At 120 months, the current economic expansion is officially the longest expansionary cycle in U.S. history. For comparison, the average duration of an expansionary period is 67 months. US growth accelerated in Q1, with the third estimate of GDP at 3.1%, up from 2.2% in Q4 2018. That being said, growth has appeared to slow in Q2, and throughout the first half of the year we have seen late-cycle deceleration characteristics becoming more prevalent. While it does not appear that the current expansion will expire in 2019, indications are that the rate of global growth will continue to decline throughout the year and into 2020.
The fading effects of the 2017 Tax Act, coupled with a general global slowdown in the face of heightened trade tensions, are expected to continue to be a drag on GDP growth. Econo-mists anticipate annual domestic growth to finish the year in the 2% range, down from 3% last year, but still around the current expansion’s annual average. Barring any unforeseen setbacks, the economy should be able to avoid recession in 2019 for a couple primary reasons. First, cyclical sectors (autos, housing, inventories, and business investment) do not appear over-extended, nor does there seem to be any particularly dangerous areas of financial excess. Secondly, we have seen a shift towards a more dovish monetary policy which should further buoy growth.
Though the expansion continues to extend, domestic corporate profit growth has decelerated meaningfully and is not expected to return to 2017/2018 levels. In 2018, three consecutive quarters of 25%+ year-over-year growth were followed by a steep decline to 3%, in Q4 2018. Although this was somewhat concerning, rates appear to have stabilized, and expectations are that corporate earnings will continue to achieve low to mid-single digit growth throughout the remainder of 2019. In addition to the fading effects from the 2017 Tax Act, and higher costs related to wages, uncertainty surrounding trade tensions stemming from the U.S. have caused many businesses to suspend their investment spending practices, which has a direct impact on growth.
From an international perspective, the pace of global expansion has steadily declined over the past year. Political turmoil in France and Italy, as well as the now infamous Brexit debacle, has led to economic anxiety across the Eurozone. European countries have experienced a climate of slowing business investment, as firms delay new projects until there is more clarity on the path of the region’s economy. Uncertainty regarding the U.S./China trade war has caused manufacturing activity to dip into contractionary territory (as measured by the PMI), most notably in China, Germany, Korea and Taiwan.
As is common in late-cycle expansions, the unemployment rate continues to tick downward towards “full employment.” As of June, the unemployment rate was 3.7%, well below the 50-year average of 6.2% and on it’s way to hitting levels not seen since the early 1950s. Although this trend is likely to continue, unemployment rates tend to lag GDP growth by 1 -2 quarters. With GDP growth continuing to decelerate, we would expect job gains to eventually begin to decline. Econo-mists expect to see unemployment rates level off in the 3.2%-3.5% range by the end of the year. The tight labor market has resulted in year-over-year wage growth of 3.4% (June), though still below the 50-year average of 4.1%. While a tight labor market typically leads to higher paychecks, companies have become particularly adept at holding the line on wages in recent years, suggesting that meaningful gains in employee income are less likely to materialize by the end of this expansionary period.
Ten years of monetary stimulus, economic growth and falling unemployment have succeeded in boosting home prices, bond prices, and stock prices. However, their impact on consumer prices has been negligible. In May, the overall Consumer Price Index (CPI) increased by only 1.8%, while headline PCE (the Federal Reserve’s preferred inflation measure), re-mains well below 2%. Furthermore, the Fed’s decision to freeze interest rates earlier this year has resulted in a slightly inverted yield curve. Although yield curve inversions typically precede recessions, there is some belief that the current in-version has been somewhat distorted by unprecedented central bank buying of long -term bonds. While still a cause for caution, a near-term recession does not appear to be imminent based solely on this phenomenon.
