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FIRST MIDWEST WEALTH MANAGEMENT Q2 2019 MARKET OUTLOOK

ECONOMIC OUTLOOK

Global Growth: Slowing Down

Growth & Jobs

2019

2018

2017

2016

2015

2014

2013

GDP*

Q1:3.1% Q2: 1.8%E (2019=2.5%E)

2.90%

2.30%

1.60%

2.90%

2.60%

1.70%

Consumer Spending

Q1:0.9% Q2: 2.7%E (2019=2.4%E)

2.60%

2.80%

2.70%

3.60%

2.90%

1.50%

Unemployment#

June: 3.7%

3.90%

4.10%

4.60%

5.00%

5.70%

6.90%

Payroll Additions#

June: 224,000 YTD: 1,033,000

2,679,000

2,153,000

2,318,000

2,729,000

3,006,000

2,302,000

Source: #Bureau of Labor Statistics (Next Release: August 2, 2019)

*Bureau of Economic Analysis (Next Release: July 26, 2019)

 

From “Patience” to “Insurance Rate Cuts” and from “Trade War” to “Trade Truce”

The U.S. economy has achieved a record-long economic expansion – over 10 years – after growing at 3.1% in the first quarter with estimates of 1.8% for the second quarter. In June, the Federal Reserve signaled that it is willing to provide conditions to continue that expansion, including lowering interest rates, after raising rates 9 times since 2015. A headwind to the U.S. economy remains slowing growth overseas. With inflation remaining low, and below the Federal Reserve target of 2%, the Fed has the flexibility to lower interest rates as needed. The Fed Futures, a market-based trading instrument, currently points toward a potential rate cut as early as the end of July.

 

The U.S. economy has slowed from the 2018 pace, but has proved to be resilient during prior periods of global slowdowns such as the European Debt Crises in 2011/2012 and the China/Emerging Market slowdown in 2015/2016. For now, the economy continues to add jobs, averaging around 172,000/month albeit slower than the 2018 pace of 220,000/month. In June, the Federal Reserve maintained its estimate of U.S. GDP growth for 2019 at 2.1% and 2% for 2020 (lower than the 2.5% Bloomberg consensus estimate).

 

Global growth has slowed with China dealing with the impact of the Trade War and Europe moving ahead at slow-to-stall speed. The OECD Leading Indicator has declined for 17 straight months, and is down -1.4% from last year. For the past 11 months, it has been signaling contraction (under 100). Similarly the JPMorgan Global-PMI is near 3-year lows. Consequently, the OECD lowered its estimate for global growth in May to 3.2% from 3.5% at the start of the year and the World Bank lowered their estimate for global GDP to 2.6% from 2.9%.

 

The Federal reserve has commented on the slowdown overseas, and the added uncertainty it creates in the U.S. economy. With the global economy slowing, inflation low, and wage- growth still relatively low, the markets now expect the Fed to lower rates in the coming months to support the ongoing economic expansion. This has been compared to an “insurance cut”; similar to 1995 and 1998 when the Fed lowered rates due to overseas economic shocks to maintain that (at the time) record long economic expansion.

 

Core Inflation Dips Lower: Providing Central Bank Flexibility

Inflation Measures

2019

2018

2017

2016

2015

2014

2013

Consumer Price Index (CPI)#

May YOY: 1.8%

1.9%

2.1%

2.1%

0.7%

0.8%

1.5%

Producer Price Index (PPI)#

May YOY: 1.9%

2.5%

2.5%

1.7%

-1.1%

1.6%

1.2%

Core PCE*

May YOY: 1.6 %

1.9%

1.5%

1.8%

1.3%

1.9%

1.5%

Unit Labor Costs#

Q1-19 YOY: 2.1%

1.0%

0.4%

1.1%

1.8%

2.0%

0.9%

Employment Cost Index#

Q1-19 YOY: 2.8%

2.9%

2.5%

2.2%

2.2%

1.9%

1.9%

Source: #Bureau of Labor Statistics 

*St. Louis Federal Reserve

With the record economic expansion now over 10 years, we will continue to monitor data including any further late-cycle slowing. Growth can continue based on:

  • Monetary Stimulus. The Federal Reserve and other global central banks have signaled easing monetary policy. Global central banks acknowledge the slowing data and have either lowered rates (China, India, Australia) or signaled a willingness to do so (U.S., Europe).
  • Trade War to Trade Truce. After a rocky month of May, the U.S. & China agreed to a temporary Trade Truce (no additional tariffs) and an agreement to have further discussions in the coming months. Trade Deals can take years to complete, not weeks.
  • Job Openings. There continues to be more job openings, than unemployed individuals seeking This shows a willingness for businesses to keep hiring.
  • Low Inflation. remains low, with the Consumer Price Index at 1.8%; giving the Fed flexibility to cut rates if/when needed.
  • Other Record Long Expansions. Other developed countries have experienced longer economic expansions than the current U.S. expansion (Australia & Canada) and other developed countries have had even lower unemployment rates than the current U.S. rate, (Japan is currently at 2.4%).

Areas of concern include:

  • Peak data. Some measures of economic activity have likely peaked this cycle (autos, home sales). For example, on a year over year basis, existing home sales have declined 15 straight months.
  • Confidence Leveling Off. Measures of business and consumer confidence remain at historically high levels, but are off the 2018 highs and may have also peaked.
  • Slower Capex. Measures of business spending have slowed. Some business spending may have been pulled forward into 2018, after the tax cuts. The Federal Reserve also commented that “indicators of business fixed investment have been soft”.
  • Yield curve. The yield curve remains inverted, as measured by the 3-Month T-Bill and the 10-Year T-Bond. Historically, an inverted yield curve has preceded recessions. If and when the Fed cuts rates, this could restore a more traditional positive-sloping yield curve. Recently the NY Fed Recession Probability Model which uses the yield curve posted a worrisome reading near 30%. When the indicator has been above 30%, it has coincided with economic slowdowns.
  • Divergent Data. The U.S. jobs report includes 2 surveys of job growth, the Non-Farm Payrolls report and the Household survey, and they tend to be correlated over time. While the Non-Farm Payrolls report has averaged a solid 172,000 new jobs/month in 2019, the Household survey has showed weak growth, at only 10,000 new jobs/month in 2019.

 

STOCK MARKET

Financial Markets Exhale After Last Year’s Tailspin

 

2nd Qtr

Returns

YTD

Returns

2018

Returns

2017

Returns

2016

Returns

2015

Returns

2014

Returns

2013

Returns

DJIA

3.20%

15.38%

-3.48%

28.1%

16.5%

0.2%

10.1%

29.7%

S&P 500

4.31%

18.54%

-4.38%

21.8%

12.0%

1.4%

13.7%

32.4%

RU.S.sell Mid Cap

4.13%

21.36%

-9.06%

18.5%

20.7%

-2.2%

12.3%

33.5%

RU.S.sell 2000 (Small)

2.10%

16.99%

-11.03%

14.6%

21.3%

-4.4%

4.9%

38.8%

NASDAQ

2.78%

14.73%

-3.88%

29.7%

7.5%

7.1%

13.4%

38.3%

International (Developed)

3.68%

14.02%

-13.78%

25.0%

1.0%

-0.8%

-4.9%

22.8%

Emerging Markets

0.61%

10.58%

-14.57%

37.3%

11.2%

-14.9%

-2.2%

-2.6%

Source: Bloomberg

The financial markets found added confidence that the U.S. Fed is preparing to reduce interest rates to support future economic growth. The U.S. Fed signal that it will follow other central banks by abandoning interest rate tightening policies sparked a continued rally in global equities. The U.S. stock market as measured by the S&P 500 Index hit new highs during the quarter, all other major stock market indexes are well off their highs as the stock market is torn between the final phase of a bull market or another slowdown in growth.

For 2019, the earnings growth has continued to be better than expected where analysts had been estimating a 4% decline for Q1 and the actual decline came in at -0.3% according to FactSet. Looking forward it appears the bar is set rather low for corporate earnings expectations given the widespread fears of slowing economic growth. Downward revisions for companies in the Energy and Financials sectors were driving the decline in Q2 estimates. The forward 12-month P/E ratio for the S&P 500 is 17.1, above the 5-year average of 16.5 and the 10-year average of 14.8 according to FactSet. The major concerns continue to be the earnings growth slowdown, a looming earnings recession, and sluggish global growth.

