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IWM Commentary August 2019


Global equity markets were negative across the board in August, as another month of trade tensions, geopolitical uncertainty, and recession fears quickly overcame any positive effects resulting from decidedly more dovish global central banks.

The MSCI All Country World Total Return Index lost 2.33% in August, with the S&P 500 and Russell 2000 Indices falling 1.58% and 4.94% on a total return basis, respectively. International equity market weakness was somewhat more pronounced than US weakness, as the MSCI EAFE Total Return Index shed 2.58% in August, while Emerging Market equities fell 4.85%.

The silver lining was that equity markets rallied the last several trading days of the month, primarily on the expectation of cooling trade tensions. On the whole, however, we think investors should be cautious of such trade optimism, and skeptical of news one way or the other—for some time we’ve been stuck in an apparently never-ending cycle aptly depicted in the chart below (source: StockCats).

On the fixed income side, bond markets continued their nosebleed-level rally in August, with the Bloomberg Barclays Global Aggregate Bond Total Return Index gaining 2.03% and the Bloomberg Barclays US Aggregate Bond Total Return Index gaining 2.59%. Year to date, these indices are up 7.42% and 9.10% respectively.

Yet not all that glitters is gold, as the saying goes, and there is evidence to suggest that bond markets have gotten ahead of themselves with this year’s sublime year-to-date gains. An August BlackRock report indicated that “approximately 75% of year-to-date returns have come from price appreciation with the balance coming from yield, i.e., carry… This attribution differs significantly compared to the previous 18 years when more than 80% of returns came from carry.”

In other words, today’s bond markets have borrowed from the future, and investors should not expect 2019 to be the new norm, despite more dovish central banks. Market participants must not forget that longer duration bonds are considered more risky than shorter duration bonds for a reason, even those backed by the full faith-and-credit of the US government—when interest rates rise, long duration bonds still take a beating, no matter how minimal the credit risk might be.

The recent flight to safety has been exacerbated by weak overseas growth and record-low (even negative in many cases) bond yields. A recent Wall Street Journal report noted how “foreign investors say they see American assets as a haven [and] bought nearly $64 billion of U.S. stocks and bonds in June, the largest sum since August 2018, according to the latest available Treasury Department data.”

Quite telling is the fact that, according to the latest Bank of America Merrill Lynch survey, over 75% of global equity managers believe US stocks are overvalued—yet they were still willing to pile client assets into US financial markets. Part of the reason for this, the survey suggests, is that 95% of the world’s investment grade yield comes from the US, and US equity markets still lead global equity markets in returns despite stretched valuations. It appears that the hunt for yield and the hunt for returns have led foreign investors to US waters, no matter what valuations are saying.

Investors and financial news outlets also fixated in August on the inversion of the US yield curve, specifically the 2 year-10 year spread turning negative for the first time since 2007. (In our estimation, it seems that many forgot or ignored the fact that 3 month Treasuries have been yielding more than 10 year Treasuries for over 3 months now, as the 3 month-10 year spread inverted in May). But while yield curve inversions have historically been harbingers of recessions, data shows that yield curve inversions do not mean immediate bear markets, nor do they herald the immediate onset of a recession. It should be noted that yield curve inversion is normally caused by the Fed hiking rates; in this situation it was caused by the Fed cutting rates. We can not find an example of this happening previously.

Data gathered by Tony Dwyer, Chief Market Strategist at Canaccord Genuity, shows that the median increase in the S&P 500 from yield curve inversion to market peak was a very respectable 21%, approximately 18.5 months after yield curve inversion. In the last downturn, according to Dwyer and his team, the S&P 500 rose nearly 25% in the 22 months from yield curve inversion to stock market peak. Of course, there is always a chance that this time really is different—an inverted yield curve may not guarantee a recession (especially with the unprecedented amount of central bank intervention this time around), and stocks may not rise following an inversion.

