Subscribe for Ideas

FIRST MIDWEST WEALTH MANAGEMENT Q3 2019 MARKET OUTLOOK

Economic Outlook

 

2019

2018

2017

GDP1 U.S. Growth Rate

Q2: 2.0%      Q3:2.0%Est. 2019=2.3%Est.

2.90%

2.30%

Unemployment Rate

Sept. 3.5%

3.90%

4.10%

Payroll Additions2

Sept. 136,000
YTD: 1,447,000

2,679,000

2,153,000

Consumer Price Index

Aug. YOY: 1.7%

1.9%

2.1%

Employment Cost Index

Q2-19  YOY: 2.7%

2.9%

2.5%

Sources: 1 Bureau of Economic Analysis, Next GDP Release: October 30, 2019 

2 Bureau of Labor Statistics, Next Jobs Release: November 1, 2019

Mounting macro headwinds – The U.S. economy continues to grow despite global challenges that continue to impact the U.S. economy to some degree. In the second quarter, the economy grew at a 2% pace. The latest September projections of the Federal Reserve showed estimates for growth of 2.2% for all of 2019 and 2.0% for 2020. The economy has continued to add jobs, averaging nearly 161,000 a month in 2019. GDP growth this year has been led by the consumer and continued job growth has helped maintain consumer spending. Inflation remains low, with the Consumer Price Index at 1.7%. Low inflation has given the Fed increased flexibility to lower interest rates twice so far in 2019, with an expected third rate cut in October, as the latest reading implies the markets have priced in a 75% probability of another rate cut in October.

Global growth continues to slow, primarily due to on-going trade tensions. China and Europe continue to report slowing data in the latest retail sales and business surveys. In  response so far this year, 18 central banks around the world have lowered interest rates with the intention to provide more stimulus to boost growth. The OECD, or Organization for Economic Cooperation and Development Leading Indicator, a broad measure of global growth, has declined for 20 straight months and is 1.2% lower than a year ago; indicative of on-going sluggish growth.

With the record economic expansion now over 10 years, the incoming data reads are more critical this late in the cycle.

Growth can continue based on:

  • Monetary Stimulus. The Federal Reserve and other global central banks have signaled further easing of monetary policy. The Fed has repeatedly stated that they will act appropriately to sustain the economic expansion.
  • Trade Dialogue. The on-again/off-again Trade War with China continues, and negotiations are expected to continue in October.
  • Job Openings. There continues to be more job openings than unemployed individuals seeking jobs. This figure points to ongoing job gains in the months ahead with further support for consumer spending or 70% of U.S. growth.

Areas of  concern include:

  • Slower Business Surveys. Through the summer, levels of the ISM surveys continued to decline. Levels above 50 are indicative of ongoing expansion. The last two ISM Manufacturing surveys were reported under 50, and the ISM Services survey was slightly above.
  • Slower Business Spending. While the U.S. consumer has continued to spend, business spending has slowed. Uncertainty regarding the global economy including the Trade War has led to businesses showing caution in terms of business expansion.
  • Yield Curve. The Yield Curve remains inverted, as measured by the 3-Month T-Bill and the 10-Year T-Note. During the third quarter, the 2-Year Note, and the 10-Year Note also temporarily inverted. Historically, an inverted Yield Curve has preceded recessions. Despite 2 Fed cuts, the 3M and 10Y remains inverted. Recently, the NY Fed Recession Probability Model, which uses the Yield Curve, posted a worrisome reading near 38%. When the indicator has been above 30%, it has coincided with economic slowdowns.

 

Stocks

 

3rd Qtr

Returns

YTD

Returns

2018

Returns

2017

Returns

S&P 500

1.7%

20.5%

-4.38%

21.8%

Russell 2000 Index

-2.40%

14.18%

-11.03%

14.6%

NASDAQ Composite

-0.09%

20.56%

-3.88%

29.7%

International Developed Index

-1.07%

12.81%

-13.78%

25.0%

Emerging Markets Index

-4.11

6.20

-14.57%

37.3%

Source: Bloomberg

All about the U.S. consumer – The S&P 500 Index continues to reflect the strength and resiliency of the U.S. consumer. The S&P 500 Index is up 20.5% year to date, but the Index is up just 1.8% since May 1st. Since May, it’s been a story of the U.S. having trade war clarity with China, as central banks have provoked more questions of depleted arsenals, negative side effects, and whether monetary stimulus can counter trade uncertainty. The world is counting on the U.S. consumer and central banks to backstop further economic slowing. The lack of participation by other equity classes boils down to the relative safety and liquidity of the S&P 500 relative to slowing global growth, U.S. recession fears, and trade war consequences.

