HIGHLIGHTS:
Stocks rose on hopes of a Fed rate cut and resumption of China trade talks.
Economic momentum slowed in Q2 and inflation remained below the Fed’s target.
The Fed shifted from being “patient” in favor of rate cuts in the second half.
On -and-off trade talks reminiscent of high school romances.
Q1 earnings beat lowered expectations but are forecast to remain lackluster in Q2.
Our outlook is positive, but risks of self-inflicted wounds remain and could keep markets volatile.
Stocks rose on hopes of a Fed rate cut and resumption of China trade talks.
Progress on key items in the Via Nova Worry Checklist for 2019 helped the S&P 500 touch a new record high in the second quarter, but slowing economic momentum raised concerns entering the second half of the year. Our outlook is positive for both growth and the equity markets for the rest of 2019, but the risk of policy mistakes, or self-inflicted wounds, remains a concern as it has all year.
The S&P 500 added another 4% in the second quarter on top of the surge in the first for the best first half performance in over two decades. The economically sensitive financial, technology and materials stocks led the advance, suggesting an improving outlook. The only negative sector was energy, where slower economic growth crimped demand and bloated oil inventories. Slowing domestic and global economic momentum weighed on small cap, international and emerging market relative performance though all gained.
Bonds were also boosted in the quarter by tame inflation reports and a decision by the Federal Reserve’s Federal Open Market Committee (FOMC) to favor rate cuts in the second half. The change was a further move toward accommodation (lower rates) after the first quarter shift from steady rate increases in 2018 to being “patient” in assessing the need for additional interest rate hikes. The yield on the 10-year Treasury note fell to 2% from a high of 3¼% in the fourth quarter pushing down home mortgage rates and giving a lift to the beleaguered housing industry.
In other markets, oil prices declined on news that oil inventories increased despite supply constraints and OPEC production cuts, possibly reflecting slower global demand. Lower interest rates helped lift Treasury Inflation-Protected Securities (TIPS), Real Estate Investment Trusts (REITS) and gold. However, the easier stance from the Fed prompted a drop in the value of the dollar. While a weaker dollar tends to lift prices of imported goods, it boosts the value of overseas earnings for exporters, which is positive for stocks.
Economic momentum slowed in Q2 and inflation remained below the Fed’s target.
Economic growth remained positive in the second quarter, but momentum slowed domestically as well as overseas. In many ways, the second quarter has been the mirror image of the first quarter. In the first quarter, consumer spending slowed, while businesses increased inventories. In the second quarter, however, the reverse appeared to be taking place.
In the second quarter, businesses were working off excess inventories and reduced orders for manufactured goods. The slowdown was exacerbated by the problems with the new Boeing 737 Max aircraft, which precipitated extended production delays needed to fix safety issues and some order cancellations. Hiring also slowed, particularly in May, cutting second quarter GDP estimates to approximately 1½% versus over 3% in the first quarter.
However, with the unemployment rate hovering near a 50-year low reflecting a healthy labor market, personal income rising and confidence near cycle highs, consumer spending accelerated in the second quarter. Overall, the economic indicators suggest continued growth in the second half of the year, but perhaps below earlier forecasts. Importantly, inflation eased during the quarter, and the FOMC’s preferred inflation gauge, the Personal Consumption Expenditures Deflator (PCE Deflator) rose a scant 1½% over the past year and continued below the Fed’s 2% inflation target. The persistent low rate of inflation is further justification for Fed rate cuts in the second half, which would support spending on big ticket items such as homes and cars.
The Fed shifted from being “patient” in favor of rate cuts in the second half.
The weaker economic momentum and low inflation were key reasons the FOMC shifted its policy stance at the June meeting from holding rates steady in January (“patient”) in favor of rate cuts in the second half. Chairman Powell cited a re-emergence of economic crosscurrents, including a surprise slowing in job growth and a breakdown in U.S./China trade negotiations in addition to persistent below target inflation.
We believe the Fed should cut short term rates at least half percent from the current 2½% level and preferably three-quarters of a percent to restore some semblance of normalcy to the credit markets. At the end of the quarter, the yield on 10-year Treasury securities was just 2% or well under the FOMC’s policy rate creating an inverted yield curve. An inverted yield curve, where short rates are above long rates, suggests a restrictive Fed policy and historically has been a reliable signal of future recessions. The apparent willingness of the FOMC to begin trimming rates suggests the economy and the market can avoid a self-inflicted policy mistake.
On -and-off trade talks reminiscent of high school romances.
