As summer fades into fall, the rhythms of life are once again becoming more predictable for many of us. In my house, we’re savoring memories of barbeques and beach trips as the kids settle into the routines of homework, ballet, and football practice.
Yet, on the economic and market front, it’s been anything but business as usual lately. As the trade war between the U.S. and China stretches into its second year—intermittently escalating and moderating—it continues to weigh on both the market and global economy.
In August, the market took investors on a bumpy ride: it rose and fell in tandem with the latest twists and turns of the trade standoff. As Americans celebrated Labor Day weekend, the trade war entered a more troubling phase, with the U.S. imposing a new tariff on made-in-China consumer products and China responding with retaliatory tariffs. Until recently, the standoff between the world’s two largest economies had largely impacted the industrial sector. Goldman Sachs research shows, however, that the composition of goods in the latest round of U.S. tariffs is heavily skewed toward consumer items—from apparel to phones to toys.
The trade war is hitting home in more ways than one. Trade policy uncertainty has surged to its highest level in modern financial history, according to the World Trade Uncertainty index, which is based on the share of articles discussing trade.
While the shifting nature of the trade war makes it hard to forecast its impact precisely, we believe that heightened uncertainty depresses economic activity. As we’ve seen, it can also lead to sharp shifts in the market, which makes investors less confident in the economic outlook and their ability to forecast corporate earnings.
The escalating trade war and a recession signal emanating from the bond market gave rise to a fair amount of market volatility last month. The Chicago Board of Exchange Volatility Index, known by its ticker symbol VIX, closed at a high of 24.59 in early August before settling to about 19 later in the month. It’s worth noting, though, that the VIX, which measures the market’s expectation of future volatility, did not climb to the lofty levels we saw late last year when it topped 30 in mid-December.
For the month of August, the broader stock market, as measured by the S&P 500 index, closed down nearly 2%. Small-capitalization stocks, as measured by the Russell 2000 index, fared worse, declining by nearly 5 percent. The same dynamic played out between developed and emerging markets, which declined by nearly 3% and about 5%, respectively.
The August selloff came despite relatively positive company earnings for the second quarter. Companies in the S&P 500 generally beat analysts’ expectations for sales and earnings, thanks to higher-than-anticipated profit margins, according to Goldman Sachs. In theory, investors should have cheered this news, but rising anxieties over trade and the prospect of a recession loomed large in August.
Thanks to its strong start this year, the broader stock market returned more than 18% on a year-to-date basis through August, and small-cap stocks climbed by nearly 12%. For the one-year period, which captured last year’s difficult fourth quarter, the market returned nearly 3% and returns for small-cap and non-U.S. stocks were negative.
U.S. Sector Scorecard
Not surprisingly, defensive sectors—in other words, those that tend to hold up relatively well during turbulent times—outperformed in August. Utilities, Real Estate, and Consumer Staples were the only S&P 500 sectors that saw positive returns last month.
Real Estate and Utilities have not only benefited from their safe-haven status in the eyes of investors, but their historical correlation to long-term interest rates. The share prices of publicly traded real estate companies and utilities tend to rise when interest rates decline, as they have recently.
Why? For starters, lower rates reduce borrowing costs for real estate companies, which rely heavily on debt to fund their operations and tend to lift asset prices. In addition, real estate and utilities stocks generally pay high dividends, which can begin to look pretty attractive to investors when government bond yields tumble. In August and early September, strong demand for low-risk government debt pushed Treasury yields to new lows according to published reports. Bond yields fall when prices rise, and vice versa.
The U.S. bond market rally that began earlier this year continued into August—fueled by strong demand for safe-haven assets and lower yields in many other developed markets.
With central banks around the world easing monetary policy and investors flocking to safe-haven assets, the amount of negative-yielding government debt across the globe has soared to about $16 trillion, as of mid-August, according to Bloomberg. Japan had the largest share of global government bonds with negative yields, but Europe (particularly Germany) accounted for an increasingly larger share.
While the benchmark, 10-year Treasury yield has dropped precipitously since its prior peak of about 3.25% last fall, it remains quite high relative to sovereign debt yields in many other developed markets.
The relative attractiveness of Treasurys has been a boon to the broader U.S. bond market—which returned nearly 3% in August and more than 9% and 10% for the year-to-date and trailing, 12-month periods, respectively. Longer-dated Treasurys fared best for the one-month, year-to-date, and trailing, 12-month periods, outperforming even high-grade corporate bonds.
The Economy and The Fed
The American economy (officially in its longest expansion, according to the National Bureau of Economic Research) continues to be a bright spot on the global horizon, but uncertainty surrounding trade and the global economic slowdown are taking their toll in ways large and small. Here are a few signs of that:
Manufacturing activity contracted in August, following months of slowing growth, according to the Institute for Supply Management’s monthly manufacturing index (known simply as the PMI). The index fell to 49.1 in August from 51.2 in July. A reading above 50 means the manufacturing economy—which continues to have a strong correlation to the overall economy—is expanding. Anything below 50 signals contraction.
Consumer confidence, which has held up well over the past year, may be starting to fray and is worth watching closely in the months ahead. In August, the University of Michigan’s widely followed Consumer Sentiment Index posted its largest monthly decline since late 2012. The decline was tied to negative references to tariffs, according to the survey’s director.
