Commentaries
Economic and Market Overview: Third Quarter 2019
The following commentary summarizes prior financial market activity, and uses data obtained from public sources. This commentary is intended for one-on-one use with a client’s financial advisor only, as a resource to manage assets and evaluate investment portfolio performance.
The Economy
The US economy’s growth slowed modestly in the quarter. The Bureau of Economic Analysis reported its third estimate of second quarter 2019 gross domestic product (GDP) of 2.0%, in line with the prior estimate, but lower than the first quarter’s 3.1% reading. The employment situation moderated further in the latest month, with an average of approximately 156,000 jobs added each month of the quarter. The unemployment rate held steady at 3.7%. The Federal Open Market Committee (FOMC) modified its interest rate policy by lowering the federal funds rate target two times, to a range of 1.75% to 2.00%. Economists expect the FOMC to lower the fed funds rate at least once more by the end of the year.
The global economic environment continued to decelerate, driven by trade uncertainty, the lingering questions regarding how Brexit will be resolved, and heightened geopolitical risks. Eurozone economic growth slowed after growing in the prior two quarters, led by a decline in household consumption. China’s economy has also decelerated significantly since the onset of the trade frictions with the US. The country’s most recent real GDP growth was and annualized 6.2%, the slowest rate in 27 years.
Highlights and Perspectives
GROSS DOMESTIC PRODUCT (GDP)
The Bureau of Economic Analysis released the third estimate of the second quarter 2019 real GDP, a seasonally adjusted annualized rate of 2.0%, lower than the first quarter’s 3.1% annualized growth, and in line with the prior estimate. It was the lowest annualized growth rate in the past eight quarters, with the exception of the fourth quarter of 2018. Trade issues were the primary driver of the quarter’s slowdown, but the effects of last year’s fiscal stimulus have also dissipated. Corporate profits rose by 3.8% (not annualized) during the quarter, while real disposable income rose by 1.8%. Economists pointed to the fading benefits from 2018’s deficit-financed tax cuts and the Trump administration’s trade war with China and other trading partners as being the key reasons for the slowdown, as they combined to undermine business sentiment. Some analysts estimate that the trade war with China has resulted in a reduction in real GDP of 0.3 percentage points, and a loss of 300,000 jobs. Since the economic impact of the trade war arguably has been worse for China, economists hope that some sort of rapprochement may be in the offing, particularly as President Trump heads into an election year.
HOUSING
The housing segment continued its steady improvement of the past nine months. One of the primary reasons for the recovery from the 2018 drop is the decline in mortgage rates, which have fallen approximately 120 basis points since November 2018. Existing-home sales for August (the latest monthly data available) grew at an annualized rate of 5.5 million units, 1.3% higher than the results from July, and up about 2.6% from year-ago levels. The inventory of existing homes was at about four months of supply, in line with levels of the prior year. Existing-home prices in August increased 4.7% from August 2018. In the new-home segment, the NAHB Housing Market Index, a measure of homebuilding activity, ended the quarter at 68, slightly higher than both the prior month’s and year-ago levels. The data indicate that homebuilders are very positive on the outlook for the housing market.
EMPLOYMENT
The employment situation deteriorated somewhat in August, continuing the slowing experienced much of 2019. Employers added 130,000 jobs during the month, below the consensus expectations of 158,000 new jobs, and below the prior month’s gain of 159,000. Waning business and consumer confidence resulting from uncertainty around frictions with various trading partners contributed to the lackluster gains in payroll growth. The three-month moving average actually rose modestly despite the lower-than-expected gains in August, coming in at 156,000. The unemployment rate in May remained at 3.7%, and the labor force participation rate rose to 63.2%, its highest level of the year. Average hourly earnings increased by 3.2% from the year-ago level.
FEDERAL RESERVE POLICY
The FOMC ended its recent September meeting by announcing that there would be a reduction in the federal funds rate target range to 1.75% to 2.00%. This was the second 25 basis point reduction in the quarter, following the one approved at the FOMC’s July meeting. The move was widely expected, and had been fully priced in to the market. For the first time since 2016 there were three dissenters on the committee, with one seeking a more aggressive cut of 50 basis points, and two others not seeing the need for a reduction. Economists viewed the cuts in the quarter as an insurance policy against further slowdown caused by trade developments. The consensus among analysts is that there will likely be one more reduction this year, perhaps at the FOMC’s October meeting.
INTEREST RATES
Fixed income securities’ prices and yields were buffeted by several factors during the quarter, foremost of which was the deceleration in economic growth resulting from the escalation in the trade war with China. Other issues prompting investor concern were the ongoing drama surrounding the UK’s Brexit decision, and geopolitical tensions with nations such as Iran. The FOMC responded to the moderating growth in the US by lowering interest rates twice during the quarter, bringing the target federal funds rate range to 1.75%-2.00%. The slowing growth produced a rally in bond prices, and a drop in yields. Economists expect this trend to continue, as seven FOMC committee members anticipate cutting the fed funds rate by an additional 25 basis points this year. The fed funds rate is now expected to end 2020 at current levels, as opposed to an expectation of 2.4% three months ago.
