In a Nutshell
- U.S. Stocks solid in spite of tariff uncertainty. International stocks, not so much.
- Bonds in middle of a rough patch. The Federal Reserve isn’t helping.
- Econ 201 – The yield curve and threat of inversion
- Strong dollar impacts international stocks and (some) commodities
U.S. Stocks – Bucking the Trends
After the first quarter and its 10% correction, I’m sure more than a few investors thought about following the old market saw – ‘Sell in May and Go Away’. Historically, the May – October period has been the roughest for stocks. Add the fact that mid-term election years aren’t great for stock performance and who could fault the folks that were looking for the exits.
While history shows a poor 2nd quarter would not have been a surprise, it just goes to show that when it comes to investing, there are no absolutes. U.S. stocks overall were solidly up. Enough so that they reversed their losses from the first quarter and are now positive year to date. As in the 1st quarter, smaller companies continued to lead the way and growth stocks continued to outperform value and dividend paying companies. Most technology and energy companies had strong performances. Americans also continued to feel good about the economy and that was reflected in the outperformance of many retail stocks, in addition to perennial world beater Amazon. (Sources: JPMorgan, Russell Indices, Standard & Poors)
On the flip side, industrial and financial stocks struggled, with those sectors each lower by 3% for the quarter. (Source: Standard & Poors)
As mentioned last quarter, by most metrics the U.S. economy is currently running on all cylinders. Unemployment is at multi-generational lows, inflation is still low and corporate profitability is very strong. And the tax cuts enacted last December along with increased government spending will benefit companies even more as the year progresses.
Trade War on the Horizon?
Yet, there is one big risk to the economy; the threat of a trade war. In my opinion, the positive performance of domestic stocks in spite of this shows that investors are cautiously optimistic that the current talk out of Washington is just that, talk. The market is betting the comments coming out of the White House are more about gaining leverage in current and future trade negotiations. If threats of more tariffs turn into reality, however, that confidence will evaporate.
International Stocks – Tariff Worries and a Strong Dollar
As solid as U.S. markets were during the quarter, international stocks went the other way. While the U.S. seems to have shifted into another gear with it’s recovery, Europe and Japan (aka Developed Markets) continued to limp along. And emerging markets, China being the largest, went in reverse. Chinese stocks dropped over 14% during the quarter. While threats of massive tariffs on Chinese exports didn’t help, economic growth has been slowing as it becomes a more mature economy.
The strengthening U.S. dollar also played a role in the poor performance. For U.S. tourists traveling overseas, a stronger dollar is nice as it buys more international currency and makes the trip less expensive. When investing internationally, however, the opposite is true. If the dollar’s value goes up while holding international stocks, it then becomes more expensive to exchange the local currency back into U.S. dollars once those stocks are sold. And while you don’t have to exchange dollars into the equivalent Euros, Pounds and Yen before buying an international stock fund, this currency exchange gets reflected in the price.
Bonds – All Eyes on the Yield Curve
Bond investors, especially those who like to keep their ‘safe’ money in U.S. Treasuries and blue chip company bonds, saw their investments drop this quarter. Additionally, returns for these asset classes are now negative for the past year. I’ve discussed in past quarterly reviews how rising interest rates act as a headwind to bond returns. The Federal Reserve raised interest rates another 0.25% during the quarter, it’s 2nd increase this year. And it has told investors to expect continued slow and steady rate increases over the next 2 years so it looks like this will continue for a while.
As important as the threat of a trade war is to investor sentiment, recent developments in the bond market are just as important. In fact, if it wasn’t for tariff talk dominating the news flow, the financial headlines would be dominated by the yield curve and the threat of an inversion.
Positive & Inverted Yield Curves
If you’re not familiar with these terms, some fundamentals. The yield curve is nothing more than a graph showing the different maturities of U.S. Government bonds on the horizontal axis and their corresponding interest rate on the vertical axis. Normally, bonds with shorter maturities have lower interest rates than bonds with longer maturities. This is called a positive yield curve and is how the chart looks most of the time. Every now and then, however, the yield curve ‘inverts’, meaning that bonds with longer maturities pay less interest than those with shorter interest rates.
Why is an inverted yield curve so bad? Quite simply, it’s an accurate predictor of recessions. In fact, every recession since 1955 has been preceded by an inverted yield curve. (Source: San Francisco Federal Reserve Board). And as can be seen in the nearby chart courtesy of the Federal Reserve Bank of St. Louis, or FRED, the yield curve is getting close to inverting again.
So, does this mean a recession is imminent and a bear market is around the corner? Not necessarily. Just because long term interest rates are close to falling below short term interest rates doesn’t mean that they actually will anytime soon. Note in the chart that the yield curve moved sharply down and came close to inverting back in 1995. However, it didn’t invert until 5 years later. In the meantime, the stock market more than doubled in value.
Effects of an Inverted Yield Curve
And even when the yield curve inverts, it usually takes anywhere from 6 months to 2 years before the economy goes into recession (Source: San Francisco Federal Reserve Board). In the meantime, the stock market can continue to go higher. LPL Research reviewed the past 5 recessions and found that after the yield curve inverted, the stock market rose an average of almost 22% before peaking.
In conclusion, the flattening yield curve is something to keep an eye on. Just don’t get worked up over it yet.
Commodities & Alternative Assets – Dollar Strength
Alternative assets were a mixed bag. As with international stock performance, the strength of the U.S. dollar offers at least a partial explanation. By one measure the dollar was up 6% during the quarter versus other major currencies (Source: Invesco). A strong U.S. economy relative to Europe and Japan has been the primary driver of this trend, and it doesn’t look to change for a while. This is because the Federal Reserve is on a steady march to raise interest rates in response to continued economic strength. Europe and Japan have yet to show enough confidence in their economic growth to do the same.
As most commodities are globally priced in dollars, a stronger dollar has the effect of making them more expensive for other countries. While this will serve to reduce foreign demand, it is only one of many drivers that influence commodity prices. This is evident when looking at specific commodity groups. For example, oil prices were up 18% for the quarter while an index that tracks corn, wheat and soybean prices was down 11% (Source: Blackrock) Primary drivers for oil have been continued strong global demand coupled with supply disruptions in countries such as Iran and Venezuela. Conversely, agricultural commodity prices have been negatively impacted largely due to tariff threats along with multiple years of bumper crops.
Commercial real estate prices rebounded strongly during the quarter and are now flat for the year. Global Real Estate firm CBRE credits continued economic growth and perceived undervaluation by investors. New construction in recent years has also not outpaced demand (Source: CBRE)
What’s up with Gold?
One interesting thing to note is that gold prices were down for the quarter. The shiny metal is usually seen as a safe haven asset during uncertain times and most would agree the current trade situation qualifies. Is this the market’s way of telling us that the current tariff spat is a temporary phenomenon? We’ll have to wait and see.