury bonds
- Expectations for lower global growth and inflation
- Competitive rates, relative to other parts of the world
The US 10-year Treasury yield in June briefly dipped below the 2% mark—a low that hasn’t been seen since 2016. Nevertheless, this yield still looks attractive compared to government-issued debt in the Eurozone, which is trading with negative yields. Prices and rates move inversely to each other on bonds; when prices move higher, yields move lower.
Despite bouts of risk-aversion due to escalating trade conflicts and lingering late-cycle fears, high-yield credit and investment-grade credit have also had strong returns since the beginning of the year. This change is largely due to the Fed’s pivot towards guarding against deflation in the first half of 2019.
The Fed’s willingness to lower interest rates when needed, known as a put, has encouraged investors to reach for yield in lower credit quality instruments, bolstering demand for lower interest-rated credit as the global supply of negative-yielding debt has surged. Some argue this change has taken place even while credit quality has been declining.
While challenges to the global economic expansion have been evident in slower earnings growth, the risk of a recession in the United States still appears unlikely in the near term.
There’s reason to remain cautiously optimistic going into the second half of 2019, while acknowledging that political risks, in particular escalating trade disputes, have created downside risks that could trigger renewed volatility and further impede growth.
Monetary expectations and the Fed’s positioning have shifted dramatically since the beginning of the year. The Federal Reserve is now willing to cut interest rates, which supports riskier assets, such as equities. A reversal of this more dovish Fed stance, due to inflation or some other factors, is a risk to the markets.
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For more insight into Q2 activity or how these trends could affect your investments, contact your Moss Adams professional.