More Of The Same Please
US stocks rose 3.7% in the second quarter of 2019. Following the double-digit gain in the first quarter, the YTD return is impressive. The ascent pushed the S&P 500 to a new all-time high towards the end of the quarter, and the broad market index continues to flirt with record levels. The performance of bonds and success of stocks seem disconnected considering the yield curve inverted last quarter, flashing a recession warning. Yet is has been the softer economic data which put the Federal Reserve ("the Fed") interest rate increases on hold, an outcome well received by investors and one that enabled stocks to climb.
It is easy to fear a recession and it is tempting to become defensive when economic data softens. Yet in reality, economic data rarely point in the same direction and there is always some statistic to cite that validates a recession concern. A weight-of-the-evidence approach is more successful and preferred, but even then, the data is backward looking whereas investments are forward looking.
That said, the stock market remains one of the best leading indicators of the economy, and it is acting pretty well. For now, a confirmation of a recession is lacking. Yes, some data (like PMIs) are falling but that is likely the result of monetary tightening over a year ago. With the Fed currently taking a wait-and-see approach, we seek a confirmation from weaker data, a change in behavior from consumers and businesses, and/or a stock market correction before fearing a recession.
Thus far, evidence from consumers and businesses suggest fears of a recession aren’t strong either. The current readings on consumer and business confidence are up and confirm their positive sentiment. The latest consumer confidence results released by the University of Michigan rose to 98.2 at the end of the quarter, up from 97.9, and reside at a very healthy level. Home prices have also been strong, a key input into whether consumers feel capable of spending money, as lower mortgage rates have positively affected Spring sales. Unemployment rates are still low and business profit margins are historically high. Consumer confidence and corporate profitability are important gauges because a desire to protect profit or reduce spending can accelerate recessions. A siege mentality from either group can restrict economic activity.
Freedom from the Fed
The Federal Reserve has signaled its intentions to slow interest rate increases, and there is some speculation the next move might be a rate decrease. This is a sharp reversion from the four hikes expected heading into 2019 and a big reason why the market has been able to rally to new highs. While anything is possible, we are suspect of a rate cut being on the horizon anytime soon, as it seems unlikely the Fed would feel the need to cut rates with the S&P 500 at record levels and the housing market healthy. Given the lag time between when an interest rate increase actually weighs on the economy, it seems too soon to begin reversing rate hikes without the existence of a crisis or structural issue. Besides, it is only through time and reflection that people readily admit mistakes.
We still believe the Fed’s ultimate goal is to return interest rates to a level that would allow it to re-arm its toolkit. At depressed levels, its ability to affect monetary policy is compromised, thus the use of massive quantitative easing during the last economic crisis. The Fed is also slowly reducing the quantitative liquidity it introduced and seeks to return interest rates mechanics to full power.
Towards the end of the quarter, financial stocks helped boost markets and sentiment. The Fed had reviewed capital plans for 18 of the largest banks with minor tweaks. The positive review allowed nearly all of the banks monitored to either raise dividends, increase repurchases or demonstrate a solid growth in capital reserves. Since past bear markets have coincided with problems in the banking system, this is nice to see.
Apart from some initial salvos and posturing, the potential trade war with China continues as a trade skirmish. The market has experienced trade rhetoric based volatility on the status of talks or press releases, but this has obviously had little lasting effect. We remain skeptical of a full-blown trade deal for several reasons, but continued talks and/or delaying the imposition of tariffs appear enough to satisfy investors and rally the market. Even a compromised deal would go a long way to relieve uncertainty overhanging the market.
More of the Same
Going forward, it is likely more of the same. A mix of economic data that is healthy and less-healthy due to tightening in the system and issues in developing markets, a scattering of geopolitical flair-ups, political rhetoric, and trade salvos. Valuations are above average but not at historic extremes to exit equities. With buybacks and dividends growing, high levels of profitability, and an absence of inflation, valuations still look healthy.
Thank you for reading.
Robert Stimpson, CFA, CMT
Co-Chief Investment Officer & Portfolio Manager
Oak Associates Funds
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