A solid first half helped the market shake off the drubbing it took at the end of last year. But the momentum is unlikely to last. Market performance in Q2 revolved around what could be false hopes for Federal Reserve (Fed) interest rate cuts combatting lingering global growth, inflation, trade and geopolitical concerns. In our view, caution should be the order of the day in the second half, as those aren’t the only risks out there.
What to Know: Fed Hopes Could be Misplaced
The Q2 turn in the market’s expectations for the Fed can be traced to President Trump taking his tariff threats to Mexico’s doorstep. Prior to Trump’s threat, the market priced in one interest rate cut this year; thereafter, expectations jumped to three.
The market parsing Fed-speak played a big role. The implied probability of an interest rate cut at the July 30-31 Federal Open Market Committee (FOMC) meeting spiked significantly following the removal of the word “patient” from the June FOMC minutes. For perspective, the implied probability of a cut in July began Q2 at 25.9% and ended the quarter at 100%.
The Mexico tariff threat is gone – for now – but Fed fund futures continue to suggest the Fed will cut three times before the year is out. The problem is that the US doesn’t have a growth problem currently. Also, Core Consumer Price Index (CPI) weakened a slight 0.1% to 2.0% from April to May. Taken together, these factors wouldn’t seem to be enough to give Fed officials a reason to cut. Not to mention, with the S&P 500® Index having had its strongest first half since 1997, it’s unclear if a Fed put even applies here; however, political will could infiltrate into places it should not be.
What to Watch: Corporate Profits Problem
Signs of an earnings recession are evident and continue to grow. According to some estimates, S&P 500 constituents’ profits in Q1 fell year over year for the first time since early 2016.
Now, it’s necessary to give profit performance some context. Profits grew more than 20% in 2018, so some pullback is to be expected. However, forecasts at 2-5% for 2019 were already low and leading profit growth indicators continue to deteriorate, to the point where earnings forecasts may need to be revised down even further.
We’ll also be watching debt ceiling negotiations this fall, along with everything else in Washington. There is no reason to not expect tensions and posturing. Failure to raise or suspend the limit during the next round of negotiations would, at best, leave certain government programs without funding; at worst, the US would default on its debt. The Treasury Department has used extraordinary measures to prevent the U.S. from breaching the debt ceiling, but these maneuvers will not last beyond the fall and a longer-term deal must be made.
Q2 Recap: Tariffs and Monetary Policy Push and Pull
Shifting dynamics between trade concerns, their implications for global growth and the potential global monetary policy responses were behind most of the movements in equity and fixed income markets.
Performance in April was solid, boosted by expectations for a more accommodative Fed. In May, tariffs took center stage as foreign policy continued to play out by tweet. Mexico joining China in the crosshairs and ever-suggestive hints of levies on Europe and Japan halted the momentum.
The promise of trade discussions and a potential deal at the G20 summit at the end of June stemmed the slide. This helped markets regain lost ground and hit new highs in June.
At the G20 summit a trade truce was negotiated. The agreement to resume trade negotiations following a six-week stalemate is a positive for the global economy and risk assets. Reversing the decision to blacklist Huawei has opened the path to further trade negotiations.
This potentially sets up the market for a strong start to Q3. However, market participants should keep in mind that similar to the summit in December, there are no details on commitments and the two sides have made little meaningful progress on the challenging subjects of intellectual property and technology transfer. Consequently, there is still the potential for the remainder of this negotiation to be a rocky ride and we should keep in mind that is almost impossible to read the tweet leaves.
Equities: Fed Hopes 1 – Tariff Threats 0
The market continued its rise during Q2 amid its rate cut visions, though the pace was slower than Q1’s. The S&P 500 Index returned 3.74%. International developed market equities performed similarly with the MSCI World ex USA NR USD Index up 3.79%. Emerging markets (EM) had a much sharper reaction to the renewed tariff threats and the MSCI EM NR USD Index returned 0.61%. In particular, weakness in China and South Korea weighed on EM.