Sales of some big-ticket, consumer goods are beginning to slip. For instance, shipments of recreational vehicles to dealers have fallen by about 20 percent this year, according to published reports. Shipments of RVs may seem like an odd barometer for the economy, but many economists consider the measure a sign of consumer demand for luxury items. After all, when the economy softens, consumers aren’t likely to stop buying soap, food, and other staples, but they’re less likely to splurge on RVs, boats, and other discretionary items.
Despite signs of waning growth, the labor market—an important underpinning of the U.S. economy—remains strong. In July, the unemployment rate (3.7%) hovered near a 50-year low. Job growth has been a bit weaker than expected lately, but it is still solid. According to the Labor Department, employers added about two million jobs (or about 168,000 per month on average) during the one-year period ending in March.
It’s also worth noting that the trade war appears to be taking a bigger toll on China than on the U.S. In the second quarter, economic growth in China dropped to 6.2% on a year-over-year basis, which outpaced U.S. growth, but represented a more pronounced slowdown than what we’ve seen domestically. China’s second-quarter growth rate represented its lowest level of growth since the country began reporting quarterly GDP results in early 1992, according to Goldman Sachs research. What’s more, the International Monetary Fund expects the trade war’s tit-for-tat tariffs to hit China three times harder than the U.S., as measured by the impact on gross domestic product.
The U.S. and China appear to be playing the proverbial game of chicken to see who can inflict the most pain on the other. Both sides, however, still have an incentive to craft a deal: Trump because he faces re-election; Xi because of growing economic strains at home. And, in fact, China and the U.S. recently announced a plan to resume trade talks in early October.
Meanwhile, the Federal Reserve, which in July cut its benchmark interest rate for the first time in more than a decade, has turned dovish (in other words, more concerned about weak growth or even deflation)—but not too dovish.
In his remarks at the central bank’s closely followed symposium in Jackson Hole, Wyoming, Chairman Jerome Powell hinted that the Fed may make additional rate cuts, but he stopped short of saying how much stimulus it might provide beyond that. He also cautioned that the Fed’s tools aren’t well suited to counter rising investor anxieties over the trade war:
“There are, however, no recent precedents to guide any policy response to the current situation. Moreover, while monetary policy is a powerful tool that works to support consumer spending, business investment, and public confidence, it cannot provide a settled rulebook for international trade. We can, however, try to look through what may be passing events, focus on how trade developments are affecting the outlook, and adjust policy to promote our objectives.” (Chairman Jerome H. Powell, Challenges to Monetary Policy, August 23, 2019, https://www.federalreserve.gov/newsevents/speech/powell20190823a.htm)
With no immediate end in sight to the trade war, the smart investor will want to take a cue from the central bank and look through the short-term noise to the longer-term path ahead.
I often remind my kids that author Robert Collier said, “Success is the sum of small efforts, repeated day in and day out.” Just as they need to finish their homework and show up faithfully for football and ballet practices—and, admittedly, some days will be better than others—portfolios also need to be invested for the good days and the not-so-good days in order to pay off in the future.
Live richly and invest well,
Kara Murphy, CFA
Chief Investment Officer
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S&P 500 Index: A broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. It is a capitalization-weighted, unmanaged index that is calculated on a total return basis with dividends reinvested. The S&P 500 represents about 75% of the NYSE market capitalization.
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MSCI Europe, Australasia, and Far East (EAFE) Index: This index is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada.
MSCI Emerging Markets Index: This index is a free float-adjusted market capitalization index that is designed to measure equity market performance of emerging markets. As of June 2009, the MSCI Emerging Markets Index consisted of the following 22 emerging market country indices: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, Taiwan, Thailand, and Turkey.
Bloomberg Barclays U.S. Aggregate Bond Index: This is a market capitalization weighted bond index of investment-grade, USD-denominated fixed-income securities.
U.S. High Yield Corporate: The Bloomberg Barclays U.S. Corporate High Yield Bond Index measures the USD-denominated, high-yield, fixed-rate corporate bond market. Securities are classified as high yield if the middle rating of Moody's, Fitch, and S&P is Ba1/BB+/BB+ or below. Bonds from issuers with an emerging markets country of risk, based on Barclays EM country definition, are excluded.
U.S. Investment Grade Corporate: The Bloomberg Barclays U.S. Corporate Bond Index measures the investment-grade, fixed-rate, taxable corporate bond market. It includes USD-denominated securities publicly issued by U.S. and non-U.S. industrial, utility, and financial issuers.
Bloomberg Barclays Municipal Bond Index: The Bloomberg Barclays U.S. Municipal Index covers the USD-denominated, long-term, tax-exempt bond market. The index has four main sectors: state and local general obligation bonds, revenue bonds, insured bonds, and pre-refunded bonds.
S&P 500 GICS Sectors Level-1: In 1999, MSCI and S&P Global developed the Global Industry Classification Standard (GICS) to offer an efficient investment tool to capture the breadth, depth, and evolution of industry sectors. GICS is a four-tiered, hierarchical industry classification system. It consists of 11 sectors, 24 industry groups, 68 industries, and 157 sub-industries. Companies are classified quantitatively and qualitatively. Each company is assigned a single GICS classification at the sub-industry level according to its principal business activity. MSCI and S&P Global use revenues as a key factor in determining a firm’s principal business activity. Earnings and market perception, however, are also recognized as important and relevant information for classification purposes and are considered during the annual review process.
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