Whether we like it or not, escalating a tariff/trade war with China seems to be part of the administration’s playbook and the policy is creating high levels of uncertainty. Companies must consider how to adjust supply chains, how much consumer and industrial prices will be impacted by the tariffs, how much of the price increase to absorb versus passing on to the buyer, etc. You get the idea. Real-time pricing mechanisms like stock and bond prices adjust to headline stories on a daily basis. This results in higher levels of implied and realized volatility.
The threat, and now reality, of a tariff/trade war has been with us for about the last 18 months but has recently escalated dramatically. Heavy export-reliant economies like Taiwan, South Korea, Japan, Germany and China have experienced a significant slowdown in the new orders and shipments of manufactured goods as supply chain relationships come under scrutiny. Although U.S. manufacturing has yet to move into contraction mode, measures of global manufacturing have been shrinking for two months. In fact, of the global purchasing manager indices (PMIs), 68% are below 50, which indicates a contraction. Their underlying components are weak as well. Thankfully, the measure of the U.S. service sector, which represents 85% to 90% of our economy, has remained above 50 even though it hit a three-year low this month.
An additional economic indicator worth following has been the aggregate hours worked for production and nonsupervisory employees. These hours have dipped at a 0.7% annual rate over the last six months, which indicates a weaker hiring trend in the coming months. To us, these are some of the factors that suggest that the second half of 2019 will be weaker than the first half, both domestically and globally. The longer the tariff/trade conflict extends, the slower GDP growth will be and the lower our interest rates will fall, with or without the Fed. No one knows exactly how this will end but returning to 3%+ rate of GDP growth seems unlikely anytime soon.
Domestic equity markets continued to grind higher in July and the S&P 500 index finished the month up 1.4% closing at an all-time monthly high. Anticipation of a rate cut by the Fed, continued trade discussions between the Trump administration and China and corporate earnings were the major drivers throughout the month. With the vast majority of companies already having reported, earnings results have generally been mixed with a number of multinational companies pointing to the trade environment as a significant headwind.
Equity momentum started to wane in the closing days of July. A solid jobs report gave markets pause that the Fed was unlikely to cut more than 25 basis points and steadfast U.S. economic fundamentals may not warrant significant or continued accommodative action. Fundamentals abroad, however, paint a much bleaker picture. The developed international MSCI EAFE Index lost 1.3% and the MSCI Emerging Market Index shed 1.2% for the month, as international markets extended their relative underperformance in 2019.
The Russell 1000 Growth Index climbed 2.3% in July and once again outpaced the 0.8% rise in the Russell 1000 Value. Given the choppy earnings results and forecasts, there were no clear trends from an economic sector standpoint. Consumer services (+3.4%) and information technology (+3.3%) were the top two performing sectors while energy (-1.8%) and health care (-1.6%) were the laggards.
Current market crosscurrents give investors reason to be optimistic but also cause to be cautious. Given equity valuations are slightly stretched historically, any misstep in trade discussions or by the Federal Reserve could result in a meaningful market pullback. Persistently low interest rates can support extended stock valuations for equity markets but the corporate earnings outlook suggests strength will have to come from other sources. As we head into the closing months of 2019, it may be up to the consumer, supported by recent wage gains, to drive the economy and propel equity markets higher.
Interest rates traded in a relatively narrow range for the entire month of July as investors awaited the Fed’s first rate cut in nearly 4,000 days. On the last day of the month, at the conclusion of their 2-day Federal Open Market Committee meeting, they delivered the well-telegraphed 25 basis point (bps) cut. While it was just as expected, during the following press conference Chairman Powell referred to the cut as a “mid-cycle adjustment to policy”, as opposed to the “beginning of a lengthy cutting cycle.” Although he tried to walk back the statement in subsequent answers, the markets began loudly voicing their displeasure. Equities and 10-year Treasury note yields declined while short rates increased. The curve flattening sent recessionary alarm bells ringing. The month ended before President Trump tweeted that he was preparing to apply a 10% tariff on all remaining Chinese imports, sending stocks and bond yields plummeting.
We have long espoused that the neutral Fed Funds rate is probably about the rate of inflation, implying two rate cuts, just to get to neutral, which seems appropriate given that inflation has been below target for the better part of the past decade. We would then throw in another cut as “insurance” against the softening economic data, disruptions and uncertainty caused by trade negotiations and risk of a Brexit-induced crisis in Europe. This would bring the overnight rate to a range of 1.50% to 1.75%. At that point, we believe the Fed can become data dependent. If a broad, all-encompassing trade deal is reached (unlikely anytime soon in our opinion) maybe no further cuts will be necessary. If the aforementioned risks develop, more cuts will be on the horizon. We acknowledge that rate cuts will not eliminate the uncertainties in the economy, but they can, at the margin, reduce concerns that the costs of funding will become incrementally onerous.
The yield of the 10-year Treasury note dropped 30 bps since the end of July as Trump tweeted about the new tariffs and China retaliated. Even in a lowest range, on these longer tenor bonds, since the Fall of 2016, we still believe U.S. fixed income assets represent an attractive relative value. Along with our rates, European rates moved lower as well. There are now over $15 trillion in bonds with negative yields in Europe. Even the 30-year German rates were negative for a while. Not only does the U.S. have positive yields, it remains one of the few developed countries with a positive “real” interest rate (above the rate of inflation). While rates will ebb and flow, we believe that the likelihood of higher and lower rates are roughly symmetric at this point.
Time stands still for no one. It seems like yesterday when, as a newly minted securities analyst employed by a Midwestern bank in the summer of 1982, I was quickly scribbling down stock quotes with my sharpened pencil. The quotes were relayed to me through the phone by “Bob”, the bank’s local Dain Bosworth broker. I would call Bob each day at 9am, 11am and 2pm and record the most recent stock prices, on a clipboard with “xerox” paper, for all 50 companies in our Harris Bank-inspired trust department investment portfolios. I would then hand the clipboard over to my boss, the Chief Investment Officer, and we would study the prices together. The digital age was in its infancy. The bank did not yet have a Quotron machine for retrieving quotes, much less any type of desktop computer or Bloomberg terminal as we have today. In retrospect, I was the Quotron!
One particular afternoon, August 12, the numbers were lower than they had been all summer. As the Dow Jones Industrial Average closed at 777, I remember thinking, “Could the Dow possibly be 700 by Labor Day?” Bad news was rampant, as was investor anxiety. There was speculation that if President Reagan were up for election in November of 1982, he would be beaten. August 12 was a Thursday. The Mexican Prime Minister informed the U.S. Federal Reserve that Mexico was going to default on certain short-term debt and that its foreign exchange markets would be closed on Friday. Penn Square Bank in Oklahoma had failed in July. However, little did I (or anyone) know that day would mark the start of a tremendous bull market from that 777 low. Investors wouldn’t see Dow 777 again. From that low, an eventful and, in many ways, astounding 37 years later we sit close to Dow 27,000.