Q3 2019 Economic Update: The Great Wait

The Great Wait

We are now more than half way through 2019, and we believe the theme of this market has been headline risk. The consequence has been volatility in the market, which has made it very difficult for investors to identify an entry point in the market. The biggest dilemma for investors this year has been, “do I buy the dip or are conditions different this time?” The largest cloud over the market this year has been a trade deal with China and how that has been weighing on overall global demand. We reflect on this past quarter and try to reconcile the impact it may have on this quarter.

As a whole, the year to date performance of the S&P 500 has been terrific. If an investor had put their money to work at the beginning of the year and closed their eyes, they would be up roughly 18.5%.

Total Return: December 31, 2018 – June 28, 2019

Source: Factset

However, this chart down plays the anxiety that has crept into the market. As we discussed last quarter, the market essentially had a linear rise up in the first quarter with strong economic data as well as more promise about a U.S./China trade deal and the Fed staying out of the way by not raising rates. The 2nd quarter was nearly the reverse.

Overall, performance in the 2nd quarter was about average. However, the overall performance of the quarter does not paint a full picture. There couldn’t have been 2 different months in one quarter.

Total Return: March 29, 2019 – June 28, 2019

Source: Factset

May began flat but quickly deterioated once news broke that talks between the U.S. and China were breaking down. On top of that, President Trump raised tariffs from 10% to 25% on $200 billion worth of Chinese imports, banning China tech giant “Huawei” from doing business in the U.S., and China announcing tariffs on $60 billion worth of U.S. imports. The trade war heads winds that resulted coupled with the concerns of a global economic slowdown created a mass exodus in the market. The market gave back all the gains it had made for the quarter to that point and then some.

Total Return: April 30, 2019 – May 31, 2019

Source: Factset

Again, as we examined last quarter, the Fed became the headwind to the tailwind of strong economic data and a promising outlook for a U.S. and China trade deal. As May showed mixed economic data and the collapsing of a potential trade deal, the Fed began to foreshadow their willingness (re)adopt an accommodative monetary policy. It’s been approximately 30 months since the Fed began to raise the Federal benchmark interest rate from a range of 0-0.25% to 0.25-0.50%. If the Fed does begin to cut rates in July, it will be the longest the Fed has refrained from cutting rates in nearly 30 years. In the past 30 years, the fed began a series of rate cuts four times after a series of raising rates. Below is a chart that plots out all of the fed hikes and cuts over the past 30 years with a “+” representing a 25-basis point rate hike and a “-” representing a 25-basis point rate cut. I’ve circled the four instances where a cut occurred after a series of raises:

Effective Fed Fund Rates

Data from “Board of Governors of the Federal Reserve System”

As we discussed in our first quarter commentary, the fed uses this to either curb or enable inflation, depending on economic conditions.  As you will notice in the above chart, the average time gap between the first time the Fed raises rates and when it begins to cut rates is 12-18 months.  The only exception in the past 30 years was the period between June 30, 2004 and September 18, 2007.  That was the period where the Fed continued to raise rates, which totaled to 400 basis points.  As we know, the U.S. economy fell into the worst recession since The Great Depression.  The series of rate increases over that period of time was the response to moderate inflation of 3.4% (“Factset Economics”), which was largely influenced by what was a growing asset bubble in mortgages as we discussed in our first quarter commentary.  The other instance where the Fed blindly raised rates and cut too late was in June 1999, when it began to raise rates and did so to the tune of 175 basis points before cutting rates in January 2001.  In that instance, they were again responding to moderate inflation of 3.5% (“Factset Economics”), which was being influenced by the asset bubble of rising technology costs.  As the technology sector began to deteriorate, the heightened rates caused a liquidity crunch in the market.

1 Year Forward Return of S&P 500 After Rate Cut

Data from “Board of Governors of the Federal Reserve System”

It took 5 years after the rate cuts of January 2001 and September 2007, respectively, to gain a positive annualized forward return:

5 Year Forward Return of S&P 500 After Rate Cut

Data from “Board of Governors of the Federal Reserve System”

We feel the above underscores the importance of not only how the fed acts but when and how aggressive. At this point, we are in a very long period of no accommodative policy, however, what is buoying the situation is that we had nearly 7 years of accommodative policy, recent corporate tax cuts, and deregulatory policies put into place. These measures can only buy so much time, especially in the face of what appears to be a long trade battle with China. The market has shown how important Fed action would be this month as indicated by June’s performance:

Total Return: June 2019

Source: Factset

The fluidity of the market, as shown by the reverse impact each the trade deal and the Fed has taken from last quarter to this quarter, emphasizes how important it is to create a well-balanced portfolio, especially one that introduces quality and yield. A market that has just reached record highs and is caught between a rock and a hard place needs to be approached tactically. Even in a market and an environment such as this, we believe there are still plenty of opportunities for investors. Assuming the Fed does indeed cut rates, we believe the opportunities exist more so in domestic equities than fixed income.