Earnings set to resume growth – Both 1Q and 2Q of this year, earnings were expected to see large y/y or year-over-year declines and posted better results. If we take at face value with the last 2 quarters of negative earnings growth, after 3Q’s decline this will be the first time the index has reported 3 straight quarters of y/y declines since Q4 2015- Q2 2016. The forward 12-month P/E ratio for the S&P 500 is 16.5, below the 5-year average of 16.6, but above the 10-year average of 14.8 according to FactSet. The bar is set lower for earnings growth as 2020 resumes the uptrend as earnings are expected to increase 10.5% off 2019 levels according to FactSet.

An indicator worth watching – The S&P 500 index is 3% off its all-time highs. The U.S. economy and U.S. stock market there is considerable co-dependence. If we look back to every recession and business cycle top since 1940, the S&P 500 dropped on average 9% 12 months prior to a business cycle top. Answering the question if the stock market discounts future economic activity, or the stock market drives economic activity, has no absolute answer. The risk of a near term recession will increase further if the U.S. consumer shows evidence of weakness, or if the S&P 500 falls another 4%-7% from its highs. As of now, the U.S. is experiencing an economic and corporate earnings slowdown.

Stock portfolios have continued to focus on overweighting U.S. large cap blue chip allocations over international allocations for both safety and performance. Relative to the past, we have a more balanced allocation of U.S. equity value and growth allocations at this point in the investment cycle with valuation spreads, higher levels of macro and market risk, and higher dividend yields for income and safety.

S&P 500 Operating Earnings Growth  is shown below.

 

Qtr 1

Qtr 2

Qtr 3

Qtr 4

Year

2017

14.0%

10.5%

6.6%

15.0%

11.0%

2018

24.8%

25.0%

19.3%

10.6%E

20.1%

2019

-0.3%

-0.4%

-4.1%E

2.6%E

4.1%E

2020

       

10.5%E

Source: FactSet

 

Bonds and Interest Rates

 

09/30/19

Yields

Qtr

Returns

YTD

Returns

12/31/18

Yields

12/31/17

Yields

3 Month T-Bill

1.81%

0.57%

1.81%

2.36%

1.38%

2 Year Treasury

1.62%

0.58%

3.03%

2.49%

1.88%

10 Year Treasury

1.67%

3.19%

10.87%

2.68%

2.41%

2-10 Year Spread

+5

   

+20

 

BB Int Gov/Credit

 

1.37%

6.41%

 

+53

Source: Bloomberg

Fed continues to tighten – Two 0.25% Fed rate cuts during the quarter in July and September,
deteriorating economic data overseas and in the U.S., and trade war rhetoric all  contributed to bond yields continuing their slide lower. The 10-year U.S. Treasury bond yield currently lower than the
3-month Treasury yield or the inverted yield curve since  May 23 suggests the Fed is still behind and more rate cuts may be prudent.

International drags to fade – Overseas, the ECB indicated there would be a “bazooka-like”
stimulus package to deal with weakening economic data in that region. There is now $17 Trillion in negative yielding sovereign debt throughout the world. A Reuters survey of over 100 Fixed Income strategists suggests yields will not rise for another 5 years. The 1 year forward looking yield on the U.S. 10-year Treasury is 1.8%, the lowest forecast in the 17-year history of the survey. The bright side is credit has not deteriorated in light of recent economic data. Corporations continue to take advantage of low interest rates by levering up their balance sheets and buy back stock with cash.  Investment grade corporate bond spreads remained steady, near record lows, at 1.15% and got as low as 1.08% in July. High yield spreads, or the different between high yield and treasury yields, narrowed by 0.04% to 3.73% from 3.77% a quarter ago.

Bond portfolios continue to focus on credit quality, duration (maturity) management, and issue structures that have floating rates and/or call features to hedge against periods of rising rates. Active bond portfolio durations should be 100%-110% of their benchmarks. Reinvestments should focus on the 7-10 maturities. Longer dated maturities will continue to outperform, should economic data continue to deteriorate, which will prompt recession fears. Sector allocations should be overweight Corporate bonds as interest rate spreads will compress further if interest rates continue to fall or investors continue to reach for yield.

 

 

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.