U.S. Economy

Turning to the US economy, the second estimate of second quarter GDP growth was revised lower to 2.0% annualized, down from the preliminary reading of 2.1%. According to the US Bureau of Economic Analysis, downward revisions included state and local government spending, exports, private inventory investment, and residential investment. These, however, were partially offset by an upward revision to personal consumption expenditures, as a strong US consumer continues to prop up the slowing corporate and manufacturing sectors.

US personal consumption posted its strongest quarter since 2014, rising 4.7%, vs. expectations of a 4.3% increase. Undoubtedly, strong consumption was driven by increased compensation, as the US Bureau of Labor Statistics reported in August that second quarter hourly compensation was up 4.8% quarter-over-quarter while first quarter compensation was revised upwards to 9.2% QoQ.

Yet despite a strong US consumer, there are emerging signs that these positive trends cannot continue in the face of trade tensions and equity market volatility. The University of Michigan, in its monthly survey of consumers, noted that consumer sentiment fell 8.7% in August from July, and 6.7% from August 2018. This month-over-month decline was the largest since December 2012, commented Surveys of Consumers chief economist Richard Curtin, who also noted that “unlike the repeated tariff reversals, negative trends in consumer sentiment cannot be easily reversed. The data indicate that the erosion of consumer confidence due to tariff policies is now well underway.”

On the manufacturing front, the final August US Manufacturing PMI, released by IHS Markit, came in at 50.3, up from the flash reading of 49.9 but down slightly from July’s print. The report, which pointed to very tepid growth in the manufacturing sector, was described by Chris Williamson, Chief Business Economist at IHS Markit, as the “lowest [reading] since the depths of the financial crisis in 2009.” Williamson also noted that “deteriorating exports are the key to the downturn… Many companies blame slower global economic growth for weakened order books, but also point the finger at rising trade war tensions and tariffs.”

In contrast to the IHS Markit manufacturing report, the ISM manufacturing report indicated an outright contraction in activity. The August reading came in at 49.1, down 2.1 points from July’s 51.2 reading, and marked the end of the PMI expansion that lasted 35 consecutive months. According to Timothy R. Fiore, Chair of the ISM Manufacturing Business Survey Committee, “Comments from the panel reflect a notable decrease in business confidence… Respondents expressed slightly more concern about U.S.-China trade turbulence, but trade remains the most significant issue, indicated by the strong contraction in new export orders.”

Corporate earnings for the second quarter were not as bad as originally expected, according to data gathered by FactSet. S&P 500 companies, 99% of which have reported to date, reported a decline in earnings of 0.4% in Q2, with topline growth of 4.0%. Third quarter earnings are expected to slide 3.5% with just 3.1% of revenue growth. For calendar year 2019, analyst consensus is earnings growth of 1.5% on 4.4% revenue growth—these numbers have been steadily worsening over the past several months.

A weakening business and corporate sector, in conjunction with a stable but possibly waning US consumer, has led many economists and financial institutions to call for more Federal Reserve rate cuts. At the time of writing, the CME Group’s FedWatch Tool has the market pricing in less than a 1% chance that the federal funds rate remains unchanged for the remainder of the year. Most believe the Fed will cut another 50 to 75 basis points over the course of their September, October, and December policy meetings.

The Fed’s own FOMC statements also confirm more cuts are likely this year. According to an analysis done by Canadian asset management firm Gluskin Sheff, “the number of times the FOMC minutes contained the words ‘risks’ or ‘uncertainty’ amounted to an unprecedented 69 times… [this] is actually more than what we saw at any meeting during the 2008-09 Great Recession.”

International Update

As the US economy continues to moderate, overseas economies bore the brunt of the global slowdown. In a somewhat similar position to the US, world consumer sentiment and world business sentiment have diverged by magnitudes not seen in years, as noted by Swiss financial group Pictet Asset Management. Both soft data—surveys, polls, PMIs, etc.—and hard data—inflation prints, GDP numbers, etc.—continue to reinforce the theme of moderation, which could quickly pivot to contraction (and has in some instances).

