Economy and capital markets
Investors Shrug Off Trade Tensions and Recession Fears as Risk Assets Surge
There is a well-worn investing adage that says the markets “climb a wall of worry.” This refers to the tendency of stocks (and other types of risk assets) to generally rise, even in the face of clear downside risks. This year’s market action serves as a great example of this phenomenon. Serious risks, including U.S. trade tensions, geopolitical concerns, an inverted U.S. yield curve, and slowing consumer spending, did not impede stocks and other risk assets from surging in the first half of the year. In fact, U.S. large company stocks had the best first half in more than two decades. Investment-grade corporate bonds, meanwhile, posted the best first half on record.
Watch for movement in Fed rates
It may be said that the Federal Reserve “gave a boost” to assist risk assets in their climb. Although Fed officials held policy rates steady at the June 19 meeting, their statement struck a decidedly dovish tone. In a statement, the Federal Open Market Committee removed the word “patient” from their monitoring of policy rates, instead saying that they “would act as appropriate to sustain the expansion” and made references to the rising trade tensions and slowing growth. The market now expects three rate cuts for the remainder of year (based on Fed futures markets as of June 2019). This accommodative monetary stance has been bullish for stocks and other risk assets.
Some may question the need for rate cuts. Consider the current context (as of June 2019):
- S&P 500 up 18.5 percent year to date, the best first half since 1997, and near all-time highs
- Unemployment of 3.6 percent, the lowest since 1969
- 104 consecutive months of jobs growth, the longest such stretch in history
- Approaching the longest U.S. economic expansion in history (if it continues through the end of July)
Wouldn’t it be better for the Fed to “save ammunition” for the next recession, bear market, or some sort of crisis? The Fed certainly has a difficult job trying to thread the needle of maintaining market and economic stability in a complex world. Investors will be watching the next Fed meeting (July 31) with great interest.
Strong U.S. stock and IPO markets
Within U.S. stocks, large cap technology shares had a strong quarter yet again. On a year-to-date basis, technology is the highest returning sector at 27.1 percent (versus the broad S&P 500’s 18.5 percent). The lowest returning sector is health care at 8.1 percent (Morningstar).
Small cap stocks, meanwhile, are nearly keeping pace with large caps year-to-date, after underperforming last year. The IPO (initial public offer, referring to when a company raises money by listing its stock on an exchange) market is red hot in 2019. In the second quarter alone, there were 62 IPOs, raising a combined $25 billion — the most active quarter in more than five years (Renaissance Capital). The average return for these new stock issues was 30 percent. The IPO roster included several high-profile companies, including Slack, Pinterest, Uber, and Lyft.
How markets perform following rate cuts
The market is expecting a rate cut cycle to commence at the July 31 meeting of the Federal Reserve. Goldman Sachs did a study of sector performance during 12 months following the initial cut of the last seven Fed rate cutting cycles.
Technology is the worst-performing sector, lagging the broad S&P in six of the last seven such periods (the exception being 1998, during the last years of the internet bubble) and underperforming by an average of 14 percent.
The best-performing sector during these periods was health care (+9 percent average outperformance versus the broad S&P 500). The second best-performing sector was consumer staples (+8 percent average outperformance), which includes goods like food, beverages, and household goods, that consumers are unable — or unwilling — to cut out of their budget regardless of their financial situation.
These results are in harmony with a theory that Fed initiating rate cuts are a signal of economic weakness, and it is therefore intuitive that more defensive sectors, such as health care and consumer staples, would outperform.
Strong returns from foreign stocks
Foreign stocks, while slightly lagging the U.S. year to date, have also provided strong returns this year. Developed markets were led by European equities, boosted by belief in renewed stimulus from the European Central Bank. The fundamental backdrop in Europe is not entirely rosy. German industrial orders fell in May by the largest amount since 2009 (based on year-over-year growth rate from Reuters). In the first quarter of 2019, the United Kingdom’s economy saw its first quarterly decline in seven years (Guardian UK).
In emerging markets, Russian equities were the leading performer (+33 percent year to date, Morningstar Russia NR USD Index), driven by the increasing perception that Moscow will escape further sanctions from the west and a sharp rise in oil prices this year (+25 year to date, based on Bloomberg WTI PR Index). Chinese equities, meanwhile, took a loss in the second quarter due to concerns over trade, but are still positive on a year-to-date basis (+12 percent, Morningstar NR USD Index).
A looming question: When will the next recession come?
Liz Ann Sonders, Charles Schwab’s chief investment strategist, stated in her mid-year outlook that the market’s reaction to the expected, upcoming Fed rate cuts will depend on how near we are to a recession. If a contraction isn’t imminent and the economy continues to hold firm, the rate cuts will be seen as “insurance” and markets could rally strongly on investor optimism. Alternatively, if the economy is perceived as weak and slipping into recession, the psychology around rate cuts could turn negative.
There are several indicators warning of recession. In the April 2019 Market and Economic Outlook, we pondered the inverted yield curve, which remains inverted as of this writing. Various other signals show increasing likelihood of a slowdown. The New York Federal Reserve Recession Indicator plots the probability of a recession in the next 12 months at about 33 percent (about the same at levels of July 2007, just prior to the Great Financial Crisis).
