2019 3rd Quarter Update

Top Headline for Q3: $17 Trillion in “Negative-Yielding” Global Debt

The global bond markets have truly entered unprecedented territory with “negative yielding” debt peaking at over $17 trillion during the quarter. This means that people have purchased over $17 trillion in bonds that, net of inflation, are expected to lose them money. According to analysis performed by Bianco Research, LLC this is the highest level ever recorded. Bond yields move inversely with bond prices so the drop in yields corresponds with a rise in bond prices. Most notably, the 100-year Austrian government bond is up over 66% on the year which may be the best short-term performance in the history of the bond market. Along with the Austrian bonds, approximately 1/3 of all international government bonds are now negative yielding. It’s tough to say whether the low yields are a “new normal” or a temporary situation. The “new normal” argument centers around aging populations in developed nations as a key driver – citing Japan’s aging and declining population and 10+ years of low and stagnant rates. Others argue that it’s temporary and driven by a cyclical global economic slowdown. In any case, there are big implications for both the stock and bond market that we’ll discuss in a “look ahead.”

General Market Update

US Equities: US Equities generally moved sideways in Q3 but we’re seeing a noticeable shift toward lower risk sectors. The S&P 500 Index finished up 1.2% on the quarter and the Nasdaq Composite finished down 0.1% on the quarter. The Russell 2000 continued to exhibit underperformance relative to larger indices falling 2.8%. Despite the flat performance for the market, we’re seeing a clear shift toward lower risk sectors. For example, the winners have been large companies with low price volatility and we’ve seen abnormally strong performance from REITs, Consumer Staples and Utilities. The latter sectors are often popular in a falling interest rate environment as they are sometimes used as yield-generating “bond alternatives.” Moreover, Utilities and Consumer Staples are viewed as “defensive” ahead of slowing economic conditions. Second quarter earnings were, in aggregate, positive year-over-year but have been slowing and are expected to turn negative by year end. Short-term performance will undoubtedly be affected by the trade discussions. News on this front has moved markets and October may bring additional volatility with a planned China visit to the US next week. Any changes in actual tariffs will severely hurt a few industries but, more importantly, will sway overall market sentiment.

International and Emerging Market Equities: The international markets are beginning to feel some strain from slowing global industrial and manufacturing activity (most notably in China and Germany). The Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was down 0.7% in Q3. Moreover, the more economically-sensitive Schwab Emerging Markets ETF was down 4.23%. South Korea, which is often used as a benchmark for international trade health, has seen a dramatic slowdown in exports suggesting that US/China trade tensions and a slowing global economy are having adverse supply-chain impacts outside of those countries.

US Bonds: The bond market continued its remarkable run in Q3 as global economic conditions worsened and more central banks throughout the world continued to drop rates. The market clearly sees more rate drops ahead and has added $480 billion to bond mutual funds and ETFs year-to-date despite the negative (net-of-inflation) yields. The year-to-date performance has been outstanding with intermediate-term corporate bond ETFs posting low double-digit returns and long-term corporate bond ETFs up around 20%. Treasuries also performed well though lagged corporate bonds as the market perceives that the risk of a near-term recession is still low. We’re starting to see some significant volatility in the long-bond category as the market struggles to interpret each wave of economic data.

A Look Ahead

Regarding the US and global stock market, it’s clear that we’re in a worsening economic and earnings environment especially when the effects of stimulus are removed. We’ve seen this coming for a long time but the market did not seem to care as it, perhaps, assumed any downturn would be minor or short-lived. In any case, one would likely expect some sideways stock market performance and a continued “flight to quality” (i.e., lower risk sectors) as the news disseminates to the masses that earnings are trending toward flat to down year-over-year. On the flip side, the historically low interest rates are exceptionally beneficial to many categories of stocks. For example, many “mega-cap” US stocks with international operations have taken the opportunity to raise funding through debt instruments overseas at very low interest rates. This low-cost funding should bode well for them in the long run. Moreover, some sectors, such as REITs, are very interest-rate sensitive and should thrive in a continued low rate environment absent a recession. It’s easy to be more bullish on the US than the global stock market in the short term. Despite the fact that the US is already priced much higher than many global markets, the US shows no imminent signs of recession and the Federal Reserve has a greater ability to stimulate the economy (i.e., benchmark interest rates in the US are the highest among developed countries). Lastly, one has to wonder what tools the White House may deploy ahead of the 2020 elections to avoid negative economic or market headlines.

When looking at the bond market, the key question is, “How much longer can this historic run continue?” Globally, it feels like the run is nearing an end given the sheer volume of negative yielding rates globally and the inability of global central banks to drop rates much further. However, a spreading global economic slowdown would push rates even lower in nations that have the capacity to do so. In the US, it feels like we’re trending toward an inevitable recession which should mean more interest rate drops and bond price appreciation. Of course, the signals have been growing for several years and it could be several more before any decline in GDP materializes. We still like the US bond market given a number of factors that should drive demand (e.g., the US has among the highest rates globally, the dollar is strong and the interest rate trend is downward).

In summary, our outlook hasn’t changed much since last quarter. For the US stock market, we continue to be cautiously optimistic in the short-term but a bit more bearish in the 1-3 year outlook as recession signals mount. International stock markets are priced cheaply and will be a great buy coming out of any slowdown. In this environment, we continue to like lower-risk segments of the market including higher market capitalizations and lower volatility stocks. We still like the bond market overall, though we see more potential in the US versus international.