Market & Economic Outlook

Market Commentary Q3 2019 - Economic Outlook

15 Minute Read

Third Quarter 2019

Despite signals that the global economy continues to deteriorate, investors embraced risk assets even as the disconnection between debt and equity markets deepened. Trade tensions remained unresolved, driving up consumer prices and leaving capital expenditure plans in limbo. This issue of Perspectives discusses global markets and our outlook for the third quarter of 2019.

Market Overview

Trophies for Everyone!

The second quarter and 2019 year-to-date has flipped the script on 2018 when most “risky” asset classes lost money. Nearly every asset class and index, in fact, has shown positive 2019 returns ranging from 26 percent in U.S. mid cap growth equity to 14 percent in U.S. long-term investment grade bonds as interest rates continued to decline. The trend continued in the second quarter with only Chinese equities and diversified commodity indices dipping into the red and asset classes, ranging from municipal bonds to emerging markets to gold, continuing their seemingly unstoppable march upwards.

Risk-hungry investors, buoyed by the prospect of three rate cuts before year-end, drove the S&P 500 index to record highs during the quarter and the index recorded the best first half year since the first six months of 1997: a total return of 19 percent following the 14 percent selloff in the fourth quarter of last year and a 4 percent return for the second quarter of 2019.

Unlike the volatility of the prior two years, the U.S. dollar, when measured against a trade-weighted basket of foreign currencies, has been remarkably stable so far in 2019. This is one of the most notable differences compared to 2017 when most asset classes also performed well but the dollar sold off from the near-term highs reached in December of 2016.

With market return trophies in hand, investors may wonder if the risk-on party will ever end. Equity market enthusiasm is somewhat surprising given the fact that domestic stock valuations are rich at 17 times earnings and, having nearly recovered from the year-end 2018 selloff, now stand at the high end of their historic range. Even expectations that second quarter corporate earnings will fall 3 percent versus the same period last year have not deterred investor appetite for stocks in an environment of persistent trade tensions and global bond markets signaling caution.

Growth Slowdown Continues

Meanwhile, the global economy is fragile with most regions struggling to regain economic momentum. Many key indicators pointing to economic growth—industrial production, manufacturing, consumer confidence and trade—saw disappointing second quarter readings. The odds of a manufacturing and capital expenditure recession have risen substantially given deteriorating global growth outlooks as the World Bank continues to revise global GDP downwards with 2019 forecast growth downgraded to 2.6 percent from 2.9 percent due to weaker-than-forecast trade and investment momentum. Global GDP growth in the region of 2.6 percent can be considered “stall speed”—neither indicative of growth or decline.

As shown in the chart below, global GDP is not expected to reach the 3 percent plus region recorded in 2017 and 2018 anytime soon.

chart showing slowing of global growth
Source: World Bank (World Development Indicators), World Bank Group (Global Economic Prospects, June 2019)

Other evidence of tepid global growth includes the record high amount of global sovereign debt—some $13 trillion or over 20 percent of the total outstanding--in negative yielding paper.

Global central banks continue to resist hiking rates—or in the case of the U.S. are expected to trim—and some, like the European Central Bank, are considering a return to bond purchases to drive rates even lower and, hopefully, prime the growth pump with a fresh infusion of easy money.

Meanwhile, equity market “disconnection” from bond, currency, commodity markets and inflation data continues to deepen.

Disconnected from Reality?

Even as U.S. stocks and most other risk assets celebrated a strong second quarter, bond market investors continued to dampen enthusiasm by driving down yields. The bellwether 10-year Treasury yield dropped a further 41 basis points to finish the quarter at a yield of 2.0 percent. Yield curve inversion, which some believe predicts economic recession, continued to deepen with the one-month Treasury yielding 18 basis points more than the 10-year Treasury at the end of the second quarter—up from a spread of 2 basis points at the end of the first quarter.

