In the 3rd quarter of 2019, the current economic expansion continued its historic run, albeit at a somewhat subdued pace relative to other points throughout this cycle. However, an overall slowdown in global growth coupled with heightened concerns regarding U.S./China trade policy, have become substantial headwinds for many economies around the world. Trade tensions loom large over the global economy, and are likely to finally impact the consumer by year-end. That being said, the volatility and uncertainty that plagued Wall Street, in 3Q19, doesn’t appear to have reached Main Street just yet.
Before digging into the economic data for 3Q19, it’s important to set the context within which the results have occurred. The now 2-year trade conflict between the U.S. and China seems to be approaching a tipping point. Trade tensions were once again ratcheted up in 3Q19 as the U.S. increased tariffs on $270 billion of goods from 25% to 30%. Additionally, a new tranche of tariffs was implemented on October 1st that is expected to have a more direct impact on consumer spending, effecting items such as furniture, autos, apparel, electronics and footwear. Given that many of these goods are consumer staples, there is an expectation that tariff-related price increases could expedite a decline in consumer spending. Furthermore, trade tensions are expected to continue impeding corporate growth, as the very uncertainty alone is enough to prevent business owners from making future investments. Although the U.S. and China have recently resumed talks, it is unlikely that any resolution to this dispute will occur prior to the end of 2019.
Coming off 2018, which boasted solid GDP growth of 2.9%, growth is expected to slow considerably for the remainder of 2019. Currently, year-end 2019 estimates are between 2.00% – 2.25%, which implies the 2nd half of 2019 growing at a slower rate of roughly 1.7%. This lines up perfectly with the Fed’s projections, which recently forecasted Q3 growth of 1.7%. Should these projections come to fruition, the result would be 20-30% decline in GDP growth from 2018. While one could argue this is still near the expansion average of 2.3%, the steep year-over-year decline provides evidence that uncertainty from escalating trade tensions have exacerbated a global economy that is already deep into the late stages of an expansionary cycle. Despite these trends, and barring any unexpected developments, dovish central bank policies and strong consumer spending will likely continue to buoy the U.S. economy well into next year. As such, the Fed continues to maintain its 2.0% median GDP growth expectations for 2020.
The Organization for Economic Co-Operation and Development recently downgraded its global growth estimate to 2.9%, its lowest target since 2009. Among the main reasons for this subdued forecast is weak data coming from large international economies, namely China, the U.K. and Germany. China’s growth is expected to dip to 6.1%, its lowest in decades. This is largely explained by the impact of trade tariffs on manufacturing and exports. While trade tensions have also contributed to Europe’s decelerating growth trend, the threat of a “No-deal Brexit” and general contractionary cycle characteristics have plagued its two largest economies, the U.K. and Germany, each coming off 2nd quarters of negative growth.
In the face of these relatively unfavorable trends, central banks around the globe demonstrated their willingness to intervene by pursuing aggressive easing policies in 3Q19, which helped mitigate the downside. Specifically, in response to softening global growth and severe market volatility resulting from trade tensions, central banks began cutting interest rates for the first time since the Great Recession. Typically, policies like these are intended to revive a sputtering economy during a contractionary market cycle, which has the case during the last downturn. However, moves like these are less common during expansionary periods, and have yet to make a significant impact on overall economic growth. This dovish shift has pushed interest rates to new lows. In 3Q19, the 10-year US Treasury fell to 1.7%, coming within 15 basis points (0.15%) of the post-WWII low in 2016. In Germany, 10-year government yields moved to an all-time low of -71 basis points (-0.71%). At one point, the amount of outstanding negative-yielding debt crossed over $17 billion. It remains to be seen whether central banks will continue this trend over the near-term.
One reason the Fed has gotten away with keeping rates so low is that inflation has remained uncharacteristically low throughout the expansionary cycle. As of 8/31/19, the Headline CPI (Consumer Price Index) and Core CPI were 1.8% and 2.4%, respectively, well below their 50-year averages of roughly 4.0%. While this data is particularly surprising for a late-stage expansionary period, modest wage growth coupled with the potential impact of new tariffs on consumer goods could potentially lead inflation to creep up in 2020.