The on-and-off trade negotiations with China over the past year are somewhat reminiscent of high school romances; speaking one week and ignoring each other the next. A crescendo of optimism regarding a trade deal with China swelled in April only to be suddenly dashed in early May as both sides broke off talks and tariff threats increased. Global trade tensions have exerted a drag on global growth throughout the past year. Fortunately, Presidents Trump and Xi met at the end of June and agreed to restart trade talks fueling renewed investor optimism.
Trade tariffs are off the table, at least for now, and China has agreed to increase its purchases of American farm products. In return the U.S. will resume some technology sales to Huawei, the controversial Chinese technology company. The net of effect of these two actions will increase exports to China and reduce the trade deficit, a key goal of the Trump trade initiative.
However, we believe the clock is ticking on a constructive U.S./China trade deal. A number of U.S. companies have already taken steps to diversify their supply chains away from China to other countries such as Vietnam, Cambodia and India. This initiative is not in China’s interest, as much of its economic growth has come from trade. A trade deal is good for both countries, and it could restore some normalcy and predictability to company operations, a positive for sales and earnings.
Q1 earnings beat lowered expectations but are forecast to remain lackluster in Q2.
Corporate profits growth slowed significantly this year following gains of over 20% in 2018, but positive momentum is expected to return by the fourth quarter. Four factors are cited as major reasons for the slowdown. First, is the “roll-off” of the tax reform tax cuts. While the lower rates are still in place, the incremental benefit is less. Second, is global economic slowing which curtails sales growth. China, the second largest economy in the world behind the U.S., is frequently cited, but the EU is going through its own malaise. Third, and partially related to the second, are trade tensions and tariffs. Many analysts, including Via Nova, believe that the trade tariffs are a negotiating tactic to bring countries to the bargaining table and write more favorable trade terms. However, that tactic is disruptive to global supply chains for many companies, increases costs and reduces foreign sales during the negotiating process. Finally, the value of the dollar has increased during this period of uncertainty, which makes U.S. products more expensive and reduces the value of overseas earnings.
Many of the factors that affected first quarter earnings are likely to continue in the second quarter, where earnings are currently projected to increase a modest 1%. Many companies have guided expectations lower over the course of the quarter. Technology companies, particularly semiconductor companies that have been in the eye of the trade storm, were more likely to lower their profit estimates. Soft earnings growth is expected to continue through the third quarter before accelerating toward the end of the year.
We believe U.S. economic momentum remains positive, and that the consumer is quite healthy and able to spend. However, the combination of China trade tensions, slower growth in the EU, Brexit concerns and the fading aftermath of the record Federal shutdown have weighed on some businesses and prompted many to delay planned investment spending.
Our outlook is positive, but risks of self-inflicted wounds remain and could keep markets volatile.
Via Nova’s outlook for the economy and the stock markets remains positive as we enter the second half of the year. We believe the economy will remain in an expansion at least through the end of this year and into 2020. The all-important consumer sector remains in good shape with low unemployment, rising incomes and high confidence. Businesses are also in strong financial shape despite challenges from international trade.
We believe investors and the markets are already sensing this improvement and have begun returning to the stock market, especially companies that have been adversely affected by trade and rising interest rates such as technology, industrials and housing. We believe stocks can continue to rise as our positive outlook plays out in the coming months.
The outlook is not without risks, however, and we are monitoring them closely for signs of deterioration. We believe the biggest threats to the record-long expansion are self-inflicted policy mistakes, which we outlined at the beginning of the year. We are optimistic that the biggest threats to the expansion and the markets, Federal Reserve interest rate policy and trade with China, can be avoided or at least muted. The FOMC indicated a growing need for rate cuts at their latest meeting, and U.S./China trade talks are back on. Risks related to the extended Brexit debate remain, and tensions in the Middle East are high and should not be casually dismissed.
That said, there are other risks that may be more difficult to resolve completely if at all. The 2020 Presidential election race is in full swing and promises to be contentious and unpleasant. Early political posturing has taken aim at elements of the health care and technology sectors. We also include the energy sector in our list of potential targets given the politically sensitive issue of gasoline prices and environmental concerns.
The stock market tends to climb a “wall of worry,” and we keep our 2019 Worry Checklist handy to evaluate successes and setbacks.On balance, significant progress has already been made so far in 2019 helping the S&P 500 reach new record highs.We expect additional stock market gains in the second half of the year, but also believe that the ebb and flow of daily headlines will keep markets volatile.