June 2019 Market Commentary

The S&P 500 reached an all-time high and posted its best first half of a year since 1997 as investors reacted positively to the likelihood that the Fed will respond to economic weakness by lowering its policy rate. The rally was widespread, with stocks ending the month higher globally and across sectors. While equity markets were rallying on the belief that Fed policy would give new life to the recovery, bond markets were rallying over concerns of slowing economic growth. The disconnect over the economic outlook raises questions for investors in the second half of the year.

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

Index June YTD Index June YTD
S&P 500 (Total Return) +7.05%  +18.54% MSCI All Country World (Net) +6.55% +16.24%
MSCI EAFE (Net) -5.93% +14.03% Bloomberg Barclays U.S. Agg +1.26% +6.11%
MSCI Emerging Markets (Net) +6.24% +10.58% 60/40 Blend* +4.43% +12.18%

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

June’s equity market rally can largely be attributed to news coming out of the Fed’s June meeting. While the federal funds rate remained unchanged, the Fed signaled that it could cut its policy rate as much as +.50% over the remainder of this year in response to increased economic uncertainty and a drop in expected inflation. The central bank stated it “will act as appropriate to sustain” the 10-year-old economic expansion. The Fed also removed earlier language that it would be “patient” in adjusting rates. A review of the Federal Open Market Committee members reveals that half its policymakers now show a willingness to lower borrowing costs over the next six months.

While the Fed has signaled up to 50 basis points in rate cuts through the end of the year, investors are expecting the central bank to lower its policy rate by more through the end of the year and by more than 1% over the next 12 months. The market’s expectation that the Fed’s latest move signals the beginning of a rate-cutting cycle is now leading to inflows into equities[i] ($16 billion in the week following the announcement) on the belief that an easing cycle is positive for equity prices. Research reveals that the S&P 500 gained a median of 2% and 14% during the three- and 12-month periods following the start of an easing cycle.

The Fed’s more accommodative stance officially arose in response to headline inflation falling to 1.5%, down from 1.8% in March and well below the Fed’s desired 2% level. Others suggest the Fed’s move to accommodative monetary policy is in response to the inversion of the yield curve that resulted when safe-haven investors moved to Treasury bonds, driving yields lower. After peaking at 3.24% in November, the 10-year U.S. Treasury bond yield had fallen to 2.0%, below the federal funds rate (2.5%). Treasury yields fell over concerns about weakening global growth and investors’ belief that the Fed would be forced to respond to falling rates by cutting its policy rate.

Bond markets failed to react to the change in Fed policy, with Treasury yields flat, suggesting bond investors don’t expect an upturn in growth and inflation. Numerous indicators point to slowing growth, including evidence of weakening corporate revenue and earnings growth (that equity investors tended to overlook while reacting positively to the possibility of a Fed easing cycle).

In late 2018, analysts were forecasting 2019 S&P 500 earnings of near 7%. After falling nearly 3% in the first quarter from a year earlier, earnings are expected to fall another 3% in the second quarter. At the beginning of June third-quarter earnings were forecast to grow by +0.3%, but that estimate has been lowered to -0.2% following 77% of companies issuing pre-announcements stating profits will be worse than expected.

At a macro level, the Atlanta Fed is revising down its estimate of second-quarter GDP growth from 1.9% to 1.5%, following 3% growth in the first quarter. The primary driver of slowing U.S. growth is weakness in manufacturing, itself a victim of flat export growth in the face of the U.S. – China trade dispute. The ISM Manufacturing index has decreased to 52.1 (its lowest level since 2016) from a high of 60.8 in August of 2018, while growth in exports, which make up 12% of U.S. GDP, has shrunk to just +0.4% in 2019.

Growth in consumer spending remains positive (+0.4% higher in May), supported by job and income growth, but consumer confidence fell last month as concerns over the impact of the trade-dispute received increasing attention in the media. The negative impact on future growth of declining sentiment and confidence has already seen its way into business decisions; capital goods expenditures fell in the first quarter for the first time in three years, while job growth (+75,000) fell unexpectantly in May. The Morgan Stanley Business Conditions index fell to its lowest since the 2008 financial crisis. According to Morgan Stanley, “these indicators point to business expansion coming to a near halt in June,” because the unresolved tariff battles have made it difficult for companies to develop business strategies and forced many to alter their supply changes.  Economic indicators across the rest of the global economy tell similar stories. Citigroup Inc.’s global economic surprise index has been negative since April 2018, indicating that actual growth is taking place below expected levels as PMI manufacturing indexes fall toward 50.

In looking to the second half of the year, bond markets appear to be seeing more of the same – slowing growth.  Equity markets, on the other hand, have overlooked weakening earnings growth in favor of a belief that central bank easing will help reset growth higher into 2020.  While the outcome is unclear, what is clear is that the next quarter is likely to be characterized by increasing volatility as investors gain greater clarity regarding the impact of trade and monetary policy on the direction of growth.  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.  As a result, Caprock reiterates its recommendation that clients use any rally in equity prices as an opportunity to trim equity balances to a modestly under-weight allocation.

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[1] Prior to the Fed’s announcement, U.S., European and global equities had experienced outflows of $41 billion, $71 billion and $138.5 billion year-to-date according to the Bank of America.