Fireworks in July: Trade Wars and Rate Cuts

Like many Americans, I ushered in July by watching fireworks light up the night sky on Independence Day. From an economic perspective, though, last month’s grand finale came courtesy of the Federal Reserve which, as was widely expected, cut its benchmark interest rate for the first time in more than a decade.

During the first half of this year, despite slower global growth and uncertainty surrounding trade policy, the stock market marched consistently higher, seemingly certain that the Fed will protect the economy from a downturn. Now, by cutting its key, short-term rate—which, in theory, leads to lower borrowing costs for consumers and businesses—the central bank aims to manage what appears to be a soft patch in the record-long expansion. Speaking with reporters after the rate cut was announced, Federal Reserve Chairman Jerome Powell indicated that the modest, quarter-point cut was a precautionary move, not the beginning of a rate-cutting campaign. But he also left open the possibility of additional cuts should the U.S. outlook deteriorate, according to a report published by Bloomberg.

Equity Markets

After surging the prior month, the market eked out a small gain in July, when large-company stocks returned less than 2% and small-company stocks less than 1%.

Despite the market’s overall tepid performance, many investors grew increasingly bullish as a rate cut appeared all but certain at month’s end. The rising tide of optimism had several pronounced effects on the market:

• The S&P 500 and tech-heavy NASDAQ Composite closed at record highs in late July.
• Cyclical stocks (think metals and mining, banks and semiconductor manufacturers) outperformed defensive stocks during the final weeks of the month, according to our internal research group. Cyclical stocks tend to do well when growth is on the upswing, while defensive stocks typically hold up well during periods of flat-to-declining growth.
• Wall Street’s index of volatility, known as the VIX, flirted with 18-month lows, another indication that investors weren’t especially concerned about potential bad news.

Year to date through July, the market returned more than 20%—in other words, more than a typical year’s worth of gains. Small-capitalization stocks, as measured by the Russell 2000 index, also saw double-digit returns for the same period, which could be a sign that investors were feeling confident about the outlook for growth.

Certain cyclical sectors shined in July. Information Technology, for instance, returned more than 3% for the month and nearly 16% for the year-to-date period, despite the fact that some of the country’s largest players have come under intense regulatory scrutiny and the sector’s earnings normally robust growth appears to be decelerating, according to FactSet research. Financials, meanwhile, returned nearly 2.5%, a sign that many investors had shrugged off the conventional wisdom that lower interest rates cut into banking profit margins.

Energy, Healthcare and Utilities—all defensive sectors—suffered losses in July. Healthcare proved to be an early casualty of the brewing presidential campaign season. Politicians are once again hotly debating government’s role in the healthcare arena, with particular focus on high drug prices.

Fixed Income

The bond market eked out a minor gain in July but continued its steady upward march over the year-to-date and trailing 12-month periods.

Investors have put money into bond funds at a record rate this year—seeking safe havens (and the regular income that bonds typically offer) amid uncertainty over the outlook at home and abroad. For the trailing 12-month period through July, the U.S. bond market returned more than 8%, outperforming the stock market for the same period. Longer-dated Treasury debt fared best, returning nearly 13% for the 12 months ending in July.

Interestingly, bonds further out on the risk spectrum also rallied. Corporate and high-yield (or junk) bonds returned more than 10% and nearly 7%, respectively, for the trailing 12 months through July.

The strong demand for bonds has been a global phenomenon. For evidence of this look no further than the sudden popularity of Greek government debt. In late July, the yield on Greece’s 10-year bond dipped below 2% for the first time ever. Its yield at the time was even lower than the yield on the 10-year U.S. Treasury. Yields fall as bond prices rise, and vice versa. Greece may now be considered a stable member of the European Union, but it wasn’t long ago that the country teetered on the edge of financial collapse and appeared ready to exit the E.U. In 2012, the yield on the Greek 10-year bond peaked at nearly 48% (Source: CNBC,com, July 25, 2019).

The Economy and the Fed

Unlike the last time the Fed cut rates, the U.S. economy is on firm footing, albeit growing more slowly than it has during the last couple years. The unemployment rate is near a 50-year low, wages are rising modestly and in July consumer confidence hit its highest level this year.

Not only did the public market rally during the first half the year, but investors put substantial amounts of new money to work in the private capital market. A reportby PwC noted that in the first six months of the year, U.S. venture capital funding reached a high not seen since 2000, when the so-called dot-com bubble peaked.

Despite this investor exuberance, for those listening closely, warning bells may be heard from various corners of the economy — including a slowdown in the housing market and manufacturing activity. U.S. manufacturing activity dipped to a three-year low in July, according to the Institute for Supply Management’s monthly index of factory activity, and will likely suffer further should trade wars continue to escalate.

In fact, it is just this potential for further weakness in manufacturing activity and business investment that Fed Chairman Jerome Powell cited when announcing the Fed’s action. That said, he was careful to suggest that this most recent rate cut was not the start of a new easing trend, but instead a “mid-cycle adjustment.” What remains to be seen is whether the Fed’s adjustment will be enough to offset the effects of policy beyond its control. Indeed, right after the Fed announcement, the trade war intensified, once again rattling investors worldwide.

Conclusion

Despite its current challenges, the U.S. economy, for the time being, remains a bright spot on the global horizon. China’s economy, measured by GDP, grew by more than 6 percent in the second quarter, though it has slowed dramatically because of the trade war (Reuters, Wall Street Journal). Meanwhile, Eurozone growth slowed sharply in the second quarter, climbing by less than 1% as weak manufacturing activity took its toll (Wall Street Journal).

As we’re reminded every Fourth of July, America has served as a shining example, economically and otherwise, throughout its history. But even a bright flame can dim at times, which is why it serves investors well to remain vigilant.

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.

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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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