July 9, 2019
Dear Clients and Friends:
2nd Quarter Market Commentary
June performance ended the second quarter on a positive note. The S&P gained 7.05% for the month and finished the 2nd quarter up 18.5% for the year. Below is a summary of major stock and bond index performance for the 2nd quarter and year-to-date through the end of June:
Trading was choppy. April saw a 4.05% rise in the S&P 500. This was followed by a 6.4% drop in May before the June rebound. Throughout the quarter, U.S. markets ebbed and flowed between the unpredictability of trade talks and the Federal Reserve’s new accommodative stance. The markets rallied early in June as Fed Chairman Powell indicated that they are watching trade talks closely and “will act as appropriate to sustain the expansion”1.
Meanwhile, U.S. interest rates continue a relentless move downward. The U.S. Treasury 10-year yield started the year at 2.7% and ended June at 2.0%. The Fed Funds target rate for short-term borrowing now stands roughly 0.5% above the 10-year Treasury yield, a market phenomenon known as an inverted yield curve. Economists have identified an inverted curve as typically signaling a pending recession.
The graph below details the year-on-year change in the U.S. Conference Board’s Index of Leading Economic Indicators (LEI) and the Institute for Supply Management U.S. Manufacturing Purchasing Manager Index (PMI) – a gauge of U.S. manufacturing activity. Both indices have sustained a downward trend into 2019.
With global economic growth slowing and investor optimism growing, investors must now grapple with the question, “where do we go from here?”. Investor optimism pertaining to future U.S. rate cuts is well-founded. The Federal Reserve Open Market Committee, which governs the Fed Funds target rate, is aware of the inverted yield curve and much has been written about the bond market pushing the Fed into additional rate cuts. We believe it is likely that the Fed will announce two rate cuts during the 2nd half of 2019, which would bring the Fed Funds rate roughly in-line with current longer-term Treasury yields discussed above.
Lower rates are benefiting the housing market. A more accommodative monetary policy by the Fed will bring the U.S. more inline with other global central banks and should help spur economic growth in the short-term. We are concerned that much of this expected positive impact is already being priced into the equity market, leaving the market susceptible to downside risks if positive expectations fail to materialize.
With respect to U.S. – China trade negotiations, contentious issues remain to be settled. We do not expect a short-term solution and expect continued market volatility around headlines speculating on both positive and negative developments in negotiations.
U.S. earnings growth and capital investment will increasingly come into focus as we move into the second half of the year. Second quarter earnings are expected to contract by roughly 2% relative to the prior year. Two consecutive quarters of earnings contraction would meet the technical definition of an “earnings recession”, and, should this come to pass, would be the first such event in the U.S. since 2016. This would likely have a negative impact on equity prices. In addition, economic data indicates that capital investment by U.S. corporations has been declining this year as uncertainty around trade has increased. Capital investment needs to reestablish a growth trend in order to support longer-term economic growth.
We believe the current economic expansion, which is now the longest in U.S. history, will continue into 2020, but with increased downside risks in equity market returns for the rest of this year. While the market is currently pricing in the benefits of a more accommodative Fed monetary policy and the resolution of the trade war, economic data and earnings must respond positively for the market to move materially higher.
As the graph of U.S. Leading Indicators and Manufacturing PMI shows, the U.S. economic slowdown has been material, and it is notable that international data has been weaker than U.S. data. While we expect global economic conditions to improve going forward and think there is a chance that third quarter earnings for the S&P 500 may be positive (thereby avoiding an earnings recession), we are decidedly cautious about equity returns from current levels. We also expect market volatility to remain elevated for the foreseeable future.
In our judgement, the current market environment is somewhat fragile and demands sticking to a long-term investment plan, where portfolio risks have been adequately geared to longer-term investment objectives.
- Strategic Positioning: In the stock portion of our client portfolios, we maintain an overweight to U.S. equities relative to international. This positioning (characterized as a “U.S. equity tilt”) was helpful to performance as U.S. markets have outpaced international equity markets for the quarter and year-to-date.
- New Tactical Fund: One of the additions to the portfolio in the first quarter (the JP Morgan Global Allocation fund), which is managed tactically, has contributed to positive performance relative to its benchmark since our investment.
- New Defensive Alternatives: The defensive alternatives in client portfolios added significant value during the quarter. This was particularly true of two of the investments we added earlier in the year: gold and managed futures. Like traditional fixed income, both investments have historically performed well during periods of market stress, but with much less sensitivity than bonds to changes in interest rates. Defensive alternative strategies are an important component of our overall defensive positioning, designed to diversify portfolio equity risk.
- Traditional Fixed Income Underweight: For some time, we have positioned portfolios with an underweight to traditional fixed income investments. This was intended to reduce exposure to rising interest rates as the U.S. Federal Reserve embarked on a plan to reduce its balance sheet, which had grown due to the quantitative easing program, and to normalize or increase U.S. interest rates. This portfolio positioning served us well, with the 10-year Treasury yield increasing from approximately 1.5% in 2016 to above 3.0% in November of last year – negatively impacting bond performance. However, it has detracted from performance during 2019, as interest rates have significantly decreased in response to slowing global economic conditions and a perceived change in the Fed’s policy stance.
- China Trade War: Historically, the Asian component of the emerging markets index has been much less volatile than its non-Asian counterparts (e.g., Latin America and Africa). However, the highly publicized trade tensions between the U.S. and China have brought increased volatility to the equity markets in the region. As a result, Compass Ion’s overweight to Asia relative to broader emerging markets risk detracted from performance in Q2 relative to the more diversified emerging market benchmark.
- On June 13th, one of our structured notes matured. This note, purchased in April 2018, was linked to the international developed equity markets. It outperformed the international developed equity benchmark during its term due to the structural features we incorporated into the note. These features protected the first 10% of loss in the equity index and hedged the foreign exchange exposure associated with the non-U.S. equity investment. As a result, the note matured with a full redemption of invested principal (a break-even return), while the benchmark Euro Stoxx 50 Index lost 1.52% during the same period. We used the proceeds of this note to allocate to another note linked to the international developed market, although we selected a different region of that market in order to utilize advantageous market pricing and further diversify the non-U.S. equity risk within our note portfolio. The new note references the ASX 200 Index, which is comprised of Australian large cap companies. This new note also hedges the currency risk associated with the Australian Dollar underlying investment.