Given decelerating GDP growth and corporate profits, unusually low inflation, and ongoing trade tensions, global monetary policy has shifted dramatically in the first half of 2019. Generally, the Federal Reserve looks to increase interest rates during the late-stage of expansionary cycles, in order to prevent the economy from overheating. However, the Fed ended its recent June meeting by announcing that there would be no change in the federal funds rate (2.25% to 2.50%) and that the committee would be more open to a rate cut. The futures market is currently pricing in a couple rate cuts by year end. Either way, it appears the Fed will likely end its tightening measures at a much lower level of rates than is typical in a long economic expansion. The rationale has been largely driven by remarkably low inflation and significant pressure to offset potential economic shortfalls on the horizon. The belief is that with inflation remaining low, reducing rates could offset an y fallout from ongoing trade disputes, thus sustaining the current expansion for a little longer. Similar steps may be taken by the European Central Bank, which has also indicated its willingness to cut rates and resume bond purchases to counteract any further growth slowdown.
During the first half of 2019, geopolitical risk has also played a key role in the global slowdown. Trade tensions between the U.S. and China are unlikely to be resolved in the near-term, while additional disputes are developing between the U.S. and some of its staunchest European allies. This appears to be in response to Europe’s general unwillingness to fully sup-port U.S. imposed sanctions on Iran. Particularly, if the U.S. follows through on threats to use military action in response to Iran’s uranium enrichment activities, this conflict could further exacerbate the global slowdown if it appears that access to oil reserves is materially hindered. Of course, news related to trade discussions on all fronts has been somewhat unpredictable, so it remains to be seen as to whether this matter will continue to be a long -term concern. The most likely scenario seems to be a general continuation of tough rhetoric with little change to actual trade policies. Should this continue, global growth expectations will continue to be limited, but should avoid a rapid descent towards the next recession.
Equity markets experienced a roller coaster ride during the quarter with stocks posting strong gains in April, before revers-ing course in May following the collapse of trade discussions with China and threats of tariffs on Mexico. Then indices ral-lied again in June as it became apparent that the Fed would take a more dovish approach and trade tensions seemed to ease a bit, renewing investor confidence. Within this landscape, the S&P 500 Index finished the quarter with a gain of 4.3%, up 18.5% YTD. Growth outperformed value, and small caps slightly underperformed large caps. The Russell 2000 gained 2.1% in Q2, up 17.0% YTD.
With the exception of the energy sector, all primary economic sectors were positive during the quarter. Financial Services, Materials, and Info Tech were the strongest relative performers, generating returns of 8.0%, 6.3%, and 6.1%, respectively. The Energy, Health Care, and Real Estate sectors were the poorest performers, posting returns of -2.8%, 1.4%, and 2.5%, respectively.
As was expected, international stocks continued to lag US equities in Q2. The MSCI EAFE Index of developed international countries was up 3.7% for the quarter, 14.5% YTD. Emerging markets posted only a modest gain of 0.6% in Q2, up 10.8% YTD. A rising U.S. trade deficit could cause the dollar to fall in the 2nd half of the year, thus amplifying the return for international equities. That being said, it’s worth noting that the vast majority of international countries are more vulnerable to economic shocks from geopolitical risk (Brexit, trade tariffs, Iran, etc.) than is the U.S., which makes those
markets more volatile and risky given the current environment. However, at the moment, international stocks are considerably cheaper than domestic stocks, with emerging markets having the most favorable long-term growth prospects.
For the remainder of 2019, equity returns are expected to moderate as dovish bank policies attempt to offset decelerating growth trends. In the short-run, a growing economy coupled with declining interest rates will likely favor stocks over bonds. That being said, equity returns for the 2nd half of 2019 are more likely to come from earnings growth than multiple expansions, implying that value may be preferable to growth at this time.
Turning to the bond market, slowing global growth and a dovish Fed have resulted in a continuation in the rally in bond prices and a drop in yields. The Fed’s decision to freeze rates has led to a negatively-sloped yield curve, as well as generally low nominal and real yields. The benchmark 10-year US Treasury ended Q2 at 2.0%, compared to 2.41% at the end of Q1. Total returns on fixed income securities were positive across the various market segments. The Bloomberg Barclays US Aggregate Bond Index was up 3.1% in Q2 and is up 6.2% for the first half of 2019. Intermediate term treasuries rose 3.5% for the quarter, up 6.1% YTD. High yield securities, which often follow the performance of equities, climbed 2.4% in Q2 and are up 10.1% YTD. Municipals continued to perform well, up 2.1% for the quarter and 5.1% YTD. Prices of non -US fixed income securities were also higher during the quarter and emerging markets bonds continued climbing, up 3.8% in Q2, 10.6% YTD.