Though GDP growth has been on a path of deceleration, consumer spending has remained strong through the first three quarters of 2019. Consumer spending is by far the largest sector of the U.S. economy, and is increasingly driving the growth that is sustaining this record expansion. One of the main factors driving consumer spending is a historically tight labor market. As of 9/30/19, the unemployment rate checked in at 3.5%, well below the 50-year average of 6.2%, and its lowest tally since 1969. Year-over-year wage growth is still hovering at approx. 3.5%, just below the 50-year average of 4.0%. In addition to a robust labor market, household debt service ratio and consumer savings rates are at record highs.
In the 3rd quarter trade tensions escalated further, and a new round of tariffs are expected to more significantly impact U.S. households by year-end, as the next installment will primarily target many of the most popular consumer goods. Although consumer confidence remains high, business sentiment has started to wilt in the face of trade uncertainty. This weak sentiment has been reflected in a drop in manufacturing output, which has fallen to its lowest level since 2016, and a slowdown in industrial output, reflecting the global trend of weakening production. That being said, manufacturing only accounts for 13% of domestic GDP growth (services accounts for 70%), which has prevented these results from materially impairing overall growth prospects thus far.
Despite a bumpy ride, the S&P 500 continued its march forward in Q3 with returns of 1.7% for the quarter and an impressive 20.6% YTD in 2019, after finishing down -4.4% in 2018. Mid cap stocks showed only slight gains in Q3, up 0.5% for the quarter, and 21.9% YTD; while small cap stocks posted negative returns for the quarter, down -2.4%, up 14.2% YTD. In general, defensive and less-cyclical equity sectors/factors led the markets in Q3, such as utilities, real estate, consumer staples, and minimum-volatility stocks.
The resiliency of domestic stocks over the past two years is partially attributed to corporate buyback support following the passage of the Tax Act of 2017. However, this activity is generally starting to subside, while equity fundamentals are simultaneously beginning to show signs of weakness. Through the first half of 2019, S&P 500 companies posted a mere 2.6% YoY EPS growth, which is a steep decline from EPS growth of 22%. However, much of the 2018 earnings growth was as result of increased margins due to the corporate tax cuts.
Substantial deceleration in economic growth throughout much of the developed world, coupled with exacerbated trade tensions, has caused growth in international markets to lag the U.S. thus far in 2019, despite support from extremely dovish central bank policies designed to buoy global markets. Most international markets posted losses for the quarter, though they have managed to hold on to meaningful gains for the year. The MSCI All-Country-World Index (ex-USA), finished Q3 down -1.8%, but up 11.6% YTD. It’s also worth noting that three of the largest international markets, China, the U.K. and Germany all posted returns below the MSCI benchmark, up 7.8%, 10.2% and 10.7%, respectively. Emerging Market equities fell -4.2% during the quarter, up only 5.9% YTD in 2019.
Traditional fixed income assets have performed well thus far in 2019. The Barclays Aggregate Bond Index posted Q3 returns of 2.3%, up 8.5% YTD. However, much of the return has come from price appreciation, a symptom of falling interest rates, as well as increased demand as investors have begun to reduce their risk assets. As this trend continues, income from these investments is expected to decline, as lower overall rates result in lower interest income. Additionally, volatility among fixed income investments increased significantly in 3Q19. Yield on the 10-year U.S. Treasury was down 1.0%, with more than half the decline occurring in August alone. While this has helped to boost current bond prices, the increased volatility has slightly offset one of the primary benefits to fixed income securities – safety. Going forward, due to slowing growth and a dovish shift in monetary policy, bond yields are expected to continue to decline.
The 3-month/10-year treasury spread has been negative for the past four months, resulting in an inverted yield curve, a signal that typically indicates a recession on the horizon. However, as we pointed out last quarter, there are few factors that make the current inversion less reliable as a downturn predictor than is traditionally the case. To begin with, the current inversion is not as prominent has previous occurrences prior to recessions. Secondly, the yield curve inversion typically results from central banks reducing short-term rates to restrain economic growth. Contrarily, this occurrence is being fueled by a steep drop-off in long-term rates, which itself is usually a reflection of pessimism towards domestic growth prospects, but in this case is largely the result of downward pressure from overseas (Germany’s 10-year fell to negative 71 basis points in 3Q19). Finally, while previous expansions have primarily been fueled by business investment (CAPEX spending), the current expansion is largely being driven by the consumer. Mortgage rates are of more significance to the consumer, and those have increased slightly, but still remain relatively low compared to historical averages encouraging continued spending and adding fuel for the continued expansion.