Economic growth concerns continued to weigh on small caps relative to larger-cap stocks. The Russell 1000 Index returned 4.25% and the Russell 2000 Index 2.10%.
Growth stocks continued to outpace value, though size dictated performance to a greater extent. The Russell 1000 Growth Index took the lead at 4.64%, followed by the Russell 1000 Value Index at 3.84%. Smaller-cap stocks fell more in May and despite a strong rebound at the end of June, this was insufficient to bring their quarterly return to the level of their larger cap peers. The Russell 2000 Growth Index and The Russell 2000 Value Index returned 2.75% and 1.37%, respectively.
Year to date, performance was slightly more split between growth and value with the Russell 1000 Growth Index at 21.49% and Russell 2000 Growth Index at 20.36% being the top performers. The Russell 1000 Value Index wasn’t too far behind at 16.24%. The Russell 2000 Value Index lagged the pack with a 13.47% return.
U.S. Sectors: Marching Forward
Ten of the 11 Global Industry Classification Standard (GICS) sectors had positive returns in Q2. Within the S&P 500 Index, Financials (+8.00%), Materials (+6.31%), Information Technology (+6.06%) and Consumer Discretionary (+5.28%) were the top performers, reflecting a strong “risk on” shift at the end of the quarter.
– Financials had a strong start to Q2 and the sector was less affected by the pullback in May. However, expectations for lower interest rates led to a more subdued recovery in June. The Insurance segment had a strong return after holding up well in May.
– Materials is typically a highly growth driven sector. As a result, the sector bounced significantly at the beginning of June when trade concerns declined and expectations for a more dovish Fed increased.
– The Information Technology sector had an excellent June. The blacklisting of Huawei dampened this sector in May, while the potential for a trade deal helped to propel this sector at the end of the quarter. Given the removal of this ban at the G20 summit, we should see a strong start to the quarter for this sector.
– The Consumer Discretionary sector pretty much tracked the Russell 1000 Growth Index for most of the quarter, with the growthier segments of the sector boosting performance. Some of the top performing segments included the Leisure Equipment & Products, Automobile, Hotels Restaurants & Leisure and the Internet & Category Retail Industries.
Energy (-2.83%), Healthcare (+1.38%) and Real Estate (+2.46%) were the weakest sectors in Q2.
– Energy was the only sector to decline. WTI crude oil prices began Q2 at $61.59/barrel and ended the quarter at a similar level. In between was a different deal altogether as WTI declined 18.8% to $51.14/barrel in the second half of May and the first half of June due to concerns about global growth and lower trade levels. Supply-side concerns, driven by geopolitical issues surrounding Iran, helped to boost prices at the end of June.
– Healthcare was weak due to poor performance in April amid renewed focus on drug pricing. Biotech declined with the rest of the sector and then plateaued while the rest of Healthcare regained most of what it gave up in April.
Year to date, 10 of the 11 sectors notched double-digit returns. Information Technology (+27.13%), Consumer Discretionary (21.84%) and Industrials (+21.38%) led. All three of these benefitted from their strong performances in Q1 and sharp improvements in June.
Healthcare (+8.07%) was the only sector that returned less than 10% in the first half. Renewed focus on dismantling the Affordable Health Care Act and drug pricing were headwinds. Also, the sector held up relatively well in the final stretch of 2018, and therefore had less ground to regain.
Fixed income: And back to 2% we go
Oh, how yields can fall. Treasury yields are down significantly in 2019 due to expectations that the Fed’s next move will be a cut. These expectations helped fuel fixed income securities in Q2 and year to date. The Bloomberg Barclays U.S. Aggregate Bond Index returned 3.08% and 6.11% in Q2 and year to date, respectively.
The 10-year Treasury yield started the year at 2.69% and remained reasonably constant until mid-March when there was a shift in expectations to a more dovish Fed. The 10-year yield began Q2 at 2.41% before dropping sharply to approach 2% by the end of May. In June, it trended lower and ended the quarter at 2.00%.
