Institutional 3rd quarter market update: What summer lull?

So much for a 2019 “summer lull.” Investors were anything but bored in the third quarter, instead kept busy by a torrent of geopolitical headlines, astonishing declines in global interest rates, and increased equity market volatility. The U.S.-China trade war escalated. Protests erupted in Hong Kong. The Federal Reserve reduced interest rates for the second time this year. To end the quarter on anything but a dull note, an attack was launched on Saudi oil facilities, knocking out about half of the country’s total production, and impeachment drama intensified in Washington. Among all of the headlines, trade has dominated, and actions by both the U.S. and China have whipsawed equity and bond markets.

The prolonged trade war has cast a cloud of uncertainty over the global economic growth outlook, and both the OECD and the IMF have reduced their 2019 global growth forecasts to post-crisis lows. The global economy is expected to grow 3.2% in 2019, down from expectations for growth of 3.5% at the beginning of the year. Economic growth and corporate profits are being dragged down by declining trade volumes and slowdowns in manufacturing and business investment. Equity and bond markets have thus far maintained their strong year-to-date performance, buoyed by accommodative monetary policy and recent optimism over an eventual trade deal.

Global growth slowdown has broadened to U.S. manufacturing; however, U.S. consumer remains resilient

Manufacturing activity has contracted across major developed economies for two consecutive months through September. Eurozone manufacturing activity recently hit a seven-year low, and the U.S. manufacturing purchasing managers’ index (PMI) fell into contractionary territory for the first time since 2016 and to its lowest level since 2009, prompting equity market volatility at the beginning of the fourth quarter. The new export orders sub-index of the U.S. manufacturing PMI fell sharply in September after contracting in August, a clear sign of the economic detriment caused by the trade war. However, similar to 2016, U.S. services activity continues to expand, and despite a manufacturing contraction in 2016, the U.S. economy did not enter a recession.

The U.S. economy is forecast to grow 2.3% in 2019, exceeding the growth of many other developed countries. That growth is largely due to strength in consumer spending, which makes up about 70% of the U.S. economy. Negative trade headlines failed to curtail spending as retail sales accelerated through the summer, and second quarter GDP grew more than expected on solid consumption trends. Historically low unemployment and steady wage gains have underpinned a healthy consumer. Also, lower mortgage rates may finally be providing some economic boost through a resurgence in housing activity. Housing starts jumped to a twelve-year high in August, and new home sales have also recently perked up.

Equity markets trudge higher in spite of stalled corporate profits

Slowing economic growth ties directly to what we are observing at the company level: sluggish earnings growth. First and second quarter 2019 earnings-per-share growth for the S&P 500 are not exactly commensurate with the 20% return the S&P 500 has generated this year. EPS growth has been held up by share buybacks, which totaled $370 billion in the first half of the year, down slightly from the same period in 2018. According to data from the Bureau of Economic Analysis, however, total U.S. corporate profits have remained relatively flat since 2018 and are well below their 2014 peak. S&P 500 earnings are expected to bounce back beginning in the fourth quarter, but we believe this will be dependent on positive developments in the trade war and their impact on business confidence. In the September Chief Executive Magazine CEO Confidence Survey, the majority of CEOs did not see a recession as likely in the next year, but their economic outlook has deteriorated with confidence in the economy one year from now at its lowest level since 2016. Trade sentiment has somewhat improved ahead of trade talks expected to resume in October, and in light of tariff delays and concessions announced by the U.S. and China.

Interest rates: How low can they go?

Interest rates plummeted during the third quarter as the trade war escalated and the global growth outlook deteriorated. The amount of negative yielding global debt reached a record $17 trillion while the U.S. thirty-year Treasury yield hit an all-time historic low of 1.95%. The European Central Bank (ECB) cut interest rates further into negative territory in September. Beginning in November, the ECB will initiate bond purchases of 20 billion euros a month, adding to downward pressure on European bond yields. The Federal Reserve reduced the Fed Funds Target Rate 25 basis points to 2.0% on September 18th, although some Fed members voiced opposition to reducing interest rates given a relatively stable U.S. economic backdrop. In fact, the September Fed meeting had the largest number of dissents at a meeting since December 2014, a testament to the complexity of the current market environment.