In the Eurozone, the IHS Markit PMI came in at 47.0 for August, a half-point improvement from July’s reading but still below the 50.0 no-change mark. IHS’ report commented how “Eurozone producers are suffering as the summer slump in factory production persisted into August. Although up on July, August’s manufacturing PMI was the second-lowest since early 2013, and a marked deterioration in optimism about the year ahead suggests companies are expecting worse to come.”

In late August, Reuters reported that German business sentiment deteriorated rapidly in the face of trade tensions and economic uncertainty. According to the Munich-based Ifo Institute, “there are ever more indications of a recession in Germany… the last time that industrial companies demonstrated such pessimism was in the crisis year of 2009. Not a single ray of light was to be seen in any of Germany’s key industries.”

The hard data also supports the notion that global economies are slowing; Germany, the Eurozone’s largest economy, contracted in Q2, falling 0.1% quarter-over-quarter. Though not in contraction territory (yet), the Eurozone also reported less-than-stellar GDP growth of 0.2% quarter-over-quarter (an increase of 1.1% versus Q2 2018). As more and more data points have come in, the European Central Bank has taken a notably more dovish stance and all indications point to incoming ECB head Christine Lagarde enacting considerable monetary stimulus when she officially takes control of the central bank on September 12.

In the Far East, the trade war continues to hurt some of the world’s leading economies. In mid-August, China reported industrial production, fixed asset investment, and retail sales numbers for July, all of which came in below economist expectations as polled by the Wall Street Journal. Trade tensions are undoubtedly a catalyst for weakening Chinese growth, as tariffs on Chinese imports have been increasing steadily since late 2017.

In addition, China’s underlying consumer is becoming increasingly reliant upon debt, which could be a major factor in a downturn as China’s economy continues to struggle. According to JPMorgan estimates, China’s household debt to GDP ratio will climb to 61% by 2020, up from 26% in 2010. China’s ratio of household debt to disposable income, another measure of consumer leverage, is at a staggering 117%, up from just 43% in 2008.

The Wall Street Journal notes that the increase in Chinese consumer debt is partly fueled by its growing youth cohort—those with lower annual incomes but strong appetite for financing out-of-budget spending. Some economists interviewed by the Journal believe “China’s slowdown could be exacerbated if young Chinese lose their jobs or see their wages cut and have to sharply curtail spending.”

Asia’s second largest economy, Japan, is feeling the effects not only from the US-China trade spat, but also from renewed tensions with its neighbor South Korea. South Korea recently decided to scrap a military intelligence-sharing pact with Japan, a move which Japanese officials have called a “failure to appreciate the growing threat from North Korea”, as reported by Reuters.

On the economic front, Japan’s July industrial production and retail sales offered mixed results, as production unexpectedly jumped (0.7% increase vs. -0.6% expected), while retail sales missed forecasts of a 0.7% decline, instead falling a full 2.0%. Manufacturing continues to struggle as well, as the August PMI reading from IHS Markit was little changed from July’s 49.4 print (49.3 in August), indicating a sluggish demand environment for Japanese manufacturers.

Reuters reports that “Japan’s government left its assessment that the economy is recovering at a moderate pace unchanged in August, with weakness continuing to center on exports,” indicating that trade tensions continue to wear on business demand. Adding to the uncertainty is the consumption tax hike that is to take effect in October—so far there is no indication that Japanese Prime Minister Shinzo Abe is planning on delaying this policy.

On the whole, August was a continuation of trends we saw in the second quarter and July of this year. Volatile financial markets, ongoing trade tensions, and dovish central banks stole headlines as investors pondered the sheer amount of negative yielding debt and slowing global growth. The bright spots, though few, appear to be resilient, chiefly a strong and spending US consumer—though market volatility and trade tensions are beginning to expose cracks in consumer confidence. As always, our investment team remains on high alert as we continue to watch these and many other data points and economic trends. Thank you for your continued trust and support.

David Young, CFA®
Chief Investment Officer, IWM, LLC

Brent Pine, CFP®, CPA
President & CEO, IWM, LLC

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*David Young is not affiliated with Geneos Wealth Management, Inc.
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