Certain segments of the yield curve remain inverted, the most concerning of which is the 10-year/3-month. After inverting briefly at the end of March, this segment of the curve has been inverted since late May.
A distinct change in the patterns forming in the yield curve appeared in June. In the year to June, the intermediate region and the longer-end of the curve generally moved downward while the short-end held reasonably constant. But the yield curve pivoted lower on the short end in June due to expectations that the Fed’s next move will be a cut.
Credit: About that Fed Put
Riskier assets performed like there is a reasonable probability that the Fed put still exists. Corporate credit spreads widened in May but plunged sharply in mid-June. Similarly, credit default spreads recovered quickly from their spike at the end of May to reach a year-to-date low in mid-June.
The spread between investment grade corporates and the 10-year Treasury, as measured by the U.S. Corporate BBB/Baa 10-year Treasury Index, started 2019 at 1.86%, declined sharply in January, plateaued thereafter and ended Q1 at 1.59%. This spread continued to decline in April, reaching a year-to-date low of 1.45% before spiking up to 1.63% in early June before ending the quarter at 1.47%.
Some of the top-performing fixed income segments in Q2 were Long-Term Investment Grade Corporates, Preferreds (both fixed and variable rate), USD Denominated EM Debt and Long-Term Treasuries.
This is similar to the year-to-date trend where Long-Term Investment Grade Corporates, Fixed Rate and Variable Rate Preferreds, USD Denominated EM Debt, Long-Term Treasuries, High Yield Corporates and Local Currency Denominated EM Debt were the top-performing fixed income segments.
The list of market risks is lengthy, both fundamental and what could be in store via tweet. In our view, investors shouldn’t bank on the possibility of a still-intact Fed put being able to replicate first-half returns in Q3 and Q4, as downsides in equities and less than coupon-like returns in fixed income seem likely. More focused exposures could be a way to steer clear of broader market volatilities, including thematics, which continue to grow in prominence and scale.
All data sourced from Bloomberg.
S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.
Put: A put is an option where the entity holding the option has the right but not the obligation to sell at a predetermined price. Typically, a fee is paid for this right. A put is most likely to be used when the price of a security declines. In the case of the Fed put, this is the commonly held belief that the Federal Reserve has the will and ability to rescue the economy by reducing interest rates. This potentially provides holders of risk assets with an implied put option that they never had to pay for.
MSCI World ex USA Net Total Return Index: The index captures large and mid cap representation across 22 of 23 Developed Markets countries -excluding the United States. With 1,017 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI Emerging Markets Net Total Return Index: The index captures large and mid cap representation across 24 emerging market countries. With 845 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Russell 1000 Total Return Index: Consists of the largest 1000 companies in the Russell 3000 Index. This index represents the universe of large capitalization stocks from which most active money managers typically select.
Russell 2000 Total Return Index: Consists of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
Russell 1000 Growth Index: The index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000 Value Index: The index measures the performance of those Russell 1000 companies with lowest price-to-book ratios and lowest forecasted growth values.
Russell 2000 Value Total Return Index: The index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.
Russell 2000 Growth Total Return Index: The index measures the performance of those Russell 2000 companies with highest price-to-book ratios and highest forecasted growth values.
Global Industry Classification Standard (GICS): This is a standardized classification system to sort business entities by sector and industry group. It consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries.
Bloomberg West Texas Intermediate (WTI) Cushing Crude Oil Spot Price Index: Designed to track the spot price of WTI.
Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS and CMBS (agency and non-agency).
U.S. Corporate BBB/Baa 10-year Treasury Index: This is a Bloomberg provided spread index of the difference in yield between the U.S. Corporate BBB/Baa Index and the yield on 10-year Treasuries.
U.S. Corporate BBB/Baa Index: This is a Bloomberg provided yield index that is constructed daily using USD denominated senior unsecured fixed rate bonds issued by U.S. companies that have a Bloomberg composite rating of BBB/Baa.
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