The Treasury yield curve continued to maintain a “trough” shape during the third quarter, with yields on the shortest- and longest-term maturities being higher than yields in the intermediate-term “belly” of the curve. Overall, the Treasury curve moved lower from the prior quarter. In addition, the yield curve briefly inverted during the quarter, meaning that the yield on the 10-year Treasury declined below the yield on the 2-year Treasury. Historically, yield curve inversions have predicted economic recessions 9-12 months in the future. Some analysts, however, point out that the current situation may differ from previous instances in that there is heavy demand for U.S. Treasury debt because of low (or negative) yields on sovereign debt issued by other nations. Such demand drives up the prices of the securities, and lowers the yields. By the end of the quarter, the yield on the benchmark 10-year US Treasury note was lower, ended at 1.67%, compared to 2.01% on June 30.
Interest rates spent much of July in a tight range hovering around the 2% yield level on the 10-year Treasury. In August, however, yields declined sharply as the trade war escalated. Yields bottomed out early in September after there appeared to be some softening of the trade rhetoric between the US and China. Investors also grappled with the seemingly never-ending Brexit theater, as the new UK Prime Minister, Boris Johnson, has so far failed to deliver a solution palatable to all parties. Geopolitical tensions also spiked during the quarter, as Iran responded to heavy economic sanctions by firing missiles at Saudi Arabia’s oil infrastructure. Against this backdrop, yields at the short end of the yield curve (up to three years) ended the quarter generally about 30-40 basis points lower than in June, while those on the longer end were lower by approximately 40 basis points. The yield on the 3-month Treasury Bill settled at 1.82% at the end of the quarter, down about 25 basis points from the end of the previous quarter. The yield on the 5-year Treasury Note ended the quarter at 1.55%, compared to 1.8% on June 30, and as mentioned above, the yield on the 10-year Treasury Note fell to 1.67% from 2.03% over the same period. At the same time, the yield on the 30-year Treasury Bond declined, ending the period at 2.11%, compared to its beginning level of 2.55%. Inflation expectations were somewhat lower, with the Fed’s gauge of five-year forward inflation expectations declining slightly from 1.80% on June 30.
Total returns on fixed income securities were positive across most of the market segments. The Bloomberg Barclays Treasury 5-7 Yr. Index rose by +1.7% for the quarter. The Bloomberg Barclays US Corporate 5-10 Yr. Index gained +2.4% during the three months. High yield securities, which often follow the performance of equities, climbed, posted a return of +1.3%. Municipals also rose, as the Bloomberg Barclays Municipal Bond Index gained +1.6% during the quarter. Prices of non-US fixed income securities were lower in the quarter, as the Bloomberg Barclays Global Aggregate ex-US Index declined -0.6%. Emerging markets bonds continued their positive trend, with the JPM EMBI Global Index gaining +1.3%.
DISCLAIMER The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this quarterly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions always should be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors, and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results. Information obtained from third-party sources is believed to be reliable but not guaranteed. Envestnet | PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing, and are subject to change at any time without notice. Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons, such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines, or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to their direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value, and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile, can suffer from periods of prolonged decline in value, and may not be suitable for all investors. Index performance is presented for illustrative purposes only, and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index. Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. Investors should conduct their own due diligence to ensure they understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and nontraditional instruments, such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks, such as merger arbitrage, long/short equity, convertible bond arbitrage, and fixed income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products use short selling, derivatives trading, and other leveraged investment techniques, such as futures trading, to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses. Neither Envestnet, Envestnet | PMC™ nor its representatives render tax, accounting, or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding US federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor. SR# 1222456 INDEX OVERVIEW The Dow or DJIA (Dow Jones Industrial Average) is an unmanaged index of 30 common stocks comprising 30 actively traded blue chip stocks, primarily industrials, and assumes reinvestment of dividends. The NASDAQ Composite is a stock market index of the common stocks and similar securities listed on the NASDAQ stock market. The S&P 500 Index is an unmanaged index comprising 500 widely held securities considered to be representative of the stock market in general. The DJ U.S. Select REIT Index is a subset of the Dow Jones Americas Select RESI and includes only REITs and REIT-like securities (The Dow Jones U.S. Select Real Estate Securities Index (RESI) represents equity real estate investment trusts (REITs) and real estate operating companies (REOCs) traded in the US). The Bloomberg Commodity Index is a broadly diversified commodity price index that tracks prices of futures contracts on physical commodities on the commodity market, and is designed to minimize concentration in any one commodity or sector. The MSCI EAFE Index is recognized as the preeminent benchmark in the US to measure international equity performance. It comprises the MSCI country indices that represent developed markets outside of North America: Europe, Australasia, and the Far East. The MSCI Emerging Markets Index is a free float-adjusted market-capitalization index that is designed to measure equity market performance in the global emerging markets. The MSCI ACWI Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of developed and emerging markets. The MSCI ACWI consists of 46 country indices comprising 23 developed and 23 emerging markets country indices. The MSCI Emerging Markets (EM) Eastern Europe Index captures large and mid cap representation across four emerging markets (the Czech Republic, Hungary, Poland, and Russia) countries in Eastern Europe. With 52 constituents, the Index covers approximately 85% of the free float-adjusted market capitalization in each country. The MSCI EM (Emerging Markets) Latin America Index is a free float-adjusted market-capitalization-weighted index that is designed to measure the equity market performance of emerging markets in Latin America. The MSCI ACWI Ex-U.S. Index is a market-capitalization-weighted index maintained by Morgan Stanley Capital International (MSCI) and designed to provide a broad measure of stock performance throughout the world, with the exception of US-based companies. The MSCI China Index captures large and mid cap representation across China H shares, B shares, Red chips, and P chips covering about 85% of this China equity universe. The Bloomberg Barclays Municipal Bond Index is an unmanaged index comprising investment-grade, fixed-rate municipal securities representative of the tax-exempt bond market in general. The Bloomberg Barclays Global Aggregate ex-U.S. Index is a market-capitalization-weighted index, meaning the securities in the index are weighted according to the market size of each bond type. Most US-traded investment- grade bonds are represented. Municipal bonds and Treasury Inflation-Protected Securities are excluded, due to tax treatment issues. The Index includes Treasury securities, government agency bonds, mortgage-backed bonds, corporate bonds, and a small amount of foreign bonds traded in the US. The Bloomberg Barclays U.S. 5-10 Year Corporate Bond Index measures the investment return of US dollar-denominated, investment-grade, fixed-rate, taxable securities issued by industrial, utility, and financial companies, with maturities between 5 and 10 years. Treasury securities, mortgage-backed securities (MBS), foreign bonds, government agency bonds, and corporate bonds are some of the categories included in the Index. The Bloomberg Barclays Capital US 5-7 Year Treasury Bond Index is a market-capitalization-weighted index, and includes Treasury bonds issued by the US with a time to maturity of at least 5 years, but no more than 7 years. The Russell 1000 Index is a market-capitalization-weighted benchmark index made up of the 1000 largest US companies in the Russell 3000 Index (which comprises the 3000 largest US companies). The Russell 2000 Index is an unmanaged index considered representative of small cap stocks. The Russell 3000 Index is an unmanaged index considered to be representative of the US stock market, and measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market. The Russell Midcap Index is a subset of the Russell 1000 Index. It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. The Housing Market Index (HMI) is based on a monthly survey of NAHB members designed to take the pulse of the single-family housing market. The survey asks respondents to rate market conditions for the sale of new homes at the present time and in the next six months, as well as the traffic of prospective buyers of new homes. The JPMorgan Emerging Market Bond Index (EMBI Global) tracks total returns for traded external debt instruments in the emerging markets, and is an expanded version of the JPMorgan EMBI+. As with the EMBI+, the EMBI Global includes US dollar-denominated Brady bonds, loans, and Eurobonds with an outstanding face value of at least $500 million. The CBOE Volatility Index (VIX) is an up-to-the-minute market estimate of expected volatility that is calculated by using real-time S&P 500 Index option bid/ask quotes. The Index uses nearby and second nearby options with at least 8 days left to expiration and then weights them to yield a constant, 30-day measure of the expected volatility of the S&P 500 Index. DEFINITIONS The Federal Open Market Committee (FOMC) is the monetary policymaking body of the Federal Reserve System. The federal funds rate is the interest rate at which a depository institution lends funds maintained at the Federal Reserve to another depository institution overnight. The European Central Bank (ECB) is the central bank for Europe's single currency, the euro. The ECB’s main task is to maintain the euro's purchasing power, and thus price stability, in the euro area. The euro area comprises the 19 European Union countries that have introduced the euro since 1999. The Gross Domestic Product (GDP) rate is a measurement of the output of goods and services produced by labor and property located in the United States. The Bureau of Labor Statistics (BLS) is a unit of the United States Department of Labor. It is the principal fact-finding agency for the US government in the broad field of labor economics and statistics, and serves as a principal agency of the US Federal Statistical System. The Bureau of Economic Analysis (BEA) is an agency in the US Department of Commerce that provides important economic statistics, including the gross domestic product of the US. It is a governmental statistical agency that collects, processes, analyzes, and disseminates essential statistical data to the American public, the US Congress, other Federal agencies, state and local governments, business, and labor representatives. The PCE (Personal Consumption Expenditure) Index of Prices is a US-wide indicator of the average increase in prices for all domestic personal consumption. Using a variety of data, including US Consumer Price Index and Producer Price Index prices, it is derived from personal consumption expenditures, and is essentially a measure of goods and services targeted towards and consumed by individuals. Sector performance is represented by the Global Industry Classification Standard (GICS) sectors, developed by Standard & Poor’s and MSCI Barra.
