By: Jon Maier, Michelle Cluver, CFA
The third quarter was enough to make your head spin. The green light investors had in the first half flashed yellow at the start of Q3. Now, we see some red in that light after a roughly 50-basis point backup in the 10-year US Treasury yield, louder recession chatter following an inversion of the yield curve, a major rotation to defensive sectors and leadership shifting to value. Add politics to the lengthy list of Q4 uncertainties and it’s no wonder investors may feel a little dizzy.
What to Know: Trade Still Headlines Risks
It would be nice to be able to put the U.S. and China trade negotiations in the rearview mirror. But we can’t. Speculation is that the two sides will meet yet again October 10–11. Hopes for a partial deal, from what will be the 13th round of negotiations, increased following a Chinese delegation’s trip to Washington in September. But those low-level talks suggest the two sides remain far from any type of deal.
China’s recent order for U.S. agricultural products is likely more of a goodwill gesture than anything meaningful. Nothing suggests Beijing will drop its demand for a removal of all tariffs as part of any deal. And the Trump administration is unlikely to give up on its tariffs without China agreeing to some major concessions. President Trump’s threat to cut investments in China doesn’t appear to have much bite. But if the administration does start to push this tact, we believe the Republican Party may actually step in and say no.
Thus far, consumers have been holding on, and holding up, the economy. While that is unlikely to exist in perpetuity, we are not ready to predict the end of the consumer influence just yet.
Additional risks—some old and some new—plaguing the market include the following:
— Brexit slogs on: Britain’s prime minister, Boris Johnson, continues to promise a Brexit with or without a deal by October 31. How he plans to do that remains a mystery as the government prepares yet more proposals to resolve the Irish border issue. Complicating Johnson’s timeline is that a parliamentary law requires the prime minister to request a Brexit delay if a deal with the European Union is not in place by EU meetings slated for October 17–18.
— Manufacturing weakness: The September ISM manufacturing index fell to its lowest reading since June 2009, the index has fallen by a total of 13 points since the cycle high of 60.8 in August 2018. The last two readings reflected contraction within the manufacturing sector rather than slowing growth. This is reflective of manufacturing trends globally. Since there is no near-term end to the US led trade war with China, this weakness in manufacturing will likely have a greater impact on other sectors of the economy. Just look at how quickly oil prices declined following the September 14 drone attack on Saudi Arabia that took out 5.7 million barrels per day of oil production, or about 5% of daily global crude oil output. Concern surrounding economic growth is already reflecting in deceleration job growth.
— USD strength: Amidst growing global uncertainties and accommodative monetary policies by central banks around the world, the USD continued its strengthening trend during Q3. Dollar strength detracts from the U.S. manufacturing sector due to the strong exchange rate reducing export competitiveness. It will be interesting to see if multinational companies will blame a strong dollar on weaker Q3 earnings.
— IPO warnings: Things seem a bit frothy in the initial public offering (IPO) market. Unprofitable IPOs have raised far more money already in 2019 than any other year since the dot-com days in the early 2000s. Profitability questions now dot the IPO landscape with another 108 companies still planning to go public this year.
What to watch: How the Market Responds to Politics
Historically, the links between market performance and the ebbs and flows of politics aren’t particularly meaningful over time. However, it’s naïve not to consider the effects of Washington’s recent shenanigans. Currently, we have impeachment proceedings gaining steam.
History suggests that impeachment proceedings have minimal effects on the market and the broader economy. As of today, we expect that to hold true with the Senate unlikely to convict President Trump. But that does not mean there won’t be notable ramifications.
The status of U.S.–China trade talks could be in the crosshairs, especially if China slow-plays negotiations to see what transpires in Washington. We also expect even more political gridlock, a lower likelihood of fiscal easing and increased risk of a government shutdown. Congress needs to approve a new budget by November 23, and it is not a stretch to think that Trump would shut down the government again to embolden his base during this period of political tumult.
Political winds aren’t just blowing in the U.S., of course. In the U.K. the Supreme Court determining the suspension of parliament illegal could signal a shift in world politics, not to mention Brexit’s fate.
Something to Consider: How the climate Will Change Investing
The UN Climate Change Summit in September called attention to why the world needs to make environmental protection a priority. It was also a reminder for investors: climate change will change market dynamics. There is a market in Environmental, Governance and Sustainability (ESG) standards, and we expect investment in that market to soon become more staple than niche.
ESG investing continues to gain prominence among key demographics, including women and millennials. High net worth individuals increasingly show interest as well. Asset allocation to opportunities related to segments such as clean energy are likely to increase as wealth shifts to younger, more ESG-conscious generations. In our view, all investors should take note of this trend.
Q3 Recap: Monetary Policy and Tariffs Create Contradictory Forces
Two interest rate cuts from the Federal Reserve (Fed) provided some support for markets; however, trade concerns continued to flare up in Q3. As a result, defensive-oriented equities and fixed income segments had a strong quarter.
Globally, 16 central banks lowered interest rates in Q3, and dozens more are expected to reduce interest rates in Q4.1 Expectations for lower rates on a global scale have helped support markets year-to-date.
