U.S. equities generated modest gains in the third quarter amid ongoing growth concerns, uncertainties surrounding U.S.-China trade relations, and geopolitical friction. These uncertainties weighed on business sentiment and triggered volatility. As expected, the Federal Reserve cut rates following its July and September meetings. Markets reacted with disappointment, however, to Fed comments implying these rate cuts were only adjustments rather than the start of an easing cycle. The quarter saw the 10-year to 2-year Treasury yield curve invert for the first time since 2007, magnifying investor concerns that the economy may be headed for a recession. Second-quarter corporate earnings season although unspectacular, met expectations. Overall, it was generally a “risk-off” quarter led by less economically sensitive market sectors.
Developed international equity returns trailed those generated in the U.S. and were negative for the quarter while emerging markets produced a loss of more than 4%. European equities, as measured by the MSCI Europe Index, dropped nearly 2% during the period. The macro environment remained uninspiring as the eurozone economy expanded just 0.2% in Q2. Emerging markets produced a 4.3% loss during the quarter. China, the largest emerging market, dropped 4.7% as the Chinese economy continued to slow.
Fixed income markets were mixed. The Barclays U.S. Aggregate Bond Index gained 2.3%, while the Barclays Global Aggregate ex. USD Bond Index fell 0.6%. Government bond yields fell during the quarter as investors sought safety, particularly during August when U.S.-China trade tensions escalated. The U.S. 10-year Treasury yield fell more than 30 bps and finished the quarter with a yield of 1.67%. U.S. corporate bonds outperformed government bonds, and investment-grade corporates outpaced their high yield counterparts. The global stock of negative-yielding bonds is now more than $15 trillion.
Overall, markets are expected to remain volatile as the calendar turns from 2019 to 2020. In the near term, economies and markets should continue to be driven by trade disputes, geopolitical friction, domestic politics, and central bank action. Protectionist policies have taken a toll on corporate sentiment, and business spending has slowed. Given this environment, returns are likely to be driven more by earnings growth than by further investor enthusiasm. Late cycle dynamics imply that risks to the downside probably outweigh the potential upside.
In the U.S., given the 2020 U.S. election-year politics, an eventual trade deal may become a more likely scenario. Removing this uncertainty by year end has the potential to drive the global economy higher. If this occurs, U.S. equities should rally but may lag their international peers, which currently trade at more attractive valuations. The failure to resolve trade issues and a further escalation of tariffs have the potential to tip U.S. and global economies into a recession.
International developed equity markets have lagged their U.S. counterparts in 2019. The manufacturing sector has suffered. The services sector, on the other hand, has shown strength, driven by a resilient consumer. Despite the short-term worries, international equities do offer some long-term positives. A dovish shift by the European Central Bank bodes well for European stocks. The outlook for a weakening U.S. dollar is a positive. Finally, international stocks are currently trading at a greater discount to their long-term average than U.S. stocks.
Some exposure to emerging market equities may be appropriate, but the short-term risks suggest that caution is prudent. An accommodative Fed is certainly a tailwind for this asset class, particularly for those countries with large external debt loads. Many of the world’s other central banks are also easing. Chinese stimulus should be a benefit to emerging markets. Finally, valuations are generally attractive. On the other hand, emerging economies face the near-term risk of an escalation of trade conflicts. And there is a risk that the Chinese stimulus fails to meet the market's lofty expectations. Long-term, emerging markets do offer a rapidly growing middle class that should drive above-average economic and earnings growth.
The fixed income environment can be characterized by central bank easing, ongoing trade uncertainty, record low government bond yields, and a high level of volatility. Given this environment, investors may be tempted to reach for yield. Thus, it is appropriate to remind investors that higher yield typically comes with higher risk, and often a greater correlation to equities. Fixed income products with a high correlation to equities are less effective when they are being used in the role of ballast in the portfolio. In an environment of slowing growth and rising risks, taxable bond portfolios may benefit from an emphasis on quality and a shift to longer durations. Municipal bonds enjoy favorable supply/demand dynamics, improved fundamentals, and tax reform related tailwinds. Municipal valuations, however, appear a bit stretched. A slowing economy raises concerns about rising default rates in the high yield market.
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Based on the S&P 500 trailing twelve month Price-to-Earnings ratio, our gauge of U.S. equity valuation registers a current reading in the 23rd percentile.
Based on the Federal Reserve Bank of Philadelphia’s U.S. Coincident Index, our gauge of U.S. economic activity registers an August 2019 reading in the 35th percentile.
This economic and market commentary was prepared by Capital Market Consultants, Inc. (CMC), an independent investment management consulting firm, and has been approved for distribution by GW & Wade, LLC. Data used to prepare this report by CMC are derived from a variety of sources believed to be reliable including well established information and data software providers and governmental sources. CMC is not affiliated with any of these sources.
The information provided above is general in nature and is not intended to represent specific investment or professional advice. No client or prospective client should assume that the above information serves as the receipt of, or a substitute for, personalized individual advice from GW & Wade, LLC, which can only be provided through a formal advisory relationship.
About the indices presented above:
- Standard & Poor's 500 (S&P 500®) Index is a market capitalization–weighted index of 500 common stocks chosen for market size, liquidity, and industry group representation to represent U.S. equity performance.
- The Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the Nasdaq.
- The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. It includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership.
- The MSCI ACWI (All Country World Index) is a market capitalization weighted index designed to provide a broad measure of equity-market performance throughout the world.
- The MSCI EAFE Index is an equity index which captures large and mid cap representation across Developed Markets countries around the world, excluding the US and Canada.
- The MSCI Emerging Markets Index (EM) captures large and mid cap representation across 24 Emerging Markets (EM) countries.
- The Bloomberg Barclays Global Aggregate Bond Index measures global investment grade debt from twenty-four local currency markets. This multi-currency benchmark includes treasury, government-related, corporate and securitized fixed-rate bonds from both developed and emerging markets issuers.
- The Bloomberg Barclays US Aggregate Bond Index measures the performance of the U.S. investment grade bond market. The index invests in a wide spectrum of public, investment-grade, taxable, fixed income securities in the United States – including government, corporate, and international dollar-denominated bonds, as well as mortgage-backed and asset-backed securities, all with maturities of more than 1 year.
- The Bloomberg Barclays US Credit Index measures the investment grade, US dollar-denominated, fixed-rate, taxable corporate and government related bond markets. It is composed of the US Corporate Index and a non-corporate component that includes foreign agencies, sovereigns, supranationals and local authorities.
- The Bloomberg Barclays US Corporate High Yield Bond Index measures the USD-denominated, high yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
Views expressed are as of the date indicated, based on the information available at that time, and may change based on market or other conditions. GW & Wade assumes no duty to update any of the information presented above.
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