The US economy continues to chug along thanks to the health of US consumers. A tight labor market with historically low unemployment has boosted household confidence that’s also feeling perhaps the final gusts from the tax cut tailwind. Accounting for roughly 2/3rds of US GDP, consumption has carried growth along trend as business confidence and investment spending slows. The trade war has been blamed, but it’s difficult to identify exactly why US businesses are not reinvesting into improving or growing operations. It has been apparent that corporations have chosen to return profits to shareholders in the form of dividends and share repurchases, though the latter has begun to slow. The final estimate of 3rd quarter real GDP growth came in at 2.1%, while the estimate for 4th quarter GDP has swung from a low in mid-November of 0.3% to the current estimate of 2.3%. Employment numbers and a narrowing trade balance provided a boost to the estimate, according to the Atlanta Fed GDPNow estimate. The NY Fed Nowcast model is still only predicting 1.2% for the 4th quarter.
A “Phase 1” agreement between the US and China, which had ridden a rollercoaster of likelihood, is now scheduled to be signed early in 2020. The finer details of the deal have not been released, though a roll-back of current and planned US tariffs in exchange for increased Chinese purchases of US agricultural products constitute the bulk of the agreement. There have also been reports that issues including intellectual property protection, forced technology transfers, financial market opening, and currency manipulation may be included into the initial deal, though reporting from Chinese and American sources differ in these areas. Protests in Hong Kong and US government’s reaction continues to be a risk to relations between the two sides when the next phase of negotiations commence.
Inflation measures remains subdued, to the chagrin of the US Federal Reserve (“Fed”), which has shifted policy from rather extreme quantitative tightening at the end of 2018 to cutting the benchmark federal funds rate three times in 2019. The Fed added that it expects to pause on rate adjustments through 2020 to spur enough persistent inflation of around 2%, and so far, market-based measures seem to agree. The Fed has also been adding needed liquidity to the financial system by intervening in short-term lending markets since the end of the 3rd quarter. The market for repurchase agreements, or “Repo’s”, has continued to be a source of stress in the form of liquidity crunch that has not been seen since before the financial crisis, with rates for the inter-bank lending operation spiking to 10%. The Fed has already lifted its cap from the original $75B, to $120B, and now $150B of available lending capacity per day while also considering permanent participation in the market. In addition, the Fed has committed to purchasing $60B in short-term Treasury bills per month at least until the spring, while insisting that it is not quantitative easing (QE). A breakout in US equity markets has, none-the-less, coincided with the non-QE expansion of the Fed balance sheet.
US equity indices stumbled slightly coming out of the gate in the final quarter of 2019 due to the release of the Institute of Supply Management Purchasing Managers Index survey that showed further deterioration of confidence in both the manufacturing and services sectors. This had a short-lived effect on markets, as rising participation and a 50-year low in unemployment showed that the pessimism from businesses wasn’t leading to layoffs. After that pullback in the first couple days of the quarter, equity markets hardly drew down on the way to the S&P 500’s best 4th quarter return since 2013. The more speculative investments, which hadn’t really shown the relative strength one would expect with markets near all-time highs, finally accelerated higher in Q4. Investors rotated out of what had been winning trades for most of the year, like Real Estate and Utilities, and into Technology and Consumer Discretionary stocks. The S&P 500’s 9.1% total quarterly return was the best since 2013 if you exclude the 1st quarter of this year, which saw the US large-cap equity bellwether offset the large drawdown from Q4 of 2018. Small-cap US equities performed even better during the quarter, as shown below, with the Russell 2000 Small-Cap Index gaining 9.9% in Q4.
Developed international equities (“DM”), such as Europe and Japan, underperformed their US counterparts, though still had solid returns as geopolitical headwinds relented. The SPDR S&P World ex-US ETF (SPDW) gained 8.2% as an end to the Brexit saga came into view after a general election delivered the mandate to the UK’s conservative party to move forward with the plan to split from the EU. Sluggish growth remains an issue in the manufacturing sector, while growth in the French economy surprised to the upside despite continued civil unrest and logistical disruptions spurred by workers opposed to planned pension reforms. Expectations for a more pragmatic approach from new European Central Bank President, Christine Lagarde, boosted the Financial sector, the largest of all sectors in Europe. A two-year downtrend for Financials had been occurring due to pressure by negative interest rates. With monetary policy on hold, the ECB has implored governments to expand fiscal stimulus in countries, such as Germany, that have the capacity to do so. The Japanese market, the largest single country weighting in DM, was higher on the quarter but underperformed after a dip late in the year. The Bank of Japan has recently kept its ultra-aggressive policies on hold, which have sparked liquidity concerns for Japanese equity ETFs, given that the central bank is the largest holder of these securities and could eventually look to unwind positions.
The Phase 1 agreement between the US and China has taken pressure off emerging markets, and helped emerging market proxy SPDR S&P Emerging Markets ETF (SPEM) outperform to a 11.8% return during Q4 (shown below). Also giving boost to emerging markets are the US Fed’s liquidity injections to short-term funding markets. The US dollar has stayed strong for most of the year and caused strain on the growth of many economies that rely on US dollars for funding and transacting. Now that the Fed balance sheet is expanding again to attempt to avert an US economic slowdown, the prospect for quantitative easing in the future recently put meaningful downward pressure on the US dollar. The combination of improved US dollar liquidity and improving prospects for a complete US/China trade deal may set the table for continued emerging market outperformance.
Broad investment grade bond indices were slightly positive on the quarter, driven by positive returns on short duration bonds and tightening spreads on corporate bonds. Longer maturity Treasury prices fell from their late-summer highs as the yield curve steepened due to the yield on the 10-year US Treasury Note rising towards 2% while shorter term yields were flat-to-lower. Long-term corporate bonds rose during the quarter due to spread compression insulating prices from the rising long-term yields. Even the most speculative CCC-rated sector of the corporate bond market saw inflows after largely being shunned for most of the year as investors insulated themselves from a default-prone corner of the bond market.
The market for floating rate bank loans, which has grown substantially in size in recent years as an alternative to corporate bonds, started to show relative strength versus traditional high yield bonds in Q4 after trailing for most of the year. Though most of the loans have interest rate floors, falling rates removed the allure of these products with a floating rate nature, but concerns regarding a rise in covenant light accommodations for issuers at the expense of investor protections had spread concerns that this market would be the first to crack in the event of a downturn.
Recent outperformance from historically the most speculative investments such as bank loans, small-cap equities, emerging markets, and CCC-rated corporate bonds may be a sign that the rally may be nearing a pull-back as “fear of missing out” inflates a possible blow-off top that could soon cause a rather nasty pullback. On the other hand, the Federal Reserve has given markets a taste of its willingness to intervene at the first sign of trouble in the form of liquidity issues in short-term funding markets. So, we will remain vigilant to avoid market turbulence while exploring potential opportunities to do what’s in the best interest for your investment portfolio, and as always abiding by our principles of Passion, Integrity, Vision, and Care.
Thank you for the opportunity to be of service and we wish you a Happy, Healthy, & Profitable New Year.
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