Equities: Fed Hopes 1—Tariff Threats 1
Hopefully, it’s not too much pressure on markets, but the S&P 500 Index entered Q4 with its largest year-to-date gain since 1997. The market continued its rise during Q3, albeit at a slower rate than the prior two quarters. The S&P 500 Index returned 1.7%, outpacing both international and emerging markets. Recession fears in Germany and the Brexit cloud hovering over the U.K. dampened the performance of the MSCI World ex USA NR USD Index, which returned -0.93%.
Emerging markets (EM) tumbled at the beginning of August following the announcement of a new round of tariffs on China. The MSCI EM NR USD Index returned -4.2% in Q3, with the 2.5% decline in the MSCI Emerging Market Currency Index accounting for more than half of the decline in EM.
Economic growth concerns continued to weigh on small caps relative to larger-cap stocks. The Russell 1000 Index returned 1.4% and the Russell 2000 Index -2.4%.
A distinct shift in leadership between growth and value in September helped define Q3’s overall trend. At the beginning of the month, momentum took a backseat, and value and smaller cap stocks took the lead. Within the large-cap space, growth and value performed basically in line with each other, with the Russell 1000 Growth Index taking the lead at 1.5%. The Russell 1000 Value Index followed at 1.4%. The pullback in growth had an oversized effect on the Russell 2000 Growth Index, which dropped from third place to fourth place with a return of -4.2%, well below the Russell 2000 Value Index’s -0.6% return.
Year to date, performance was predominantly split between large and small caps as growth took the lead within each size bucket. The Russell 1000 Growth Index returned 23.3% and the Russell 1000 Value Index 17.8%, followed by the Russell 2000 Growth Index at 15.3% and the Russell 2000 Value Index at 12.8%.
U.S. Sectors: Uncertain, at Best
Returns were slightly more mixed in Q3 than Q2 with eight of the 11 Global Industry Classification Standard (GICS) sectors having positive returns. Defensive sectors took the lead in Q3, with the re-escalation of trade tensions in August driving investors toward Utilities (+9.3%), Real Estate (+7.7%) and Consumer Staples (+6.1%). The Fed’s decision to reduce interest rates also helped these bond proxies.
Energy (-6.3%), Health Care (-2.3%) and Materials (-0.1%) were the weakest sectors in Q3.
— Energy had a challenging August, bounced back in mid-September following the attack on Saudi oil assets and then proceeded to sink back on renewed fears about global growth.
— Health Care muddled along. Concerns about drug pricing continued to weigh on performance, as well as concerns about opioid cases.
— Materials struggled due to global growth and trade concerns.
Year to date, nine of the 11 sectors notched double-digit returns. Information Technology (+31.4%), Real Estate (+29.7%), Utilities (+25.4%) and Consumer Staples (+23.3%) led performance. The Information Technology sector gave up a large amount of its lead at the beginning of August amid the renewed tariff threats and then the shift away from momentum and growth.
Health Care (+5.6%) and Energy (+6.0%) were the only sectors that did not achieve double-digit returns year to date.
Fixed Income: How Low Can We Go?
Oh, how yields can fall. Treasury yields are down significantly in 2019 with the market thinking that the Fed may be at the beginning of an easing cycle. In Q3, declining yields helped fixed income securities outperform U.S. equities. The Bloomberg Barclays U.S. Aggregate Bond Index returned 2.3% and 8.5% in Q3 and year to date, respectively.
The 10-year Treasury yield started the year at 2.69% and remained reasonably constant until mid-March, when the market began to shift 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%. Yields declined sharply in Q3 due to the escalation in the trade conflict increasing concerns about global growth. Yields reached a low of 1.47% near the end of August before rising to end the quarter at 1.68%.
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. The spread between the 10-year/2-year inverted for a three-day period in August as trade tensions rose. This spread continues to hover close to 0%, and thus will be watched closely in the coming months.
The short end of the curve shifted downward after the Fed cut rates twice during Q3. However, heightened concerns about global growth caused the long end of the curve to fall as well, while the middle of the curve remained at a reasonably similar level. The result is a rather flat yield curve.
Fixed Income Segments: It’s All About Duration
Duration was the leading driver of fixed income performance in Q3 due to the sharp decline in yields. Some of the top-performing fixed income segments were Long-Term Treasuries, Long-Term Investment Grade Corporates and Preferreds (both fixed and variable rate).
Risk assets played a larger role in year-to-date performance. Declining corporate spreads and improving credit default spreads provided a boost. But in Q3 these spreads remained reasonably constant, so risk assets took more of a backseat during the quarter.
Year to date, some of the top-performing fixed income segments were Long-Term Investment Grade Corporates, Long-Term Treasuries, Preferreds (both fixed and variable rate), USD Denominated EM Debt and High Yield Corporate Debt.
At the end of Q2, we said that Q3 wouldn’t be the smoothest ride. We expect something similar in Q4, maybe even more so with new risks to consider. Slight downside in equities from current levels and less than coupon-like returns in fixed income seems likely. The shift to value suggests investors are jittery, but we are not overly convinced the leadership shift will hold. To its credit, the market continues to shrug off quite a bit, but slowing GDP growth and trade negotiations with China should be watched. Our biggest concern with impeachment is that it extends the growing list of uncertainty shocks going into year-end.
And on that note, let earnings season begin; this should be an interesting one.
All data sourced from Bloomberg
1. WSJ, U.S. Stocks Rise to Cap Volatile Quarter, 30 September 2019
S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.
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).
Originally Posted on October 4, 2019 – Q3 Review and Outlook: Red Light or Yellow
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