Although it wasn't all plain sailing, the second quarter of 2019 built on the first, maintaining an upward trajectory for both bond and equity markets. According to Morgan Stanley, US stocks saw the strongest start to a year so far since 1997, and investment grade and high yield credit had their best excess returns since 2009.
Although it wasn’t all plain sailing, the second quarter of 2019 built on the first, maintaining an upward trajectory for both bond and equity markets. According to Morgan Stanley, US stocks saw the strongest start to a year so far since 1997, and investment grade and high yield credit had their best excess returns since 2009. We saw a further dampening of equity volatility during this period too. This all appears to have been a reaction to the prospect of the Federal Reserve (Fed) cutting interest rates, which likely means an axiomatic rate cut in China, together with the European Central Bank (ECB) taking their interest rates into deeper negative rate territory, over the second half of this year.
Much is made by some commentators of the fact that the Fed is looking to cut rates to “prop up the US stock market” and to get President Trump off their back. However, global macro data has slowed, and with little or no inflation reaction to the rise in employment seen in the US over this economic cycle, a rate cut appears increasingly justified. As we enter the second half of 2019, the post-2009 streak of economic growth in the US rolls into a record 121st month, barring a hindsight-aided recession call from the National Bureau of Economic Research (NBER). Economist Gary Shilling contends that the NBER may indeed determine that the US expansion will soon, or has already, come to a close. Shilling cites the pair of large downward revisions to the March and April readings of US employment. Shilling notes that “an analysis of post-World War II data reveals that employment often slides from diminishing gains to substantial declines within a few months of the onset of recessions.” Key manufacturing data points have also turned south. The downshift in employment growth and macro data is matched by a likely retrenchment in corporate profits. As noted by FactSet, second quarter earnings among US S&P 500 companies are expected to decline by 2.6% year-over-year, which would mark the second straight quarterly earnings decline. So, the market reaction to this backdrop appears to be suggestive of Central Banks being able to pre-emptively avoid a global recession, and with interest rates heading back towards zero or further below zero, hence TINA (There Is No Alternative) as an Investment Strategy is back. Stocks, despite profit declines, corporate credit and the issuer risk, are the only game in town for your money.
The big picture global macroeconomic outlook is currently dominated by rising trade tensions, notably between the USA and China. Strategist Louis Vincent-Gave describes the situation – “we’re moving from a World that was constantly globalising to one breaking up into three different empires [US, EU and China], each with their own currency, bond market, supply chains. There are massive investment implications to this.” Assuming that the US-China standoff is not merely a Trade War, but the start of a new Cold War, then the shift in the US-China relationship will cast a long shadow over financial markets. This could see the winners of recent years – US technology stocks, China growth and the US Dollar – weaken as a result, which would necessitate significant asset allocation changes, not least from those invested in passive vehicles.
Having taken the above on board, it is worth pointing out that US financial conditions do not appear “tight” e.g. loan officer surveys show no difficulty in credit being available to business and consumers, and real (after adjusting for inflation) interest rates are equally low. The question, therefore, is are we close to the end point for monetary policy effectiveness if the Fed embarks on a series of rate cuts starting in July? The Head of the World’s Central Bank (the Bank for International Settlements), Agustín Carstens, recently offered words of caution to reporters following the release of the Bank’s annual report – “we would stress that it is important to preserve some room for manoeuvre for more serious downturns. Monetary policy should be considered more as a backstop, rather than as a spearhead of a strategy to induce higher sustainable growth.” Of greater concern, Carstens wondered about diminishing returns from additional monetary policy easing – “how much more stimulus will you get if rates are reduced by another 0.25%? That will produce [less] bang for your buck.” If the Head of the Bank of International Settlements had his way, it seems that monetary policy would do nothing until a recession had begun, job losses were occurring in earnest and deflation was a fact. We are confident that would unleash a Tweet storm from the occupant of the White House. At least the Fed has some rate cuts to play with. The ECB and Bank of Japan (BoJ) are both below the zero bound, and so look to more unconventional means to “support” their economies with policies that, ironically, make it worse and feed populism, given they only seem to stimulate asset prices.
Government bonds appear to be at an inflection point. If yields fall further (meaning bond prices rise) across the globe, then it will provide an attractive backdrop for equities, comparatively until such time that equity markets believe the recession bond yields could well be implying, and impact share price valuations more negatively than the elixir provided by Central Bank easing can support them. Perhaps the trigger for this could be the aforementioned Q2 results season that commences in early July. Outside of this, the largest contrarian stance to take is one that actively believes inflation will reappear in earnest, but we think it looks highly unlikely near-term and a pragmatic approach to investing across bonds and equities is warranted. This is dependent on economic data as regard to both the tactical and strategic positioning to take over the Summer months.