Both sides—equity market enthusiasm and bond, currency, and commodity market pessimism—can’t be right unless “Goldilocks” economic conditions remain. But a “not too hot, not too cold” environment this late in the economic cycle is unlikely as signs of declining global economic momentum in trade and industrial production continue to pile up. On balance, we believe bond markets are more realistic and suggest challenges going forward as the risks of a shallow recession increase.

For example, the chart below plots the Conference Board’s Leading Economic Index (LEI) of 10 key leading economic indicators that include employment levels, consumer sentiment, manufacturing activity, and building permits. The LEI seeks to signal peaks and troughs of the business cycle and, based on the index, U.S. economic growth appears to have stalled since the fall of last year despite strong consumer spending year-to-date.

chart of 10 key leading economic indicators
Source: FactSet, The Conference Board (U.S. Composite Index of 10 Leading Indicators, 2016=100)

Two key measurements of future economic growth—purchasing manager activity and consumer confidence—have declined by 14 percent and 4 percent respectively for the 12 months ending second quarter 2019 and confirm what appears to be slowing economic conditions and, if not a march towards recession, at least a slowing economy inconsistent with embracing a risk-on strategy. If consumer expenditures are all that stand between a stalled domestic economy or one entering recession, continuing declines in consumer confidence are worrisome.

Meanwhile, equity markets have embraced the prospect of rate cuts for the balance of 2019 with the Fed’s reaction function shifting completely from a de facto hiking bias to an easing posture in a mere six months--possibly the fastest shift from hawk to dove in recent memory. Each mention of possible easing and/or tapering prompts a Pavlovian risk asset rally—a consistent theme most of this cycle. But the cure, rate cuts and other Fed policies to prop up the economy, may be worse than the disease of an end to the longest economic expansion in U.S. history.

A Market Untethered?

Unconventional central bank policies, including near-zero interest rates and a pause in selling off nearly $4 trillion in bonds accumulated in response to the Great Recession, have manipulated asset prices and forced investors to seek yield and return further out on the risk curve. As a result, asset prices are untethered from economic fundamentals and instead are driven by central bank rhetoric and presidential tweets on the trade war with China. This is not a sign of healthy markets where the drivers are typically prospects of a better economy or improving corporate profit forecasts.

Equity markets continue to bet that the Fed can engineer a soft landing by foaming the runway with lower rates, potentially an overly optimistic view as bond markets continue to signal otherwise. Is this rosy scenario warranted when central banks’ track records as economic saviors are not particularly heartening? The Fed’s track record is typically to be behind the curve and therefore late in responding to shifting and deteriorating market conditions.

Given the disconnect between equity market enthusiasm and pessimistic bond markets, slowing global growth and continuing trade tensions, judicious rebalancing of portfolios back to strategic allocations may be warranted.

Rates and Trades and Tweets

In remarks after June’s Federal Open Market Committee meeting, Chairman Powell noted concerns regarding global trade tensions and the impact they may have on U.S. economic growth.

Shortly after Powell’s comments, President Trump and Chinese Premier Xi Jinping wrapped up their Group of 20 (G20) meeting by announcing that trade negotiations would resume after collapsing at the last round in early May when the Chinese balked at the prospect of rewriting domestic legislation to meet U.S. demands on dismantling the government’s investment in state-owned businesses.

For now, the 25 percent tariffs on $250 billion worth of Chinese imports will continue to have a negative impact on Chinese GDP and U.S. producers will continue to face export barriers. With the threat of additional 25 percent tariffs on $300 billion of Chinese imports still on the table, the trade wars with China continue to escalate despite the Osaka cease-fire, as does the risk of a domestic policy response that could pour oil on the fire.

As trade tariffs drive consumer prices higher and dampen demand, disrupt supply chains and spark uncertainty regarding business investment and capital expenditures, the administration is playing a high risk/potentially high reward endgame. A trade policy mistake would be highly destabilizing to markets: at best a major slowdown and at worst a global recession. The Fed also faces a dilemma as it considers how far to move from its past hawkish stance to an easing policy while the President continues his criticisms of Chairman Powell and his fellow FOMC Governors.