Shown below are earnings growth estimates for the S&P 500.

 

 

2017

Qtr 1

Qtr 2

Qtr 3

Qtr 4

Year

14.0%

10.5%

6.6%

15.0%

11.0%

2018

24.8%

25.0%

19.3%

10.6%E

20.1%E

2019

-0.3%

-2.7%E

-0.8E

6.0%E

2.4%E

2020

 

 

 

 

11.1%E

Source: FactSet

Outlook: U.S. and Foreign Central Banks Reduces Downside Risk; Growth Will be Upside Catalyst

Looking ahead, the path of least resistance seems higher:

  • The Fed rate cut signals, S.-China trade deal hopes, China stimulus traction, expectations of global growth bottoming and strong U.S. economic fundamentals give the bulls confidence.
  • Stock market volatility as measured by the VIX is close to 2019 lows and down 65% from last December as current sentiment seems to be the Fed will provide downside protection.
  • Further improvements in the world’s second largest economy as China continues to implement easy monetary policy and fiscal stimulus policies.

However, stock markets may experience higher volatility from a couple catalysts:

  • Further political uncertainty and further earnings growth slowdown.
  • A continued global slowdown and continued negative sentiment with unresolved trade talks.
  • Late stage investing as the cycle matures and a trade off between stock and bond valuations gives way to how much Fed intervention.

INTEREST RATES

Quarter: Lower by 30 to 50 bps Across the Board

 

6/30/19

Yields

QTR

Returns

YTD

Returns

12/31/18

Yields

12/31/17

Yields

12/31/16

Yields

12/31/15

Yields

12/31/14

Yields

12/31/13

Yields

12/31/12

Yields

3 Mos T-Bill

2.09%

0.64%

1.24%

2.36%

1.38%

0.50%

0.17%

0.04%

0.07%

0.04%

6 Mos T-Bill

2.09%

0.72%

1.39%

2.48%

1.53%

0.61%

0.48%

0.12%

0.09%

0.11%

2 Year Treasury

1.76%

1.47%

2.44%

2.49%

1.88%

1.19%

1.05%

0.67%

0.38%

0.25%

5 Year Treasury

1.77%

2.81%

4.73%

2.51%

2.21%

1.93%

1.76%

1.65%

1.74%

0.72%

10 Year Treasury

2.01%

4.23%

7.44%

2.68%

2.41%

2.44%

2.27%

2.17%

3.03%

1.76%

30 Year Treasury

2.53%

6.76%

12.04%

3.02%

2.74%

3.07%

3.02%

2.75%

3.97%

2.95%

2-10 Year Spread

+25

 

 

+20

+53

+126

+122

+150

+265

+151

Source: Bloomberg

Bond yields continued to drop in the 2nd Quarter. Global growth continued to slow as manufacturing PMIs continued to roll over throughout the quarter. There is now $12.5 Trillion in global debt with negative yields. Those countries include Germany, Japan, Sweden, Austria, and France.

Corporate bond and High Yield spreads tightened during the quarter. Corporate and High Yield debt continue to be the star performers year to date. Investment grade spreads tightened by 4 basis points to 115 on 6/28 from 119 on 3/29. High Yield spreads tightened by 14 basis points to 377 on 6/28 from 391 on 3/29. Corporates and High Yield were the best performing sectors year-to-date.

Other Fixed-income returns are posted below:

 

Q2-19

Returns

’19 YTD

Returns

2018

Returns

2017

Returns

2016

Returns

2015

Returns

2014

Returns

2013

Returns

2012

Returns

Treasuries

3.06%

5.29%

0.81%

2.4%

1.1%

0.8%

6.0%

-3.4%

2.2%

Agencies

2.31%

4.17%

1.38%

2.1%

1.5%

1.0%

3.4%

-1.8%

2.4%

Mortgages (Agency)