When the 10-year U.S. Treasury yield fell below the two-year U.S. Treasury yield in August, fears of recession once again came to the forefront due to inversion of the yield curve typically being viewed as a leading indicator of recession. We believe recession risks have increased due to slowing growth and trade uncertainty. However, as we have discussed in previous market updates, central banks are creating significant distortions in bond markets, so we would not count on yield curve inversion as a very reliable indicator of impending recession. According to Bianco Research, this is the first time in the post-World War II era that the U.S. has the highest relative long-term interest rates in the developed world.

The majority of developed countries’ credit ratings are lower than that of the U.S., so one might expect U.S. Treasury yields to be lower. Italy, whose debt has ballooned to unsustainably high levels and whose economy is expected to barely grow this year, has lower sovereign bond yields than the U.S. We attribute this disconnect to central bank manipulation and remind investors that ultra-low global interest rates across Europe and Japan continue to exert a downward pull on U.S. Treasury yields as investors reach for yield. According to Deutsche Bank, the ECB and Bank of Japan own 28% and 46% of government debt in their domestic markets, respectively!

2019 “unicorns”: Great business models, but are they also great investments?

In our second quarter 2019 market update, we highlighted the surge in 2019 IPO activity and staggering performance of many innovative, yet unprofitable companies. Some companies with very high valuations, such as Beyond Meat, continue to benefit from momentum buying and investor confidence in future profitability and growth prospects while others have not received as warm of a market reception. Uber, Lyft, and Peloton are some stocks that come to mind. Many of us would describe them as “great companies.” We love their disruptive products and the ways in which they enhance our lives, but that does not always translate into profitability or investment viability. Their post-IPO stock declines are testament to this point. All three of these companies currently fail to generate positive EBITDA, let alone net income! Peloton’s stock price fell more than 10% in its first day of trading, marking the third worst debut for a “unicorn” (technology start-up company with a value exceeding $1 billion) since 2008.

WeWork, a company that leases shared workspace, was forced to shelve its IPO after reducing its valuation from almost $50 billion at the beginning of the year to $20 billion currently. Investors pushed back on a lofty valuation of the company, whose net losses are actually widening. While disappointing for many, we view the poor performance of these stocks as a sign of a healthy market. Instead of the euphoria that preceded the 2000 dot-com bubble burst, investors are exhibiting discipline and a healthy amount of skepticism as the investments are revalued in the marketplace.

Outlook

Trade remains the biggest threat to the current expansion due to its impact on business confidence, industrial activity, and corporate profits, which drive hiring and capital spending. The sharp slowdown in U.S. manufacturing and corresponding market response earlier this month reinforce this point. Although the U.S. economy has continued to chug along due to a solid labor market and consumer, monthly payroll growth has slowed from over 220,000 in 2018 to 160,000 in 2019. Near-term, the risks of a U.S. recession remain relatively low, but persistent uncertainty, further manufacturing weakness, and an accelerated slowdown in job growth could eventually pressure the consumer, and broader economy.

The potential for an impeachment in Washington and the upcoming 2020 election are also unpacking new uncertainties for investors. There are a wide range of views as to how these political events could influence President Trump’s desire and President Xi’s desire to strike a trade deal, but we see the timing and outcome of a trade deal as increasingly difficult to predict. Low interest rates remain supportive of the economy and have contributed to strong equity and bond market performance this year, though monetary policy has limits and cannot alone fend off a slowdown. As we look to the fourth quarter, we will continue to keep a close eye on trade talks, key economic indicators such as manufacturing and business confidence, and corporate profits. We hope that the fourth quarter of 2019 brings positive developments for investors and looks nothing like the fourth quarter of 2018! See you in 2020.

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