Economic Commentary | Third Quarter 2019

The stock market was on another wild ride during the quarter, with seven new highs on the S&P 500 in July as we entered the 121st month of this expansion, only to be followed in early August by the worst day of the year when the index plunged nearly 3%. The slowing global economy, on-again/off-again tensions over trade between the US and China, and easing by central banks around the world captured investors’ attention. For the quarter, the large cap S&P 500 index was the only benchmark to finish in positive territory with a return of +1.7% while our remaining benchmarks all dropped in value: the mid/small cap Russell 2000 index was down 2.4%, the international MSCI EAFE index was off 1.1%, and the emerging markets MSCI EM declined 5.1%.

Developments in the ongoing trade war between the US and China have been the primary driver of market returns for more than a year now, with investor sentiment swinging between optimism and pessimism over the negotiations between the two countries. The uncertainty created by the fallout from the rising tariffs has also led corporations to defer capital spending, as revealed in Duke’s most recent quarterly survey of global CFOs. The Small Business Optimism Index, published by the National Federation of Independent Businesses, similarly pointed to decreased business spending as a casualty of the trade war. Although there was an expectation that the 2017 corporate tax cuts would boost capital investment, this has not played out as the administration had hoped. As corporations have ratcheted back capital spending plans, global manufacturing has taken the biggest hit, with weakness originating in the Eurozone and China and then spreading to the US. By September, the US manufacturing sector contracted for the first time since 2016. While we can take some comfort from the fact that manufacturing only represents 11% of US GDP and 8% of US employment, weakness in the sector does have ripple effects on the broader economy.

The service sector, which makes up the vast majority of our economy, remains alive and well, thanks in large part to the strength of the US consumer. While we have all been disadvantaged to some extent by higher prices on imported goods, the strength of the consumer continues to power the economy forward. Retail sales have grown for six straight months, jobs have remained plentiful at modestly higher wages, the savings rate inched back up to a healthy 8%, and the housing market bounced back in September, with strong showings in housing starts, building permits, pending home sales, and new and existing home sales. The outlook for homebuilders has also been improving steadily, as prolonged low mortgage interest rates support buying activity. These recent economic reports all serve to bolster the US consumer and thus bode well for the near-term health of the economy.

Geopolitical tensions boiled over this quarter and weighed on investor sentiment, as Iran continued to needle the west; Boris Johnson attempted to drag the UK out of the European Union with or without a deal; political unrest in China was ongoing as it clamped down on Hong Kong’s relative freedoms; and the US House of Representatives launched impeachment proceedings against President Trump.

Reacting to this global instability and economic slowing, central banks around the world sought to prop up their economies with various forms of monetary stimulus. The Fed followed suit, tilting its policy toward accommodation with two ¼% rate cuts during the quarter. Though there is plenty of room to question these moves since we are below full employment with modest inflation (the twin goals of the Fed), Jay Powell sought to reassure Americans that, despite the drag from the trade war, his view of the economy remains positive precisely because he is using the tools available to him as the Fed’s Chair.

It is worth pointing out that the yield on the 30-year Treasury dropped below 2% in September for the first time ever, as market participants flocked to the quality of the US bond market while pricing in very low inflation for many years to come. The yield curve continues to periodically invert, with the yield of the ten-year Treasury episodically falling below that of the two-year Treasury during the quarter. Historically, this has been a fairly accurate predictor of a looming recession, though the time to recession as well as the duration of the recession vary quite widely.

As we head into the final three months of 2019, the October 31st deadline for Brexit is looming, the latest round of US-China negotiations has us all keenly watching for positive developments, and governments around the world are supplementing accommodative monetary policy with the fiscal stimulus of government spending. As we track economic developments, we are grateful that our managers have positioned their funds conservatively with a keen eye towards valuations and margin of safety.