Q3 2019 Update: Trade Volatility, Monetary Policy, and Slowing Global Growth

So far, 2019 has been a positive year for the financial markets, with solid gains in riskier assets as well as safer investments. US equities and real estate both had double-digits returns, and US government bonds returned over 8% through September 30, 2019.

However, 2019 hasn’t been without its ups and downs and ever-evolving geopolitical turmoil. Following is an overview of Q3 trends and insights.

Q3 Investment Returns

The markets were once again turbulent in Q3 with many ebbs and flows in the US-China trade dispute, an impeachment inquiry into President Trump, dislocations in the overnight lending markets, ongoing uncertainty about the future direction of monetary policy, and other geopolitical events.

Although it has been a bumpy ride for investors, the Dow and S&P 500 still managed to gain around 1% each in Q3, while the Nasdaq dipped 0.1%. This marks the third straight quarterly gain for the Dow and S&P. International and emerging market stocks were both lower in Q3.

During the quarter, many investors were chasing safety, with utilities being the top-performing sector and value marginally outperforming growth.

Two days were particularly choppy: The S&P 500 recorded its worst day of the year on August 5, 2019, plunging nearly 3% amid heightened tariff rhetoric and implementation of additional tariffs and counter tariffs in the ongoing trade war between the United States and China. The equity markets had another significant setback on August 14, 2019, when the two-year-to-10-year part of the yield curve inverted for the first time since 2009. 

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Top Factors Impacting Markets

Tariffs and Trade Uncertainty

After unproductive trade talks in Beijing in August, the United States issued additional tariffs on Chinese imports. These tariffs were met with counter moves from China, including reciprocal tariffs back at the United States, halting purchases of US agricultural products and intervention measures that weakened the Chinese yuan against the US dollar.  

After a sizeable devaluation of the yuan, the US Department of the Treasury (Treasury) declared China a currency manipulator for the first time since 1994. This sent equity markets sharply lower. By the end of September, however, tensions cooled and the United States and China made plans to resume talks in early October.

Impeachment Inquiry

A formal impeachment inquiry against President Trump was launched on September 24, 2019, by Speaker of the House Nancy Pelosi.

The inquiry pertains to a conversation between President Trump and Ukrainian President Volodymyr Zelensky, wherein the president allegedly pressed the Ukrainian government to investigate Hunter Biden, the son of 2020 presidential candidate Joe Biden. While this announcement initially put pressure on the markets, support for the inquiry seems to be mixed, and the markets quickly stabilized.

Fed Changes

In July, the Fed reduced the benchmark interest rate for the first time in more than a decade, amid signs of a global slowdown. During his news conference, Federal Reserve Chairman Jerome Powell (the Fed chair) indicated that the move was a midcycle adjustment, stopping short of committing to a series of rate reductions that the market was anticipating.

The Fed chair’s comments triggered a sharp selloff in the equity markets. The Fed again cut rates another 25 basis points at their September meeting, and the Fed chair dropped the midcycle language, which cheered the markets. However, the decision to cut interest rates wasn’t unanimous, with two Federal Reserve governors voting to leave them unchanged.  

Inversion of the Yield Curve

Headlines blared in August, when an anomaly occurred in the US bond market. The yield on the benchmark 10-year treasury fell below the yield on the two-year treasury. This marked the first inversion of this part of the curve since December 2005, two years before the recession brought on by the financial crisis. 

Market participants watch for this particular inversion closely, because history suggests a correlation between a two-year-to-10-year inversion and an oncoming recession, albeit with a sometimes significant lag time. The timetable varies, but, historically speaking, recession tends to arrive within 18–22 months following such an inversion. As always, though, past correlation doesn’t necessarily translate to the future.

Overnight Money Market Dislocations

Although it doesn’t receive much attention, the overnight lending market plays a vital role in finance. Overnight lending is facilitated through bank-to-bank lending, which is typically executed near the Federal Reserve Funds Target Rate (Fed Funds Rate) in what’s known as the overnight repurchase markets.

In mid-September, the overnight markets became temporarily distressed, with the overnight lending rates more than doubling that of the Fed Funds Rate. The episode reflected a liquidity squeeze, meaning there wasn’t enough cash available on that day to finance the daily needs of the financial system.  

The cause of the sudden stress was a bit of a mystery, but it was at least partially blamed on large bank withdrawals done to make quarterly tax payments to the US Treasury. However, the overnight markets were stressed enough that the New York Federal Reserve stepped in, injecting hundreds-of-billions of dollars into the system over several days to unclog the system and return the markets to normal overnight lending rates. 

The Fed chair acknowledged real-world pressures in the markets, but said they have no implications for the economy or the stance the Fed has on monetary policy. He also said the Fed was open and willing to increase the size of the Fed balance sheet going forward to help better align with the growth of currency needs in this market. It’s widely expected that the Fed will announce a more permanent liquidity facility in the coming months.

Geopolitical Unrest

On September 14, 2019, a surprise drone attack struck two key oil installations in Saudi Arabia, damaging facilities that process the vast majority of the country’s crude output and raising the risk of disruption in world oil supplies. 