The current decade — will future generations call it The Roaring ‘10s? — will be the first in modern history without a recession if the expansion continues through the second half of this year.
When it comes to low yields, 0 percent is not the floor
Even casual observers of the bond market have likely observed that we are in a low yield environment. A quick way to assess the U.S. yield environment is the 10-year Treasury, which closed the quarter at a 2 percent yield. This seems paltry, especially when you consider that if inflation were to average 2 percent per annum over the next 10 years — perhaps a reasonable guess — that would leave you with a real yield of zero. The yield of the U.S. Aggregate Bond Index (which includes Treasuries but also corporate and government agency mortgage bonds, and other types of bonds) is just 2.7 percent (Bloomberg).
Viewed in a global context, the yields being offered on U.S. government obligations are shockingly attractive.
Viewed in a global context, however, the yields being offered on U.S. government obligations are shockingly attractive. Consider that the Japanese government 10-year bond yields -0.16 percent. Germany’s 10-year bund yields -0.32 percent. These are not typos — the bonds have a negative yield. This means that if you were to buy the 10-year German government bond and hold it to maturity, you would, instead of receiving interest payments, effectively pay Germany for the privilege of loaning them money.
This perplexing negative yield situation is wide-ranging. As of quarter-end, the total value of global debt with a negative yield was an astounding $12.9 trillion. The majority of this is debt issued by sovereign governments (see Negative Bond Yield Matrix), but about $1.5 trillion of the total is corporate bonds; 20 percent of Eurozone investment-grade corporate bonds have yields below zero (as of May 31, 2019, Bloomberg).
If you are scratching your head and asking, “Who would buy negative yielding bonds?” you are not alone. We would point to several reasons why this perplexing phenomenon exists:
1. Investors are simply listening to what the central bankers are telling them. A previous surge in negative yielding debt occurred in 2016 right after the shock of the Brexit referendum results. Both the Bank of England and the European Central Bank began an aggressive bond-buying program (“quantitative easing”). Central banks around the world have sent a clear signal that they will do “whatever it takes” (the actual words of ECB President, Mario Draghi) to inject stimulus into the financial system, and negative yields will not deter them from continuing to buy bonds with printed money and keep policy rates low.
Remember, too, the inverse relationship between yields and prices. When a bond’s price goes up, the yield goes down. The bond-buying programs of the central banks pushes yields lower.
2. There are buyers for whom price is no consideration. Many institutional investors, such as pension plans, insurance companies, and certain types of regulated bank accounts, are mandated to buy government bonds. Such “non-economic buyers” don’t care, in a manner of speaking, that the German 10-year yields minus 30 basis points. They simply must buy it. These large investors are a constant source of government bond demand.
3. Traders see opportunity. There are some investors who buy negative-yielding debt with absolutely no intent to hold the securities until maturity. Instead, they are attempting to profit by making short-term bets.
Also, negative-yielding bonds have high positive convexity. Without detouring too far into bond math and investment jargon, what this means is that the prices of long-dated, low-yielding bonds will rise more when rates fall than they will fall when rates rise. This characteristic makes them attractive to traders who are betting on rates to move lower.
4. Government bonds are a form of safe haven and their low yields may be a distress signal. Government bonds, generally speaking, offer liquidity and high credit quality. The apparently insatiable appetite for these types of bonds may represent investors being more attuned to global financial and geopolitical risks.
5. Supply and demand dynamics — exacerbated by central bank bond-buying programs — are favoring higher prices and lower yields. Lack of supply and strong demand have been driving yields lower, especially with regard to certain issuers. Let’s look at Germany. There are $1.7 trillion of German government debt securities. Compare this to the U.S. government’s $16+ trillion of outstanding bonds. Germany runs a budget surplus and, therefore, doesn’t need to issue much new debt, which restricts supply. Again, this stands in sharp contrast to the U.S., which has a rapidly expanding budget deficit that requires new debt issuance. The ECB’s bond-buying program has included German bunds; in fact, the ECB owns approximately $0.56 trillion of the $1.69 trillion in outstanding German debt (Bloomberg).
With regard to the U.S., there is no supply problem. As we stated above, the increasing federal debt and deficits will require that more debt be issued. However, demand for Treasuries is likely to remain strong. One key reason is liquidity. The market for Treasury securities is the largest and deepest of any asset class in the world, with nearly $600 billion trading volume on a daily basis (Federal Reserve Bank of New York, average daily volume year-to-date through May 31, 2019.). Treasuries are also prized the world over for their relative safety, in that the principal of bonds is backed by the full faith and credit of the U.S. government. There is a persistent demand from U.S. and overseas investors for Treasuries, even if yields are low from a historical perspective.
Some bond basics
You’ll see these terms in our discussion of bonds in this issue. Basic definitions will help you better understand the analysis.
Par value — The principal value of a bond (typically $100 or $1,000). If a bond is “trading at par,” it means its current market price is the same as its principal value.
