When I was younger, one of my favorite activities during a sick day or school shutdown day was watching game shows on television. I enjoyed the enthusiastic contestants, fun games, and high stakes on the line (high stakes for me at the time). A couple of my favorite shows were Family Feud and The Price is Right. In addition, I also enjoyed watching Let’s Make a Deal. In this show, contestants from the audience were selected to take part in various “deals” to win both cash and non-cash prizes. In some of the deals, contestants were offered the choice between a cash prize and a prize hidden behind a curtain. Behind the curtain typically was a new car or luxurious trip, but in some instances the prize was nothing more than a gag gift, such as a farm animal or some mundane household item, named a “Zonk.”
Watching the financial news last week, I couldn’t help but think of Let’s Make a Deal when the topic of the trade deal with China came up. On Friday, the major U.S. equity market indexes closed at all-time highs on positive news reports regarding the “phase one” trade deal with China. This is certainly good and welcome news; however, for the gains to hold and the U.S. equity market indexes to continue the ascent higher, more than just positive comments and optimism are needed. A tangible trade deal will need to be agreed upon and put into place relatively soon. Absent this, optimism is likely to fade, and recent news reports will turn out to be nothing more than a “Zonk.”
Our outlook for the U.S. economy remains unchanged. Our position for the duration of the year has been that we are witnessing a slowdown in U.S. economic growth with a low probability of recession. This is what has transpired, and recent economic data continues to support our position. Q3 real GDP was recently released and it came in at an annualized rate of 1.9%, down slightly from the 2% annualized rate of growth in Q2. As for other measures of economic activity, they are also supportive of continued, albeit slowing, economic growth. The Conference Board’s Leading Economic Index (LEI) came in at 111.9 in September and is holding near all-time highs. The labor market is still acting well with 128,000 jobs added in October. The unemployment rate at 3.6% is also at historically low levels. Inflation is well contained with the CPI increasing 1.8% year-over-year in October (Core CPI increased 2.3% year-over-year in October). Additionally, the services sector of the economy continues to perform well with the ISM Non-Manufacturing PMI (services) registering 54.7% in October, up from 52.6% in September. On the weaker side, the manufacturing sector of the economy has struggled under the weight of the trade conflict and tariffs. The ISM Manufacturing PMI registered 48.3% in October, below the key 50% level denoting expansion in the manufacturing sector. However, the reading was up from 47.8% in September, so we are on the lookout for an upturn in the manufacturing sector and U.S. economy.
In addition to the positive economic data cited above, the U.S. yield curve has recently un-inverted with the three yield spread measures cited in our previous article (Market Update – Barbarians at the Gate (August 26, 2019)) now positive. As of this writing, the spread between the Effective Federal Fund Rate (EFFR), 3-month yield, and 2-year yield, vs. the 10-year yield are .29%, .27%, and .23%, respectively. This is a positive development indicating an expectation of continued economic growth as we move forward. Moreover, the Federal Reserve (Fed) has provided additional monetary stimulus to the economy via three reductions in the Federal Funds Rate (FFR). At each of the three FOMC meetings in July, September, and October, the Fed cut the FFR by .25% (total reduction of .75%), bringing the range of the FFR to 1.50% – 1.75%, as of this writing. As we move forward, we expect the Fed to assess the impact of the recent reductions before taking any additional actions. As such, barring a material slowdown in the U.S. economy, we do not expect any further reductions in the FFR in 2019.
As for the U.S. equity markets, 2019 has been a very strong year. This is a welcome relief from the challenging conditions in Q4 2018. As of this writing, the Dow, Nasdaq, and S&P 500 are all trading at all-time highs with the Dow, Nasdaq, and S&P 500 up approximately 20%, 29%, and 24%, respectively, in 2019 (not including dividends). Some of the smaller U.S. equity market indexes, such as the S&P 400 & 600, have not performed as well as their larger brethren; however, gains are still respectable. The S&P 400 & 600 are up approximately 20% and 16%, respectively, in 2019 (not including dividends). As for international equity markets, some key markets have perked up recently. For example, the German DAX and French CAC 40 are up approximately 25% and 27%, respectively, in 2019 (not including dividends). Key emerging markets such as Brazil and India have performed well in 2019. The Brazilian Bovespa and India Sensex are up approximately 21% and 12%, respectively, in 2019 (not including dividends). As for Chinese equity markets, after a strong start to 2019 (January to April), the major equity indexes have been pressured given the trade conflict (tariffs) and a domestic economic slowdown. The Shanghai Stock Index and Dow Jones Shenzhen Index are up approximately 16% and 26%, respectively, in 2019 (not including dividends). As for Hong Kong, the Hang Seng Index has performed relatively poorly in 2019 given the protests and domestic unrest. YTD, the Hang Seng is up approximately 2% (not including dividends).
As we move into the final weeks of 2019, the U.S. economic and financial market backdrop is positive in our assessment. While slowing, the U.S. economy continues to expand at a modest pace and the probability of a recession still appears to be low. Moreover, the U.S. equity market indexes are performing well and international equity markets that have lagged for most of 2019 have perked up. Lastly, central banks worldwide, including the Federal Reserve (Fed), have reduced interest rates creating a favorable monetary environment. However, much of the recent optimism in the market appears to be predicated on a “phase one” trade deal with China. The optimism is justified, provided a tangible trade deal materializes in the near future. A “phase one” trade deal with China (including a rollback in tariffs) has the potential to set the stage for a rebound in economic activity, both domestic and international. If a trade deal fails to materialize, recent optimism is unjustified, and it is likely U.S. equity market indexes will fail to maintain current levels. From our vantage point, we don’t have a clear read on the outcome of the trade negotiations, and as such, we are positioned for a range of outcomes. While we are optimistic that a “phase one” trade deal will be reached, when the curtain is opened and the prize revealed, we don’t want to be shocked if a goat is staring us in the face.
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