One of the most noteworthy stories in the second quarter was the tremendous drop in global interest rates and the record amount of global bonds that now trade at negative yields. According to Bank of America Merrill Lynch, around 85 percent of German government bonds have yields below zero, and in Switzerland, the entire government bond market went negative in the second quarter! It is no wonder that U.S. Treasury yields have continued to plummet, and the U.S. ten-year Treasury bond yield ended the second quarter at its lowest levels since November 2016.
The second quarter slide in interest rates began with a May 5 tweet from President Trump that unexpectedly escalated the trade war with China. With renewed trade risks coming at an inopportune time of slowing global growth, equity markets faltered in May after a strong start to the year. Nevertheless, global equities bounced back significantly in June, and the S&P 500 had its best first half since 1997. Despite an uncertain global growth outlook clouded by the threat of drawn-out trade wars and challenged corporate earnings growth, equity investors have placed their faith in central banks and believe that easing from the likes of the Federal Reserve and European Central Bank (“ECB”) will sustain the global economy and asset prices.
A lack of resolution in the trade war with China poses a significant risk to the global growth outlook
In early May, the U.S. increased the tariff rate on $200 billion of Chinese imports from 10 percent to 25 percent, citing a lack of progress in negotiations and dashing any hopes of a near-term resolution to the trade dispute. China retaliated by increasing the tariff rate on $60 billion of U.S. imports from 10 percent to 25 percent. The top three U.S. industries affected by China’s trade retribution are the automobile, agriculture, and electronics manufacturing industries. Although the U.S. has cited fairer trade terms as a key objective of waging the trade war, intellectual property rights and national security are also important issues.
At the late June G20 meeting in Osaka, President Trump and President Xi agreed to a temporary “truce.” The U.S. will hold off on previous threats to apply new 25 percent tariffs on $300 billion of Chinese imports and will lift restrictions on U.S. firms doing business with Chinese telecommunications giant Huawei. In return, China will increase purchases of U.S. agricultural products. While developments from the G20 meeting are favorable, they are not enough to completely allay uncertainties around trade policy, and the tariffs already in place are detracting from economic growth. The U.S. has also escalated trade tensions with Europe, announcing $4 billion of European Union products that could be subject to tariffs. Tariffs and uncertainty over future policy impact the global economy through multiple channels. These channels include the sectors and companies where the tariffs are directly imposed, domestic and international supply chains, and business confidence, where they lead to delayed supply chain and capital spending decisions. Business confidence has already taken a hit, and global manufacturing indices continue to decline. We look for trade settlement progress as critical to sustaining a constructive economic outlook.
The U.S. economy has defied recession fears, but growth is moderating
Before the negative turn in the trade war, we thought the U.S. was well on its way to an economic “soft landing” with historically low unemployment and elevated consumer confidence. The current U.S. expansion has now officially become the longest on record, but growth is slowing, and economic forecasts are being revised downward due to the trade overhang. Though first quarter U.S. GDP rose 3.1 percent, the headline number was skewed higher by outsized contributions from trade and inventories. Excluding trade, inventories, and government spending, the U.S. economy grew only 1.3 percent during the first quarter.
Second quarter growth is expected to rise 1.7 percent, underpinned by a resilient U.S. consumer, which thus far has been undeterred by worrisome trade headlines. Consumer spending, which makes up two-thirds of the U.S. economy, was soft in the first quarter but increased for a third consecutive month in May, fueled by steady income gains and a solid U.S. labor market. Payrolls rose 224,000 in June, handily exceeding expectations and curbing concerns that the U.S. employment picture was weakening alongside overall growth. The most vulnerable part of the U.S. economy is business investment, which remains weak as firms put off capital spending decisions until they have visibility on trade and the viability of existing global supply chains. In June, the ISM Manufacturing Index fell to its lowest levels since late 2016, and regional manufacturing surveys have also weakened.
