Market Commentary: "Policy Developments Create Sharp Shifts"

As my kids packed up their backpacks for the last time this school year and traded their uniforms for bathing suits and flip flops, I might’ve been forgiven for wanting to shut down my portfolio and join the kids at the pool. Many investors did, in fact, head for the exits last month when the stock market suffered its first monthly loss of 2019. But, in reality, the selloff had little to do with the oft-cited (and, in my opinion, flawed) investing adage “sell in May and go away.” Instead, trade tensions—the same fear that rattled the market late last year—weighed on stocks once again.

As the U.S. and China parried new demands and threats regarding trade, Mexico was also dragged back into the mix. While the leaders of each of these countries remain incented to craft a deal—Trump because he faces re-election, Xi because of a slowing Chinese economy—the longer these disputes drag on, the more global growth decelerates. These policy developments create sharp shifts in the market, which can make it very tempting to try and anticipate the next move. But this volatility also makes the potential cost of trying to time the market even greater. In fact, even the “sell in May and go away adage” is not really helpful for your portfolio. While the summer months may tend to have lower returns than other seasons, they still tend to be positive.

Equity Markets

Equity markets, which rallied at the start of the year, turned bearish in May, when large-capitalization stocks declined by more than 6% on trade fears and another signal from the Treasury market that the economy may be headed into a recession. Small-cap stocks fared worse, declining by nearly 8% last month.

The market moves were certainly difficult to watch, but a bit less painful when taken in context. Thanks to a strong start to the year, the S&P 500 and Russell 2000 indexes still managed to return nearly 11% and about 9%, respectively, year to date through May.

Stocks were clearly channeling a growing level of caution in the corporate sector, tied to the implications of the trade war. In fact, anecdotes suggest that companies are beginning to pass along higher costs to consumers—who, one way or another, will ultimately bear the brunt of the trade standoff, whether it’s through fewer jobs and lower wage increases and/or higher prices.

Against a backdrop of greater uncertainty, manufacturing activity slowed in April, although it remained in expansionary mode. Major companies have also reduced capital spending lately and, to a lesser extent, stock buybacks. Keep in mind, though, that both of these activities got a boost last year because companies were newly flush with money from the tax cut that took effect then.

Though the damage was widespread last month, sectors seen as less cyclical or relatively immune to the trade war suffered the least. Real Estate was the only sector that managed to eke out a gain, returning slightly more than 1% for the month. It was also the best-performing sector on a year-to-date and trailing 12-month basis.

Health Care declined by more than 2% last month but remained in positive territory on a year-to-date and 12-month basis. Earlier this year, health care companies became some of the first casualties of the new election season as presidential candidates targeted pharmaceutical firms and managed-care firms over the issue of drug prices. Like Real Estate, Health Care benefitted last month from the perception among investors that it’s a domestic safe haven.

Technology was among the worst-performing sectors in May. The poor performance came on the heels of two ballyhooed initial public offerings (namely Uber and Lyft) as investors grappled with the sector’s higher valuations and the fact that some newly public tech companies have yet to generate earnings. The sector has also come under government scrutiny and finds itself in the crosshairs of the trade war because of Trump’s decision to ban U.S. companies from doing business with China’s Huawei Technologies.

Fixed Income

Last month’s selloff served as a reminder of the benefits of portfolio diversification. Investors seeking safe havens pushed returns in the bond market up by nearly 2% for the month—and about 5% and 6% on a year-to-date and 12-month basis, respectively. Longer-dated Treasury bonds fared best, rising 4.5%. The rally brought their 12-month return to more than 10%.

Not surprisingly, riskier, high-yield (or junk) corporate bonds fell into negative territory, but they were still up by 7.5% and 5.5% for the year-to-date and 12-month periods, respectively, thanks to healthy gains earlier in the year.

The Economy and the Fed

Despite the market’s gyrations, the mostly positive U.S. economic picture didn’t change much last month. The job market and household balance sheets remained healthy, and consumers were upbeat.

The current economic expansion is on track to be the longest ever, but for months now we’ve seen signs that we’re closer to the end of the cycle than the beginning. Here are a few of those signals:

• The housing market appears to be slowing again. On a year-over-year basis, sales in April declined by more than 4%, the fourteenth straight month of annual declines.
• After trending downward since late 2016, the dollar volume of bad (or non-performing) commercial loans rose slightly in the first quarter.
• Investors seeking safe havens piled into government bonds last month. Rising prices caused the yield on the 10-year Treasury note to fall below the yield on three-month Treasury bill, resulting in the second yield curve inversion of the year. Typically, longer-dated bonds have much higher yields than shorter-dated bonds, as it’s only rational that investors want to earn more in exchange for locking up their money for longer periods of time. Yield curve inversions have historically preceded recessions, although a yield curve inversion doesn’t necessarily mean a recession is imminent.

With uncertainty on the rise, the market is widely anticipating that the Federal Reserve will cut rates by the end of this year—even though the central bank is essentially taking a wait-and-see approach.

Conclusion

Like the Fed, investors don’t need to act on the market’s mood swings. The better course is to look through the inevitable ups and downs to the important, longer-term path ahead. In doing so, it may be easier to relax a bit this summer, enjoy some family time, and maybe even take a well-deserved vacation. I, for one, plan to leave my portfolio intact this summer and instead invest in some good summer reading and maybe a new pair of flip flops and some fun pool toys for the kids.

Live richly and invest well,

Kara Murphy, CFA

Chief Investment Officer

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Index Definitions

S&P 500 Index: A broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It is a capitalization-weighted, unmanaged index that is calculated on a total return basis with dividends reinvested. The S&P 500 represents about 75% of the NYSE market capitalization.

Russell 2000 Index: This index measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks; the index serves as a benchmark for small-cap U.S. stocks. .

MSCI Europe, Australasia, and Far East (EAFE) Index: This index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.

MSCI Emerging Markets Index: This index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009, the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.

Bloomberg Barclays U.S. Aggregate Bond Index: A market capitalization weighted bond index of investment grade U.S. dollar-denominated fixed- income securities.

U.S. High Yield Corporate: The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.

U.S. Investment Grade Corporate: The Bloomberg Barclays US Corporate Bond Index measures the investment grade, fixed-rate, taxable corporate bond market. It includes USD denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.

Bloomberg Barclays Municipal Bond Index: The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated, long-term, tax exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.

S&P 500 GICS Sectors Level-1: In 1999, MSCI and S&P Global developed the Global Industry Classification Standard (GICS), seeking to offer an efficient investment tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered, hierarchical industry classification system. It consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity. MSCI and S&P Global use revenues as a key factor in determining a firm’s principal business activity. Earnings and market perception, however, are also recognized as important and relevant information for classification purposes and are considered during the annual review process.

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