Coupon — The stated annual rate of interest payments. For example, a 3 percent coupon bond (with at par value of $100), will pay the $3 in annual interest (commonly paid in two, semiannual payments, of $1.50 each, in this example).
Yield — The yield will fluctuate with a bond’s price. There is an inverse relationship between prices and yields. When a bond’s price increases, its yield falls, and vice versa. Example: If you buy a 3 percent coupon, $100 par value bond at a market price of $110, you’ve bought the bond at a yield of 2.7 percent ($3 in annual interest payments divided by $110).
Maturity date — Date at which the bond will pay back the principal value. Some bonds are callable, a feature that gives the issuer the right to pay off the bonds before the stated maturity date. A bond’s yield is often expressed in terms of yield to maturity or (if it’s a callable bond) yield to call (Sometimes called yield to worst. The “worst” refers to assuming that a bond, if it’s callable, will be called at the earliest date possible by the issuer.). The math behind these calculations is beyond what we want to touch on here, but these concepts are important to bond investors.
Duration — A statistical measure of a bond’s sensitivity to changes in interest rates. A higher duration means more sensitivity to rate changes. The current duration of the broad U.S. bond market is 5.5 years (Bloomberg Barclays Aggregate).
The recent Austrian government “century bond” issue is another anecdote that captures the low yield zeitgeist. In June, Vienna came to market with a bond offering a 1.2 percent coupon and with a maturity date 100 years hence, in 2119. Investors were (metaphorically) falling over each other in a rush to get a piece of this sweet 1.2 percent/100-year action. The offering was “oversubscribed”, i.e., there were $5.9 billion (€5.3 billion) in orders for the $1.3 billion (€1.2 billion) worth of bonds to be issued.
As a side note, this type of super-long maturity bond is not unique to Austria. Other governments have issued 50- and 100-year bonds, including Argentina, Spain, and Ireland.
We are definitely living in a low yield environment, and it’s difficult to see that changing in the short term. The tag line associated with this theme is “lower for longer,” which is to say, low rates are likely to persist.
Department stores among worst performers in 2019
The “Amazon effect“ has disrupted retail markets to an astonishing degree. The growth in online retail has been a trend for years, but investors can see an acute effect over the last year. Department stores are among the worst performers in the S&P 500 this year (year-to-date returns, Morningstar: S&P 500 +19 percent versus Nordstrom -30 percent, Kohl’s -26 percent, Macy’s -25 percent). The losses are far worse for bricks-and-mortar apparel shops.
Through May, more than 8,000 retail store closings have been announced, a number which exceeds all of last year. But in a release from the National Retail Federation (NRF), Mark Mathews, vice president of research, development, and strategy, says that retail is being increasingly conducted through multiple physical and digital channels, so store closures are not necessarily a sign of distress, but rather a sign of change.
Research by the IHL Group suggests that store closures may not be as alarming as they seem. Data shows 14,000 new store openings in 2017, compared with 10,000 store closings — a net gain of 4,000 stores that year. The categories with the most openings were convenience stores, mass merchandisers, fast-food establishments, and supermarkets. Specialty soft goods and department stores saw the most closures.
The NRF also reports that retail sales rose 0.5 percent in May, seasonally adjusted from April, and up 3.2 percent unadjusted year over year. NRF’s numbers are based on data from the U.S. Census Bureau.
Auto sales remain stable amid low interest rates and unemployment
One key area of the U.S. retail market that has done well in recent years is auto sales. After being essentially cut in half during the Great Financial Crisis (see graph), sales rebounded dramatically post-crisis and have been mostly stable in recent years, aided by the favorable backdrop of low unemployment, low interest rates, and mostly sub-$3.00 per gallon gasoline.
There are some signs of slowing, with 2019 sales down 2 percent, per a report from Edmunds. Is this a sign of deeper downturn, or just a cyclical slow down?
“We are seeing a weakening in overall vehicle sales and an uneven monthly sales pace with our dealer clients,” noted Scott Gorden, managing principal of the CLA dealership practice. “Some months, like March and May, have been strong, while February and June were weak. The overall economic indicators for dealers are generally positive, however, we believe the market will continue to slow over the next couple of years.”
The importance of the auto industry to the U.S. economy can be seen when analyzing trade. Although the Trump administration’s disputes with China have rightfully received the most attention from investors and global analysts, there are signs that it is inclined to open more fronts on the trade war, including with Mexico. In late May, the president surprised many with an announcement that he was seeking a 5 percent across-the-board tariff on Mexican imports. One need only examine this table showing U.S. imports as a percent of total imports to see that such a policy would have a large impact on the U.S. auto industry.
Like scouts, investors should be prepared
Although economic data is more mixed than in recent years, there are many positives underpinning the markets. U.S. consumer sentiment is elevated (rising strongly in June in a University of Michigan poll), which bodes well for spending, the largest component of the economy. And perhaps most significantly, the monetary (central bank) and fiscal (low taxes) regimes favor a continuation of the bull market. The probability remains, however, that we are nearer the end of the bull market than the beginning, and investors must be prepared.