Central banks are keeping interest rates “lower for longer”
Due to elevated risks to the economic outlook and deteriorating inflation expectations, global central banks have altogether abandoned plans to “normalize” monetary policy and have once again turned dovish. At the end of last year, the Federal Reserve projected two, 25 basis point interest rate increases in 2019, and economists estimated that the ten-year Treasury yield would be at 3.2 percent by mid-2019. Now, the Federal Reserve is expected to cut interest rates at its July meeting and then reduce interest rates up to two more times this year. The 10-year Treasury now yields around 2 percent. What has changed? In addition to resurgent trade risks, the Fed has grown more concerned about weaker inflation, which has declined noticeably since the end of 2018. Expected interest rate cuts from the Fed have been viewed by investors as “insurance” against downside risks given that the U.S. economy has not yet fallen into a deep slump. Chair Powell echoed this view by recently saying that “an ounce of prevention is worth a pound of cure.”
Similarly, the ECB has telegraphed that easier policy is on the way. ECB President Mario Draghi said that the bank was ready to “use all the instruments that are in the toolbox”, fueling expectations for upcoming policy rate cuts and additional asset purchases. Soon after the ECB’s announcement, European government bond yields fell deeper into negative territory, and France’s ten-year government bond yield went negative for the first time in history. In Europe, many corporate bonds, including those with high yield ratings, have negative yields, putting significant pressure on the profitability of European banks. The decline in foreign yields continues to drag down U.S. Treasurys as the universe of “safe”, positive-yielding assets shrinks.
The first half of 2019 saw exceptionally strong performance across risk assets
In the second quarter, equity and corporate bond markets traded under the belief that central bank accommodation will be enough to offset prevailing headwinds. The S&P 500 had its best June since 1955 and returned almost 19 percent in the first half of 2019. However, equity returns over a one-year period are more mixed, reflecting the sell-off at the end of 2018 and subsequent first quarter 2019 snap-back. In contrast to previous periods, dramatically lower interest rates have driven recent equity market appreciation versus earnings growth. First quarter S&P 500 earnings per share declined 0.4 percent year-over-year, and second quarter earnings per share are expected to decline 2.6 percent year-over-year, which would mark the first time S&P 500 earnings declined for two straight quarters since the beginning of 2016. For full-year 2019, S&P 500 earnings per share are expected to rise only 2.8 percent.
One acronym used to describe strong equity market performance has been the “TINA” trade or “There Is No Alternative” in a world of ultra-low and negative yields. According to Strategas Research Partners, almost half of the S&P 500 yields more than the U.S. 10-year Treasury. Contrary to traditional historical patterns of positive equity performance being accompanied by weaker bond performance, we continue to see equities and bonds rise together, driven primarily by central bank intervention.
Strong reception for U.S. initial public offerings (IPOs) in 2019
Trade was not the only attention-grabbing headline in the second quarter. Every time they turned on CNBC, investors could count on hearing about the demand for the stocks of veggie burger distributors and rideshare companies. Perhaps one of the most apparent signs of “risk-on” in equity markets is the strong performance of IPOs. U.S. IPO proceeds of $40 billion in the first half of 2019 were the strongest since 2009.1 Beyond Meat, which has a market cap of $9 billion, is not yet profitable, trades at around 80x trailing annual revenue, and has returned over 500 percent since debuting as a public company! Many of these companies that went public in 2019 are experiencing rapid revenue growth, and it is very difficult to pinpoint the “right” valuation. Investors who buy the stocks of these companies believe that they represent tremendous growth opportunities and could be the next Amazon or Apple. The rapid price gains of many of the stocks suggest that current moves are being driven more by momentum than fundamentals. Although momentum to the upside is typically welcome, we remind investors that stocks such as these have higher volatility profiles and can just as easily experience momentum to the downside.
Where do we go from here?
The first six months of 2019 generated for investors more than an average year worth of returns. Most of these gains are attributed to oversold conditions coming off of the 2018 sell-off and lower interest rates. The key question for global markets is to what extent looser financial conditions can offset headwinds such as trade and slowing economic growth. We expect economic growth to continue to slow but do not believe that economic indicators point to an end of the current U.S. business cycle over the next several quarters. Unresolved trade tensions or an escalation of tensions are the most significant downside risks. We are staying tuned in to the progress of negotiations and in to second quarter corporate earnings where we expect companies to continue to focus on the impact of tariffs on their businesses and sectors. We look forward to reflecting on the latest from President Trump, President Xi, Fed Chair Powell, ECB President Draghi, and other key market influencers in our third quarter update.
1 Bloomberg, "There’s No End in Sight for the U.S. IPO Frenzy," July 3 2019.