Despite strong indications that the expansion has nearly run its course, it appears less likely that the record streak will e nd prior to 2020. In the U.S., a tightening labor market should continue to produce wage growth without materially pressuring corporate profitability. Additionally, the Fed’s decision to lower rates this year should help slow decelerating growth trends, thus extending the life of this record-setting expansion a little longer and maintaining domestic GDP growth in the 2% range. However, geopolitical variables such as the trade dispute with China, political turmoil in Europe (Brexit, France, Italy), and the possible escalation of tensions with Iran, all pose downside risks with the potential to materially impair the outlook.
Regarding equity markets, there are still reasons to be cautiously optimistic. The ongoing expansion and favorable monetary policy are beneficial to sustaining earnings growth, while decelerating growth trends and geopolitical risks are more prevalent than they were at the beginning of 2019. Although growth is still expected to be positive, it’s important to recognize that a low interest rate environment, coupled with a very long bull market run in equities, limits potential portfolio r e-turns. As such, growth rates are expected to continue in the single-digit range for the remainder of 2019, with international and emerging markets providing stronger opportunities for value in the long run. Although falling rates within a growing economy tends to favor stocks over bonds, fixed income still plays a critical role in a properly diversified portfolio. We p refer corporate over government debt and investment grade over riskier high-yield holdings. Additionally, further diversify-ing your portfolio utilizing alternatives such as private equity, private credit, and real estate, may provide enhanced return and reduced volatility.
As always, maintaining a disciplined, long-term approach to investing is critical. Consider meeting with your financial advisor to review your current risk tolerance and ensure your investments and financial strategies are meeting your personal goals and objectives.
Around the Firm
Q2 2019 has been exciting for our firm. To begin with, we welcomed a new addition to our family this quarter. Michael Van Putten, came to us from wealth management company, D.A. Davidson, where he spent three and half years as a Branch Operations Manager. Michael’s commitment to excellence and passion for serving others make him an ideal fit for our culture. We look forward to many years with him as an integral part of our team.
In May, we were honored to host another Women’s Workshop, which is a recurring event we sponsor designed to educate and equip women in our community and promote women professionals in the Pacific Northwest. The workshop featured panelists from the fields of wealth management, accounting, estate planning, and insurance planning and was attend-ed by 35+ women. The enthusiastic response we received has reinforced our commitment to these workshops. If would like more information regarding upcoming events, please email Julie Gray at: [email protected].
Integrity will be holding its quarterly investment summit in Bellevue at the end of July. Team members from around the country will come together to discuss the current economic and market environment, review trends in financial planning, collaborate on industry best practices, and of course, deepen relationships at a good old fashioned baseball game. Go Mariners!
Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA
Chief Investment Officer
Sources: 1) JP Morgan Chase – Economic Update & Market Update 3Q19; 2) JP Morgan Guide to the Markets – 3q19; 3) Goldman Sachs Market Pulse – July 2019; 4) Envestnet PMC – Economic and Market Overview, Second Quarter 2019; 5) Fidelity – Quarterly Market Update, Third Quarter 2019.
**The opinions expressed are those of the Integrity Financial Corporation (“Integrity”) and should not be taken as financial advice or a recommendation to buy or sell any security. Integrity is a registered investment adviser. Registration does not imply a certain level of skill or training. Any forecasts, figures, opinions or investment techniques and strategies described are intended for informational purposes only. Past performance is not indicative of future results. Investing involves the risk of loss of principal. Investors should ensure that they obtain all current available information before making any investment. Indices cited in the information above are intended to support the opinions expressed and are shown as general examples of market trends. It is not possible to invest directly in an index and the volatility of the index may vary from that of an investor’s actual account. Note that index performance shown does not take into account management fees, and is not intended to be indicative of future results. Additional information about our investment strategies, risks, fees, and objectives can be found in Integrity’s Form ADV Part 2.