While investors seem to be wavering between whether or not they think a recession is on the horizon, they appear to be missing the forest for the trees. Rather than view economic prosperity as a binary choice (recession or no-recession), investors should consider that one likely outcome going forward is sluggish growth that avoids a recession but still causes equity markets to recalibrate valuations, while bogging down yields to near historic lows. Although investors should be prepared for a bumpier ride into 2020, there are still reasons to be cautiously optimistic. It is important to remember that the majority of economic data still supports a continuation of the current expansion over the near to interm. term. That being said, decelerating growth trends and geopolitical risks are more prevalent than they were at the beginning of 2019.
Prudent investors should consider reviewing portfolio allocations with their fiduciary advisor to ensure alignment with their personal risk tolerance and goals. Further diversifying your investment strategy utilizing alternatives such as private equity, private credit, and real estate, may provide enhanced return and reduced volatility. As always, remembering to remain disciplined in the face of uncertainty and volatility is critical.
Around the Firm
In the 3rd quarter of 2019 the Integrity Financial family has continued to grow with the addition or our newest team member, Jordan Tuchek. Jordan joined the firm as an Operations Specialist and comes to us from Saturna Capital, where he spent 7 years establishing himself has an expert in project management, operations, and customer service. Beyond the value that Jordan has already added to our team, we are thrilled to announce that he and his wife Taylor will be expecting their first baby girl in February of 2020. We are excited to have Jordan on board and look forward to his contributions to the Integrity story.
We are pleased to announce that on November 19th, at the Woodmark Hotel in Kirkland, Integrity will be hosting an event on socially responsible and impact investing. Our principal, Kristofer Gray, will review the landscape of social impact and socially responsible investing in the wealth management industry. He will be reviewing best practices of asset managers, as well as the United Nation’s Sustainable Development Goals. Kris will discuss how private equity/credit managers are leading the way in this space and pioneering towards a more socially responsible investing environment. Furthermore, he will be conducting an interview with Gloria Nelund, CEO of TriLinc Global, and opening the floor for Q&A with one of the premier thought leaders in the social impact investing professional community.
Gloria Nelund was the CEO of the U.S. Private Wealth Management Division at Deutsche Bank, the world’s fifth largest financial institution. In this capacity, she held fiduciary responsibility for more than $50 billion in investment assets, including more than $20 billion in emerging markets and credit instruments. In addition to her role as divisional CEO, Gloria served as the only female member of the Global Private Wealth Management Executive Committee. Prior to her tenure at Deutsche Bank, Gloria spent 16 years as an executive at Bank of America, most notably as President and CEO of BofA Capital Management, Inc., managing $35 billion in assets for both retail and institutional investors. As the Founder and CEO of TriLinc Global, Gloria and team employ a disciplined ESG (Environmental, Social and Corporate Governance) screening process to assess a companies’ policies and practices as a way to mitigate certain potential risks. TriLinc’s impact tracking and reporting are designed to prove that capitalism can be used as a force for good. Since 2013, TriLinc has financed $1.1 billion in term loans and trade finance transactions to enterprises in 37 developing economies that resulted in the support of over 39,905 permanent jobs.
|Kristofer R. Gray, CFP®, CRPS, C(k)P®, MPA
|Andrew Mescon, MBA
VP of Strategy
Chief Investment Officer
Sources: JP Morgan – Guide to the Markets (9/30/19), FS Investments – Q4 2019 Economic Outlook, Federal Reserve – as of 9/21/19, Fidelity Investments – Quarterly Market Update Q4 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. The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions. There is no guarantee of the future performance of any Integrity Financial portfolio. Material presented has been derived from sources considered to be reliable, but the accuracy and completeness cannot be guaranteed. Nothing herein should be construed as a solicitation, recommendation or an offer to buy, sell or hold any securities, other investments or to adopt any investment strategy or strategies.