The S&P 500 eclipsed the 2900 level for the first time on September 20, 2018. Then, the index suffered a sharp correction through the balance of the year, reaching a level 600 points lower on Christmas Eve. Since the end of 2018, the S&P 500 has rebounded sharply, delivering new historic highs in June and the strongest first-half performance since 1997. Over the same period, the yield on the 10 year Treasury has trended inexorably lower. From a recent high of 3.24% on November 8, 2018, the yield on the 10 year Treasury fell below 2.0% in June. We commented in our March 31st letter that the stock and bond markets were beginning to send divergent signals. Market activity during the Second Quarter reinforced this view, which is the focus of this letter.
Much of 2018 was pre-occupied by the pace of monetary policy tightening, implemented through rate increases and reductions to the Fed’s balance sheet. In late December 2018, the Federal Reserve shifted direction on both measures, effectively changing its posture. As the Second Quarter drew to a close, the bond market priced in at least two interest rate reductions in 2019. Generally, the Fed lowers policy rates to infuse liquidity into the banking system and to encourage economic activity. The action implies the Fed is less concerned about inflation and more concerned about an economic slowdown.
Recent economic data, particularly regarding global manufacturing, support the Fed’s actions. Other indicators suggest the US economy is losing forward momentum. At the same time, unemployment remains below 4.0%, and wages have risen. One could effectively argue, therefore, that current economic conditions are mixed. The stock market, on the other hand, is rather unequivocal in its message. Its return to record highs would imply that economic conditions appear to be either robust or improving. As we begin the second half of 2019, this disconnect causes us some concern.
Our interpretation of these developments is that stock market investors anticipate a favorable resolution to trade uncertainties in the near future; a benign outcome to Brexit negotiations; and ongoing liquidity support from the Fed and other central banks. To the extent the US economy contracts, the stock market’s recent performance suggests any setback should prove shallow and short-lived. In fact, to a certain degree, the bond market seems to concur as the yield curve has recently steepened. A brief, shallow recession would reflect an ideal outcome for monetary policy – i.e., achieving the mythical “soft landing’, last engineered by the Fed in 1995. We would note, however, that the bond market currently appears more cautious than the stock market.
To further complicate our outlook, we believe trade negotiations have distorted economic activity. There are numerous accounts of businesses building inventories, stockpiling supplies, and otherwise hoarding resources to lock in prices prior to effective dates of tariffs. Some global companies have begun to restructure supply chains and re-locate operations to areas unaffected by current trade disputes. To economists, this type of activity suggests a “pull forward” from future quarters. The net effect is to inflate GDP growth in the current period. However, at a certain point in the relatively near future, we would expect a “payback” as inventories are drawn down. For these reasons, we adopt a cautious posture for the second half of the year. We acknowledge that resolution of trade uncertainties should provide additional momentum to the stock market. However, paying heed to the message from the bond market, we are inclined to use market rallies to render portfolios more defensive. Our specific actions depend, of course, on each client’s objectives. We look forward to discussing these issues and potential portfolio adjustments with you in the near future. Please contact the office if you would like to schedule an appointment.