Despite some serious backtracking in May (when it dropped more than 6%), the widely followed S&P 500 Stock Index jumped 18.5% in the first half of 2019, its best start to the year since 1997. Coming on the heels of a nearly 20% peak-to-trough decline in the latter part of 2018, a recovery was to be expected at some point. But the speed and trajectory of the rebound surprised even the most bullish investors, considering that very little had changed in the underlying economic fundamentals.
It now seems to be accepted wisdom that the Federal Reserve moved too aggressively in raising short-term interest rates nine times between late 2015 and 2018. Even though the fed funds rate remained at a historically low level of 2.25%-2.50% in late 2018, investors became convinced that Chairman Powell was intent on continuing to lift rates in 2019, sending the economy into recession. After he signaled that the Fed was comfortable with postponing any more increases until there was further evidence of a sustainable uptick in inflation, stock prices took off.
The on-again off-again nature of the trade dispute with China contributed to a slowing global economy and weaker performance from European and emerging market stocks. Although the MSCI EAFE Index of developed market equities (+14.0%) and the MSCI Emerging Markets Index (+10.6%) posted impressive double-digit first half gains, they trailed the US market once again. Since the equity market’s recovery beginning in March 2009, US stocks have generated an annualized return of 16.8% versus 9.7% for the MSCI EAFE and 10.1% for the MSCI EM.
Bond prices rose as yields fell across the globe. Continued stimulus from European and Japanese central banks have driven sovereign bond yields in Germany and Japan well into negative territory. The bellwether 10-year US Treasury bond, at 2%, represents an attractive alternative to fixed income investors looking for a return on their money, rather than just a return of their money.
The decline in yields led to robust first half gains for fixed income securities (Bloomberg Barclays Municipal 1-10 Year Index +3.9%) and interest-sensitive equities such as real estate investment trusts (DJ Global Select REIT Index +15.7%). Infrastructure stocks, helped by a rebound in energy pipeline companies, soared 21.3% (as measured by the Dow Jones Global Infrastructure Index).
Outlook and Strategy
As the US expansion enters its 121st month (the longest on record), investors are paying close attention to evidence that would foreshadow a coming downturn. Consensus estimates for global GDP growth have been falling all year, as economies grapple with the ongoing trade disputes between the US and most of its trading partners. As we have noted, a successful resolution in the dispute between China and the US which addresses many of China’s abusive trade practices and eliminates the recent tariff increases between the two countries would be extremely bullish for stocks. Significant obstacles remain, and in the meantime, companies are shifting supply chains (at significant cost in time, energy, and resources) in order to mitigate the damage should the dispute persist.
Equity investors seem to be pinning most of their hopes for higher stock prices on the Fed, expecting that Chairman Powell will embark on a significant easing campaign in order to reignite a weakening economy. But the markets may be too optimistic in their forecasts for Fed easing and the impact of lower rates when rates are already at historically low levels.
Generally, stock markets react quite well when the Fed begins easing monetary policy. The Fed executed five rate-cutting cycles between 1984 and 1998, and stock prices jumped each time. Returns over the following year ranged from 14% to 23%, according to data from Goldman Sachs. But in the next two rate-cutting cycles (2001 and 2007), stocks lost 12% and 18% in the following year, on their way to much more significant declines (41% and 54%) before recovering. Importantly, these rate-cutting cycles started from much higher levels than today’s, ranging from 5.25% to 9.5%. As a result, the economic benefits of lowering rates from this point may be far more muted than in past cycles.
In light of the uncertain outlook for the trade dispute and the disproportionate impact on emerging markets, we recently lowered our recommended allocation to emerging market stocks in favor of a higher weighting in the US. We remain overweight in emerging markets, believing that the long term demographic advantages and attractive valuations of these countries will translate to above-average long term growth. We recommend that investors maintain their global equity allocation at or close to their long-term target allocation.
Learn more about our Director of Research, Bruce Simon.
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