May 2019 Market Commentary

After starting the year with four positive months for equities, the S&P 500,  along with other global equity indexes sold off in May.  These declines were triggered in large part by the unexpected implementation of new tariffs aimed at China and Mexico as well as newly released economic data pointing to a continued slowing of global growth. Concern that a much-anticipated trade deal between the U.S. and China may not happen as soon as markets were hoping has heightened fears of recession, causing energy to decline and inflation expectations to fall. Investors seeking safety in an environment of weaker growth prospects and renewed trade tensions moved into high-quality bonds and pushed the Barclay’s Aggregate Bond index higher during the month.

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

Index May YTD Index  May YTD
S&P 500 (Total Return) -6.35%  +10.73% MSCI All Country World (Net) -5.93% +9.08%
MSCI EAFE (Net) -4.80% +7.64% Bloomberg Barclays U.S. Agg +1.78% +4,80%
MSCI Emerging Markets (Net) -7.26% +4.09% 60/40 Blend* -2.85% +7.37%

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

Following reports that a trade deal was “nearly complete,” trade talks between the U.S. and China broke down in early May over U.S. frustration that the Chinese were seeking to renegotiate earlier agreed to commitments. The economic implications of the failure to reach an agreement rose as the month wore on.  After the Trump administration announced that tariffs would rise from 10% to 25% on more than $200 billion worth of Chinese goods, China retaliated by announcing its increase in tariffs on nearly $60 billion of American goods.  In classic tit-for-tat fashion, the U.S. then suggested that even more tariffs could be forthcoming.

The U.S. further raised the cost of failing to reach an agreement by putting Chinese technology company Huawei on a list that substantially prevents it from conducting business with American companies. Later in May, the U.S. Commerce Department indicated it would recommend rolling back regulations allowing U.S. companies to export many technologies to China. As the month drew to a close, China announced it would end imports of U.S. soybeans and hinted it might restrict access to rare earth minerals (who accounts for 90% of global mine production). May ended with the Trump administration announcing it would impose tariffs starting at 5% on imports from Mexico until it restrains the flow of migrants attempting to enter the U.S. illegally. With the U.S. importing roughly 680,000 barrels of Mexican oil a day, the U.S. tariff decision caused the price of WTI oil to fall over 5% on the last day of the month.

In response, in part to weakening global trade growth, measures of current output across the globe are softening. In the U.S., the ISM  Manufacturing index fell to 52.1 in April (its lowest level since October of 2016), and preliminary estimates suggest its May level will fall further, a result in part of reduced export orders. In the EU, the Eurozone PMI has remained under 48 for the last three months, a value suggesting stagnant manufacturing growth.  As a result, estimates of 2019 EU GDP growth have been lowered to 1.2% from earlier forecasts of 1.6%. In China, government-provided statistics reveal that April retail sales growth fell from 8.7% to 7.2% (annualized), a 16-year low. Industrial production slowed from 8.5% annualized growth in March to 5.4% in April, below the consensus estimate of 6.5%.  And finally, a measure of employment growth fell to its lowest level since the global financial crisis.

Investor expectations for future growth and inflation all fell during the month, contributing to the drubbing in equities and the rally in Treasury bond prices. A survey of economists reveals the percentage who believe a recession will begin within the next 12-months increased from 35% to 50%. U.S. GDP grew at an annualized rate of 3.1% in the first quarter, but estimates for the rest of 2019 have trended lower, leading to full-year 2019 forecasts of 2.1% – 2.4%, down from earlier forecasts of 2.8% – 3.0%.

The Fed’s preferred measure of inflation (PCE Price Index ex-food & energy) continues to trend below the Fed’s target rate of 2.0% (recently reported at 1.6% YoY). As a result, investor expectations for future inflation have fallen from 2.2% early in 2019 to 1.7% at the end of May. The fall in expected inflation and growth has contributed to falling Treasury bond yields, with the U.S. 10-year yield plunging 37bps during the month from 2.51% to 2.14%.

While the probability of recession remains low at this time, the market increasingly believes that the Fed will be forced to cut policy rates to offset escalating fears/uncertainty from business owners and investors that could lead to curtailed production and investment decisions. Just a month ago, only 18% of investors believed the Fed would cut its current 2.5% policy rate in 2019. Today, 57% believe the Fed will cut rates 25bps by its July 31st meeting, with odds increasing that future cuts are likely (34% probability of 1.75% policy rate by January 2020).

Despite softening global growth, Caprock does not yet foresee a recession in 2019.  Additionally, the increasing potential for a rate cut by the Fed and the potential for a surprise trade deal with China make a short-term surge in equities possible. However, 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.