Going Their Own Way

The day after the president and his negotiators arrived in Osaka, Japan for the G20 summit, the European Union (EU) announced a trade deal, after two decades of negotiations, with four Latin American countries (the Mercosur economic and political bloc) that will eliminate tariffs worth billions of dollars and cover nearly $100 billon of bilateral trade annually. News of the deal came as the U.S. administration continues to play hardball with Europe-- imposing tariffs on steel and aluminum, threatening tariffs on automobiles and tweet-attacking the European Central Bank’s monetary policy responses to a slowdown in growth.

The Mercosur deal was followed shortly by an EU free trade pact with Vietnam, even as the Trump administration added new tariffs to U.S. trade with Vietnam, and follows EU trade deals with Canada, Mexico, Japan, and Singapore. Trade deals with at least four other countries are also being pursued.

We reinforce multilateral agreements whilst others rip them up

EU Trade Commissioner Cecilia Malmstrom after the Mercosur accord, Twitter

As the EU announces new trade pacts, global investors have responded to concerns over trade and geopolitical tensions from Iran to Brexit to North Korea by pouring money into flight to safety securities, ranging from U.S. Treasuries to Swiss Francs to Yen-denominated issues. The price of gold, the traditional “safest” safe haven asset class, is particularly telling, not only as an indication of investor geopolitical unease but, when combined with the price of copper, as a signal of slowing global growth.

During periods of economic expansion, copper prices can be expected to outperform gold as investors bet that future demand for commodities will be driven by increasing manufacturing activity. But as shown in the chart below, gold’s recent outperformance illustrates increasing investor concerns regarding trade, slowing global growth and the credibility and effectiveness of central banks here and abroad to act in the interests of equity and bond investors.

chart showing global growth
Source: FactSet

The Mercosur agreement and other trade pacts led by countries seeking to retain a pro-globalization worldview, as the U.S. administration increasingly embraces an isolationist stance towards trade, highlights the potential risks of what might be called “Cold War 2.0”.

If the China/U.S. trade confrontation becomes broader than trade and grows to include global political and military influence jockeying, the conflict may shape markets for the next several decades. As the quarter drew to a close, the administration’s responses to provocations from Iran to Venezuela to North Korea make it difficult to handicap the odds of a new global Cold War. But if safe haven investing in gold is any clue, they are increasing rather than decreasing.

 

Key Takeaways:

  • Fundamental economic underpinnings do not support substantially higher equity moves.
  • Global economic conditions remain fragile despite ongoing central bank interventions.
  • Bond market pessimism may be more predictive than equity market enthusiasm.
  • Asset prices are untethered from economic fundamentals and are driven by central bank rhetoric and presidential tweets.
  • Risk asset rally may be a signal to rebalance portfolios to strategic allocations.
  • Continuing trade tensions create multiple economic and geopolitical risks.

 

Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.

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HighMark, an SEC-registered investment adviser, is a wholly owned subsidiary of MUFG Union Bank, N.A. (MUFG Union Bank). HighMark manages institutional separate account portfolios for a wide variety of for-profit and nonprofit organizations, public agencies, public and private retirement plans, and personal trusts of all sizes. It may also serve as sub-adviser for mutual funds, common trust funds, and collective investment funds. MUFG Union Bank, a subsidiary of MUFG Americas Holdings Corporation, provides certain services to HighMark and is compensated for these services. Past performance does not guarantee future results. Individual account management and construction will vary depending on each client's investment needs and objectives. The benchmarks referenced in this piece are used for comparative purposes only and are provided to represent the market conditions during the period(s) shown. Benchmark returns do not reflect the deduction of advisory fees, custody fees, transaction costs, or other investment expenses, but the returns assume the reinvestment of dividends and other earnings. An investor cannot invest directly in unmanaged indices. Investments employing HighMark strategies are NOT insured by the FDIC or by any other Federal Government Agency, are NOT Bank deposits, are NOT guaranteed by the Bank or any Bank affiliate, and MAY lose value, including possible loss of principal.

 

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