2.01%

4.30%

1.00%

2.5%

1.7%

1.5%

6.1%

-1.4%

2.6%

Corporates

4.33%

9.55%

-2.24%

6.5%

6.0%

-0.6%

7.5%

-1.5%

10.4%

Municipals

2.32%

5.33%

1.05%

5.4%

0.4%

3.3%

9.1%

-2.6%

6.8%

High Yield

2.55%

10.12%

-2.25%

7.5%

17.5%

-4.6%

2.5%

7.4%

15.6%

Source:  Bloomberg

Outlook: Rates Steady to Lower

Interest rates will be lower than 2018 for most of 2019:

Growth potentially slowing – U.S. GDP final read for 1st quarter came in at 3.1%. However, the strength came from those areas considered unsustainable. 1) Inventory growth (contributing 0.55% to the 3.1 percent overall rate) and 2) net exports (contributing 0.94%) skewed the quarter higher. Personal Consumption (typically ~70% of GDP) only contributed 0.6%. Business fixed investment was 0.61% and Government Spending was 0.48%. Sharp inventory growth made up for thin levels in prior quarters but, with inventories still rising in the second quarter raises the question; given the decline in consumer spending, will inventories begin to slow and pull down GDP. Net exports in the second quarter are clearly negative as imports are widening vs exports. Excluding both inventories and net exports, GDP on this basis (final sales to domestic purchasers) rose only 1.6% in the first quarter for 0.5% decline from the fourth quarter.

Inflation steady – Inflation data continues to remain tame. Core PCE, the Federal Reserve’s preferred measure of inflation, remains near 2.0% and forecasted out at 2.0% for the foreseeable future. The Consumer Price Index (CPI) came out on June 12th and slowed to 1.8% from 2.0%.

The yield curve, as measured by the 3-month to 10 year Treasury, inverted on 3/22 and was in negative territory until the Chinese Manufacturing surprised to the upside on 3/29. The yield curve inverted again on 5/23 following a weak durable goods order that fell 2.1% during April and the trade war escalated during May. As of this writing, the yield curve has been inverted for 30 straight trading days. While all inverted yield curves have NOT led to a recession, all recessions have been preceded by an inverted yield curve. The market has priced in a 25-50 bps rate cut in July and September. All else being equal, if the Fed did cut rates, the curve would be positive sloping or “normal”.

Fed “open” to rate cuts – On June 19th, the Fed statement acknowledged slowing growth and low inflation and indicated it may be open to cuts. The words “patient” and “transitory” were removed from the statement. Fed Chairman, Jerome Powell, walked back his forecast for hikes in 2019 to 0 from the original forecast “3, possibly 4”. The Fed sees one rate hike in 2020 and 0 in 2021. The Fed continues to reiterate that it is “data dependent” for all future rate hikes. We are of the view, with growth slowing from 3+% to just above trend, that GDP will be 2.3%-2.6% for 2019.

Feds Balance Sheet – The Fed announced an end to the Balance Sheet run-off back in May. The caps went down to $15 billion in May from $30 billion for Treasuries; $20 Billion caps remained in place for MBS securities. Anything more will be reinvested back in to short term Treasuries in order to shorten the duration of the Balance Sheet. The end of the run-off was supposed to be in September of this year. Ending this sooner could be a viable option to cutting rates before the Fed is comfortable.

Concerns that may change this projection and add volatility to credit markets include:

  • Global growth continuing to slow and the effects on U.S. growth.
  • The British breaking from the European Union (Brexit).
  • The Growth in negative yielding sovereign debt and the effects on U.S. rates.
  • Continued “trade war” rhetoric with China and parts of the European Union.

With consideration of the above, bond portfolios will continue to focus on quality, duration (maturity) management, and issue structures for added safety (floating rates, and call features). Active bond portfolio durations should be 95%-105% of their benchmarks.  Reinvestments should focus on a barbell type of strategy whereby the concentrations are in 0-2 years, and 8-10 years, depending on portfolio duration when maturities come due. We continue to prefer Investment Grade Corporate debt, up to 40% of the fixed income portfolio, over Treasury and Agency paper.

 

Past performance is no guarantee of future results. This commentary has been prepared for informational purposes. Information and opinions expressed herein reflect our judgment and are subject to change. Wealth Management services are offered through First Midwest Bank. Most wealth management products are not FDIC insured.