Market Commentary: "The Sunnier, More Optimistic Outlook Propelled Stocks"

For a week in June, I traded in my office in Dallas for a farmhouse in the picturesque Catskill Mountains of New York. While my older kids attended a nearby summer camp and the rest of my family explored the countryside, I worked remotely from a finished treehouse at the mountaintop farm—looking up from my laptop now and then to take in views of sun-drenched hayfields and the occasional cluster of dark clouds in the distance.

The views from my perch were both stunning and reminiscent of the juxtaposition playing out between the stock market and the U.S. economy last month. Investors were certainly more upbeat than they had been in May, largely based on the expectation that the Federal Reserve will soon cut its benchmark interest rate and thus mitigate the economic drag of the prolonged trade war with China.

The sunnier, more optimistic outlook propelled stocks to solid gains and the market to its best first half since 1997. Yet, the market’s strong performance in June contrasted with proverbial dark clouds in the form of mounting international and economic risks.

Equity Markets

After suffering its first monthly loss of the year in May, the market rebounded strongly last month, when large- and small-capitalization equities each gained about 7%. Even emerging market equities (which had fallen out of favor because of the trade standoff and strong U.S. dollar) saw a solid return in June, with the MSCI Emerging Markets Index climbing by roughly 6%.

The market captured more than a typical year’s worth of gains for the year-to-date period through June when the S&P 500 was up by nearly 19%. On a trailing 12-month basis, the market has more than recouped the losses suffered during last year’s tumultuous fourth quarter.

U.S. Sector Scorecard

Feeling more optimistic, investors rotated back into some of the more-cyclical areas of the economy last month — including Financials (up 9%), Communication Services (up 6.5%), Technology (up 6.4%) and Industrials (up 4.1%). There were exceptions to this bullish trend: Energy, for instance, declined by more than 7%, and the sector was essentially flat on a trailing, 12-month basis. In addition, Materials returned only about 4% for the month and just 3% for the trailing, 12-month period.

Interestingly, Tech — an engine of stock-market growth over the last couple years — staged a rebound despite the fact that the sector’s earnings power appears to be deteriorating. Analysts expect earnings for the Tech and Energy sectors to decline by about 10% and 13%, respectively, in the third quarter on a year-over-year basis.

Tech and Energy are the only two S&P 500 sectors expected to have negative earnings growth in the third quarter. It’s also worth noting that Industrials — among the sectors seen as most-vulnerable to the trade war — is expected to have the strongest level of earnings growth in the third quarter.

Fixed Income

The bond market also rallied last month on rising expectations that the Fed will cut its benchmark interest rate (at least once). Bond prices have an inverse relationship to interest rates: when rates fall, bond prices rise, and vice versa.

The Bloomberg Barclays U.S. Aggregate Bond Index returned 1.3% in June, building on earlier gains to rise about 6% year to date and nearly 8% for the trailing, 12-month period.

Bonds farther out on the risk spectrum generally outperformed last month. High-yield (or junk) bonds fared better than municipal bonds, returning 2.3% versus 0.4%, respectively. Meanwhile, longer-dated 10- and 20-year Treasurys did better than one- and three-year Treasurys, returning 1.5% versus 0.5%, respectively.

Globally, the demand for bonds, particularly government bonds, has been strong, largely due to concerns about the outlook for economic growth and expectations that other central banks will also ease monetary policy. Bonds are seen as a safe haven during uncertain times.

Robust demand has pushed up bond prices and driven yields in most major economies down to all-time lows. As of late June, a record high $13 trillion in global debt traded at sub-zero yields, surpassing the prior 2016 peak, according to a report by Goldman Sachs Asset Management. The collapse in interest rates tends to punish savers, but it’s also good news for home buyers and other borrowers.

The Economy and the Fed

Despite the market’s solid performance this year, there are multiple signs that domestic growth— a healthy 3.1% in the first quarter—is tapering off. Among them:

• Manufacturing activity, which is directly impacted by the trade war, has essentially come to a halt, and companies in other sectors (such as tech and telecom) have had to rethink their global supply chains. One of my preferred economic indicators, the Institute for Supply Management’s Purchasing Managers’ Index (PMI), turned in a reading of 51.7% last month. This was the third straight month of slowing expansion and its lowest reading since October 2016. A reading above 50% indicates that the manufacturing activity is expanding; a reading below 50% indicates that it’s contracting.
• Economic indicators are generally coming in worse than expected. Citigroup’s Economic Surprise Index, which tracks how economic indicators are faring compared with expectations, declined again in June after rebounding somewhat in April and May.
• Corporate expectations of business conditions have deteriorated sharply. The Morgan Stanley Business Conditions Index fell by 32 points in June to a level of 13 from 45 in May. The decline was the largest one-month drop on record and the lowest level since the financial crisis.

In more ways than one, there’s a lot riding on the Fed’s next move. The market is widely anticipating that the Fed will be able to save the day by finetuning monetary policy to offset the effects of the trade war and other drags on economic growth. That’s a potentially trepidatious path for investors. What if, for instance, the Fed’s rate cut is ill timed? What if its cut (or cuts) amount to too little, too late? Or what if it decides to maintain its current neutral stance?

Complicating matters is the fact that the Fed (long an independent, apolitical body) must decide what to do in the face of ongoing political pressure to ease monetary policy. Such pressure certainly makes it more difficult for the Fed to ease—as some current economic data seems to warrant—and maintain its appearance of independence. The Fed must also decide whether to adjust course in response to what some argue is a politically induced slowdown; in other words, the trade fight with China.

Conclusion

No matter what the Fed ultimately decides to do, the market is likely to experience more volatility in the weeks and months ahead. Of course, volatility isn’t all about downside risk as we’ve seen lately. Over the last year and half, the market endured a couple of double-digit selloffs as well as a significant decline in May, but it still managed to bounce back to record levels.

Today’s proverbial storm clouds may bring rain, or they may dissipate—perhaps in response to monetary and other policy shifts. In the meantime, the smart investor can make sure his or her roof is intact by preparing to ride out the market gyrations and staying focused on the longer-term path ahead.

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 U.S. 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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