Although crude oil prices rose almost 15% after the attack, they retraced fairly quickly following Saudi Arabia’s rapid response to the crisis. The attack was attributed to an Iran-backed terrorist faction attempting to create a supply shock to disrupt the global economy.

China

The ever-shifting United States and China trade talks have kept the market on its toes throughout 2019. The dynamic appeared to stabilize at the end of September when the two parties agreed to continue negotiations in early October.   

Meanwhile, China is experiencing its own internal tensions. Widespread unrest broke out across Hong Kong on October 1, 2019, which marked the 70th anniversary of National Day of the People’s Republic of China. Protesters organized demonstrations they called National Day of Grief, resulting in some of the worst violence the autonomous territory has seen since protests began months ago. The unrest brought commerce to a near standstill in parts of Hong Kong. 

These geopolitical tensions may continue to create uncertainty throughout the remainder of the year.

US Economic Activity

Recent data has shown that trade policy uncertainties and tariffs have started to dampen economic activity, particularly in the manufacturing sector. Throughout Q3, the trend has led to softer data in the United States and abroad.

Gross Domestic Product

The US Gross Domestic Product (GDP) grew 2% in Q2, down from 3.1% in Q1. Estimates for Q3 GDP are slightly weaker, at approximately 1.8%.

Employment

Employment data remained encouraging despite slight slowing. The three-month and six-month averages for new job creation were both around 150,000—down from about 230,000 a year ago. The unemployment rate for the August report remained unchanged at 3.7%, while average hourly earnings increased by 3.2%.

Confidence Indices

Consumer confidence declined in September, following a moderate decrease in August.  Consumers were less positive in their assessment of current conditions, and their expectations regarding the short-term outlook also weakened. While the escalation in trade and tariff tensions in late August appeared to have modestly impacted consumers, the overall level of consumer confidence remained strong due to the solid US labor market.

Business confidence and business activity also continued to weaken.

Manufacturing

The manufacturing sector has shown continued weakness, with the most recent purchasing managers index (PMI) showing contraction. The PMI is based on a monthly survey of supply chain managers across multiple industries and is a measure of the prevailing direction of economic trends in manufacturing.

A reading under 50 indicates contraction, suggesting expectations for future business conditions are deteriorating. The manufacturing PMI in the United States dropped to 47.8 in September from 49.1 the previous month.

Housing

One bright spot during the quarter was housing; sales of newly built homes and pending home sales were strong, spurred by low mortgage rates and strong employment.

International Market Trends

Outside of the United States, geopolitical tensions and softening global trade continued to weigh on growth throughout Q3. Weakness has continued in Japan and the Eurozone, with Germany being 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.

Eurozone GDP

The Eurozone’s Q2 GDP growth was an underwhelming 0.2%, down from 0.4% in the previous quarter. When looking at growth by member states, decreases were observed in the United Kingdom, Germany, and Sweden.

Negative Interest Rates

In an effort to thwart slowing economic growth, many central banks outside of the United States have adopted a zero-interest rate policy and, in many parts of the world, sovereign interest rates are negative. As of the end of Q3, about $15 trillion in worldwide bonds were trading at negative yields.

Tariff Threats

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.

In early October, the World Trade Organization permitted the United States to move forward with plans to impose some $7.5 billion in annual tariffs on EU goods to counteract what it identified as years of improper European subsidies and loans to Airbus.

Emerging Markets

Emerging markets are bearing the brunt of the trade war. Flows into emerging markets are highly sensitive to factors, such as geopolitical uncertainty and slowing global growth.

A strong US dollar has been an additional headwind to many emerging markets that rely heavily on US dollar-denominated funding for their debts. Countries that have borrowed in US dollars generally see their total cost-of-debt service increase as the dollar strengthens against their local currency.

Fixed-Income Markets

US Treasury bonds have increased in value during 2019 due to the following factors:

  • Investors turning to safe assets, like treasury bonds, during market uncertainty
  • Heightened expectations for lower global growth and inflation
  • Competitive rates, relative to other parts of the world

In August, the US’s 10-year Treasury yield dipped below the 1.5% mark—a low that hasn’t occurred since 2016. Nevertheless, current yields on treasuries still look attractive compared to government-issued debt in the Eurozone, which is trading with negative yields.

As a note, prices and rates move inversely to each other on bonds; when yields move lower, prices move higher.

Credit Trends

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 2019.

The Fed’s willingness to lower interest rates when needed has encouraged investors to reach for yield in lower credit-quality instruments, bolstering demand for these bonds as the global supply of negative-yielding sovereign debt has surged. Some argue this change has taken place even while credit quality has been declining.

In fact, companies around the globe issued a record amount of corporate bonds in September, totaling more than $400 billion of corporate credit.

Looking Ahead

While challenges to global economic expansion have been evident in slowing US 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 last quarter 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 Fed 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 Q3 activity or how these trends could affect your investments, contact your Moss Adams professional.