July 2019 Market Commentary

Fueled by better than expected U.S. GDP and corporate earnings growth, the S&P 500 reached another all-time high in late July before selling off over uncertainty about the direction of Fed policy and weaker economic data at month’s end. Global equities, including emerging market equities, lost value in July over continuing uncertainty about a resolution to the U.S. – China trade dispute and growing economic weakness in Europe. Treasury bond yields fell sharply to end the month as investors expressed dissatisfaction with Fed guidance following its 25-basis point rate cut.

The following table contains a summary of July and year-to-date market performance:

Index July YTD Index July YTD
S&P 500 (Total Return) +1.44%  +20.24% MSCI All Country World (Net) +0.29% +16.57%
MSCI EAFE (Net) -1.27% +12.58% Bloomberg Barclays U.S. Agg +0.22% +6.35%
MSCI Emerging Markets (Net) -1.22% +9.23% 60/40 Blend* +0.26% +12.48%

*60% All Country World Index / 40% Bloomberg Barclays US Aggregate Bond Index

The S&P 500 reached a new all-time of 3025 following the release of the 2nd quarter U.S. GDP report and better than expected earnings reports before ending the month at 2980. Real GDP grew 2.1% from a year earlier, down from first-quarter growth of 3.1%, but better than the consensus estimates of 1.8%. The biggest driver of real GDP growth was strong consumer spending while shrinking exports and business investment were headwinds to faster growth. Consumption spending rose 4.3% as consumers benefited from stable job growth and rising real wages. In responding positively to GDP growth, investors overlooked falling investment, inventories, and exports.  Domestic investment fell 5.5% from a year earlier, led by a 10.6% annualized decline in spending on structures. Lower exports than a year earlier cost the U.S. economy 0.63% of growth, while the decision of businesses to reduce inventories cost the economy 0.86% of growth.

Markets received additional good news in the form of corporate earnings growth.  Investors, who have been pessimistic about expected earnings in the face of slowing revenue growth and falling profit margins instead found that 77% of companies reporting so far are beating analyst estimates by 5.4% on average. While companies are reporting better than expected profits, second-quarter S&P 500 earnings are still expected to fall by over 2% from a year earlier, due largely to double-digit declines in the earnings of companies dependent on foreign-based revenues for the majority of their sales.  If that is the case, earnings would have fallen for two straight quarters.

Markets were unsurprised by the Fed’s decision to cut its policy rate by 25-basis points to a target range of 2%-to-2.25% at the end of July.  The central bank telegraphed its intentions in advance as global economic uncertainties increased and inflation expectations decreased – a troubling combination for Central Bankers. However, while the initial reaction to the rate cut was muted, market participants turned decidedly more negative as Chairman Powell indicated at the post-meeting press conference that this cut might be all that is needed rather than the start of a rate-cutting cycle as many investors were hoping.  Equities proceeded to fall 1% while the 10-year Treasury yield fell from 2.06% to 1.90% to end the month.

Concerns about decelerating growth were bolstered by late July data showing a further slowing in the manufacturing sector. The ISM Manufacturing Index fell to a three-year low of 51.2 from 51.7 a month earlier and down from 60.8 last year; a fall that has been attributed to weak export demand. Measures capturing new orders, factory employment, and construction spending also fell from a month earlier.

While U.S. growth is slowing, it is slowing even more in most of the rest of the world including the European Union (EU) due in part to stagnant global trade, a key driver of economic growth for many nations. The EU grew just 0.2% in the second quarter after growing 0.4% in the first quarter. Much of the weakness is attributed to shrinking manufacturing and exports that has resulted in deteriorating business and consumer sentiment.  The latter has fallen for four straight months to its lowest level in more than three years. The downward trend in growth has forced the ECB to reverse course, state that the outlook is deteriorating, and that more stimulus is needed. The Chinese economy grew at an annualized rate of 6.2% in the second quarter, its weakest growth in 27-years. China believes it’s recent counter-cyclical measures to support the economy will show more obvious results during the second half of 2019, but its impact will be tempered by evidence that US manufacturers are shifting production to countries outside of China, production that is unlikely to return.[i]

As captured by the S&P 500 index, U.S. equities have gained over 20% year-to-date in an environment where earnings are expected to grow by only 2% over the next 12-months.  The 12-month forward P/E ratio for the S&P 500 has climbed from 14X at the start of 2019 to nearly 18 today. At the same time, bond markets appear to believe that growth is slowing and will continue to slow without additional rate cuts.  With the current recovery over 10-years old, economic and earnings growth is unlikely to accelerate without a solution to global trade disputes. In the absence of a reacceleration of global and U.S. economic growth, The Caprock Group sees limited upside opportunity in equities in the medium-term at current prices. As a result, Caprock reiterates its recommendation that clients continue to rebalance to our modestly under-weight target equity allocation recommendation.

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[i] “Executives at companies that are moving operations outside China said they expect to keep them that way because of the time and money invested in setting up new facilities and shifting shipping arrangements.” WSJ, July 14, 2019