Top Headline for Q2: Largest Expansion Ever!
Since June 2009, the U.S. GDP has grown for a record 121 months without a recession. While this is the longest expansion in duration, the cumulative GDP growth thus far of around 25% is among the lowest on record. While it’s exciting to mark this milestone, it’s noteworthy that it was achieved with significant help. The U.S. Government created tail-winds through government stimulus including low interest rates, tax incentives and growth in the federal reserve balance sheet. At this point, everyone is wondering when the party will end. More to come on that front below in “A Look Ahead.”
General Market Update
U.S. Equities: U.S. Equities continued to march higher in Q2, albeit at a much slower pace than in Q1. Congratulations to the S&P 500 Index which, after rising 3.8% in the quarter, ended at a new all-time high. The Nasdaq Composite finished up 3.6% and the Russell 2000 Index was up 1.7% for the quarter. Many analysts continue to point out that we’re starting to see more price variance in the universe of U.S. stocks. For example, there is a bit of a shift toward safety and quality as REITs, Utilities and low-volatility stocks all saw large asset inflows year-to-date in 2019 and well above-average performance. Meanwhile, the higher-risk Russell 2000 (small cap) companies have not come close to regaining their peak levels from 2018. It’s noteworthy that the U.S. stock market is expanding in price in the face of shrinking earnings. Factset is reporting that earnings estimates for Q2 and Q3 are expected to be negative on a year-over-year basis. Moreover, it’s likely that the full year will also be negative. So, price increases are coming mainly from the rather tenuous price/earnings-multiple expansion rather than reported or projected earnings expansion.
International and Emerging Market Equities: Like the U.S. market, the international markets enjoyed gains in the 2nd quarter. For example, the Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 3.3% in Q2. The uncertainties surrounding the U.S. – China trade war has kept central bankers across Europe ready to respond to any continued economic slowdown with additional stimulus. Moreover, the Schwab Emerging Markets ETF was up 1.5% in Q2. The emerging market ETF grew despite a slight pullback in China’s equity market during the period. China has continued to inject large amounts of liquidity into their financial system and has guided short-term interest rates lower in an effort to stimulate their economy.
U.S. Bonds: The bond market continued its march higher in Q2 as bond buyers began to predict, with increasing confidence, a drop in interest rates in 2019. The year-to-date performance has been outstanding with intermediate-term bond ETFs posting high single digit returns and long-term bond ETFs generally into double-digit returns. Corporate bonds outperformed Treasuries indicating that the market’s appetite for risk is high. Demand for intermediate and long-term Treasuries has driven long-term effective interest rates down in a short period of time (e.g., the 10-year rate sits at around 2% after peaking at over 3.2% in Q4 of 2018). The market is so convinced of a rate drop in 2019 that any non-action by the Federal Reserve will likely adversely impact both stocks and bonds.
A Look Ahead
As we’ve commented previously, it’s hard to get too comfortable with the current U.S. stock market. Most signals suggest that it’s time to cut back on equity positions. For example, there are many signals that suggest that we’re in the final phases of the current GDP expansion and corporate earnings are decelerating such that they may be negative overall for 2019. However, the market continues to grind higher. So, where do we go from here? This market brings to mind the following two famous investing quotes: (1) “the trend is your friend” and (2) “don’t fight the Fed.” The first quote is a by-product of human behavior. An upward trending market attracts more buyers which drives markets even higher. The second quote is an acknowledgement of the power the Federal Reserve has over the markets. It seems that both factors are at play. The U.S. stock and bond markets have strong momentum and the market participants assume, with high confidence, that any Federal Reserve actions will be beneficial in the near-term. Moreover, with a 2020 election on the horizon, it’s reasonable to assume that there will be substantial and continued pressure on the Federal Reserve from the Executive Branch to be generous with stimulus.
Given these factors, it’s tough to bet against the U.S. stock market but we do see a few things that could rock the boat. For one, any inaction by the Federal Reserve at this point (beginning with the late July meeting) could have a very negative impact. Moreover, as earnings are reported throughout Q3, we’re likely to hear more negative surprises than normal. In fact, Factset reports that negative earnings guidance for Q2 (i.e., downward revisions in estimates) is the 2nd highest number that they’ve recorded since they started recording data in 2006. And, the heavily-followed Technology sector is leading all other sectors in expected negative news.
In summary, for the U.S. stock market, we continue to be cautiously optimistic in the short-term but a bit more bearish in the 1-3 year outlook. In this environment, we continue to like lower-risk segments of the market including higher market capitalizations and lower volatility ETFs. On the bond side, we continue to favor short to medium duration segments of the yield curve given the current potential for volatility in the longer-dated bonds and relatively low risk-premium.