Third Quarter 2019 Key Takeaways
The third quarter of 2019 was a choppy one for financial markets as investors continued to weigh the overall health of the global economy. Uncertainties included the ongoing trade war with China, a drone attack on Saudi Arabia’s oil fields, the seemingly never-ending Brexit negotiations, and – as September wrapped up – an official presidential impeachment investigation in Washington, D.C.
On the economic front, the Federal Reserve followed its 0.25% interest rate cut in late July with another 0.25% cut in mid-September. This was in response to the weak global economic environment and the impact of trade policy on U.S. business sentiment and capital expenditure. The European Central Bank also cut its policy rate.
Amidst this backdrop, equity markets rose in July, fell in August, then rallied in September. Largecap U.S. stocks gained 2% for the quarter and have netted over 20% year to date. Smaller-cap U.S. stocks suffered more acutely during the market drops and ended the quarter down 2.3%. However; for the year to date, they are still up a healthy 14.1%.
Despite a rebound in September, foreign stocks posted negative returns for the quarter. Developed international stocks fell 0.9%, European stocks fell 1.8%, and emerging-market (EM) stocks fell 4.1%. In addition, the U.S. dollar appreciated 2% to 4% versus other currencies during the quarter, which was an equivalent drag on foreign stock market returns.
Bond yields around the world continued to move lower in the third quarter as deflation concerns took hold. The benchmark 10-year Treasury yield dropped to below 1.5% in early September as trade war and recession fears crescendoed. It then sharply reversed, then dropped back, ending the quarter at 1.68%, down from a 2% yield at the end of the second quarter. For the first time, conversations around rates going negative in the U.S. entered our collective mindsets. Remember that as interest rates drop the value of existing bonds increase in value and thus have had a positive impact on portfolios.
The economic environment continues to feel like a game of tug of war between the contractionary effects from U.S. trade policy and accommodative/expansionary global monetary policy. There are many potential outcomes from here including a recession. We remain balanced in our portfolio approach and focus on diversification.
Recession fears continue to loom large, and each new data release can cause high volatility in day-to-day market valuations. Investors have been living with this overhang for several years, yet while they wait, portfolio returns have been relatively strong. We remain diligent in our recession watch and have designed our portfolios to be as resilient as possible, while at the same time attempting to capture as much upside as we feel is prudent.
Third Quarter 2019 Investment Letter Market and Portfolio Outlook
The financial environment continues to feel like a game of tug of war. On one side, we have a still-solid U.S. economy that has grown for a record number of consecutive years. While measures of manufacturing activity are slowing, global services activity, which represents upward of 70%-plus of the global economy, still looks solid. (See the following chart from BCA Research. Note that Purchasing Managers Index (PMIs) above 50 denote expansion and PMIs below 50 denote contraction.) Household balance sheets and consumer spending also remain healthy, supported by low unemployment and solid wage growth.
The news media reports negative news when these indexes are slowing, but what is often overlooked is that the indexes are healthy.
On the other side, global economic growth remains weak and consensus expectations are for further slowing. In particular, the longer a China-U.S. trade agreement remains elusive, the weaker the economy will get as corporations further delay capital expenditures and hiring decisions, not to mention the direct impact already felt by the manufacturing sector.
The expansive monetary policies of central banks around the world continue to present an unknown risk factor. The total value of negative-yielding bonds globally is over $14 trillion. Central banks in Europe and Japan have resorted to these experimental policies because simply lowering interest rates, even to zero, has not helped them meet their growth and inflation targets. While no one really knows what the long-term ramifications will be, we can identify some clear short-term dangers, including investors seeking out riskier assets than they normally would, driving up the prices of these investments to unprecedented levels and exposing their portfolios to greater loss.
Much has also been made in the financial press of the “inversion” of the yield curve, i.e. an uncommon, inverse yield-time relationship where longer-maturity bonds carry lower interest rates than shorter-term bonds. A yield curve inversion is historically significant in financial markets, given that an inversion has preceded the last seven recessions. One interpretation is that bond markets are telling us, “Good times are here … but bad times are coming.” However, with foreign rates negative, foreign buyers are purchasing higher amounts of positive rate US bonds, which possibly skews our normal yield curve. Nothing is easy to analyze.
Looking Further Ahead
No single indicator, however reliable in the past, is sufficient enough to make an investment decision.
We continue to use bonds and other fixed income instruments as a portfolio diversifier. The role of fixed income is first and foremost to provide support to portfolios during deflationary events and bear markets in stocks.
U.S. stocks may indeed be priced at historically high levels, but the opportunity cost of selling our U.S. stock positions is too great, given they may continue to go up over the short term as they have for several years.
Following a comprehensive review of our global equity assumptions, we also remain convinced that foreign stocks are relatively attractive as they are, particularly versus U.S. stocks. Despite the risks, we continue to see country-level reforms and company-level restructuring as significant positives for foreign stocks. If and when global growth returns to healthy levels, as it started to in 2017 before trade war tensions contributed to a growth slowdown, we think European and emerging markets stocks are poised to do very well.
The current investing environment and its range of conflicting outcomes serve to highlight why we believe it is important to incorporate a wide range of scenarios in our portfolio management process. The most effective way to do this is through diversification across multiple asset classes and investment strategies that have different risk exposures and different sources of return.
Of course, this also means that not every position will perform well in every scenario or macroeconomic environment. That’s the definition of portfolio diversification and the essence of risk management during times of uncertainty. There is an old joke that says, “Diversification means always having to say I’m sorry.” Any one area or asset class that is included in the portfolio to reduce risk will not perform as well as the hottest asset class at the time. Investors often look only at the US stock market and wish their whole portfolio had performed that well. Conversely, they typically do not desire the risk of investing in just one asset class.
We appreciate your trust in us and welcome any questions you may have.
Ron Dickinson, CPA, CFP®, MPA-Tax
[Financial Planning and Investment Management Services offered through Dickinson Investment Advisors, Registered Investment Advisor. Statistics and market information provided by Litman Gregory Advisor Intelligence.]
