Equity performance in the third quarter of 2019 was characterized by mixed returns and a high degree of volatility. The S&P 500 Index produced modest returns of 1.7%, while most other major indices generated losses. After reaching a new all-time high in late July, the S&P 500 fell 6.5% over the next three weeks, primarily due to concerns that a prolonged trade dispute with China could lead to a global recession. Small company stocks and international equities performed poorly during the quarter, as these market sectors are considered to be more vulnerable to an economic downturn.
The table below shows the performance of major equity indices for selected time periods.
Equity Performance for Periods Ending on September 30, 2019
|Total Return Index||Market Sector||Quarter||YTD||1-year||3-year||5-year||10-year|
|S&P 500||Large U.S. Companies||1.7%||20.6%||4.3%||13.4%||10.8%||13.2%|
|Russell 2000||Small U.S. Companies||-2.4%||14.2%||-8.9%||8.2%||8.2%||11.2%|
|MSCI EAFE||Developed Int’l Markets||-1.1%||12.8%||-1.3%||6.5%||3.3%||4.9%|
|MSCI EM||Emerging Int’l Markets||-4.3%||5.9%||-2.0%||6.0%||2.3%||3.4%|
In the middle of the quarter, the stock market demonstrated a high level of volatility as the outlook on the trade war with China changed on an almost daily basis. Over the 26 trading days from July 31 to September 5, the S&P 500 had 14 days in which it either rose or declined by more than 1%. Yet the total decline for that timeframe was just 1.2%, as the Trump Administration seemed to offset each report of negative news with a positive tweet or comment. Stocks declined when the administration announced it would be imposing more tariffs on September 1, but generally recovered with news that trade talks with China would resume in October.
The most obvious impact of the trade war is higher prices borne by U.S. companies and consumers as a result of tariffs. Economists from University College London and the London School of Economics have predicted that tariffs will cost the average American family $460 a year. Moody’s Analytics has estimated that the trade war with China has lowered GDP by 0.3% and has resulted in 300,000 fewer U.S. jobs being created.
According to Deutsche Bank Research, prior to the start of the trade war, the U.S. had the second lowest level of tariffs out of 14 major economies, including all G7 countries. Only Canada was lower. If all of the proposed tariffs are implemented, the U.S. will have the highest tariffs, surpassing current leaders Brazil and India, and more than double those of China. One must question whether the administration has gone too far in its effort to rectify trade issues with China and other trading partners.
Perhaps the most damaging effect of the trade war is that it has created a significant degree of uncertainty for businesses, leading many companies to postpone or curtail purchases of goods and services, or to delay investment in both foreign and domestic operations. Until the trade war is settled, it will be virtually impossible for many companies to determine how to source goods and where to produce their products. Much of the slowdown in the global economy is being attributed to this uncertainty, as well as to the inefficiencies already caused by the disruption to current supply chains.
It is impossible to predict how the trade dispute will play out. However, President Trump is likely to want major aspects of this issue resolved before going into next year’s election. The longer it goes on, the more likely it will have a negative effect on the economy, stock market, and President Trump’s chances for reelection. In our 2018 fourth quarter letter, we commented that since 1949, the third year of the presidential cycle has produced average total returns of 19.9%, about double the level of the other three years. There has never been a loss in the third year of the presidential cycle. As a presidential election approaches, we posited the party in power would attempt to stimulate the economy to gain favor with voters. With this in mind, we expect the current administration to attempt to resolve the trade war before it does more damage to the economy.
During the second quarter, the Federal Reserve twice lowered its key interest rate by 0.25% to a range of 1.75% to 2.00%. While employment and the housing sector remain strong in the U.S., manufacturing has begun to show signs of weakness. As it has done in the past several years, the Fed appeared to consider global economic conditions in crafting its monetary policy. Estimates for GDP growth in most major economies (including the U.S.) have been cut as the year has progressed. Foreign central banks have acted aggressively to stimulate their economies, resulting in a significant amount of foreign debt now carrying negative interest rates. However, even with a monetary policy intended to be very stimulative, a number of major economies, including Germany and Japan, are teetering near recession. Many analysts believe that only fiscal stimulus, such as infrastructure spending, will reinvigorate growth.
The trade war and slowing global economy have negatively impacted earnings for U.S. companies and has created an earnings recession. According to FactSet, S&P 500 earnings for the third quarter of 2019 are expected to decline by 3.7%, the third consecutive quarterly decline. Currently, analysts are forecasting 2.9% earnings growth in the fourth quarter and 10.6% growth for 2020. We believe that these optimistic estimates are likely incorporating the assumption that the trade war will be resolved in the near term.
Valuations for U.S. companies appear to be reasonable, although they are trending a bit higher than average. According to FactSet, the forward price/earnings (P/E) ratio of the S&P 500 currently stands at 17.0 versus a 14.8 average for the past 10 years. The higher P/E is somewhat justified by the low interest rate environment, which makes stocks relatively attractive compared to low yielding fixed income investments.
Looking ahead, we see equity returns as being highly dependent on the resolution of the trade war and partly dependent on the ability of the President to reach a deal with Congress on infrastructure spending, both promises of the Trump Administration that have not yet materialized. As such, the outcome of the next presidential election will likely impact markets. In the near term, stocks could rise sharply with the favorable resolution of the trade war and renewed optimism for global growth. On the other hand, a continuation of the trade conflict could cause further uncertainty, stall economic growth, and weaken corporate earnings, leading to a recession. Both outcomes are possible.
With interest rates declining in the third quarter, bonds generated relatively strong total returns. The Bloomberg Barclays Aggregate Bond Index, the broadest benchmark for the U.S. taxable bond market, produced returns of 2.3% in the quarter. During the quarter, the yield on the 10-year Treasury bond fell significantly from 2.00% to 1.68%.
Our portfolio strategy is not highly dependent on making predictions on government policy decisions, economic indicators, or the direction of the stock market, as numerous academic studies have shown such activities do not add value. No one has a crystal ball. Rather, we believe equity exposure should be determined by an investor’s risk tolerance, long-term objectives, and time horizon.
John D. Frankola, CFA Lawrence E. Eakin, Jr. Matthew J. Viverette
Vista Investment Management, LLC is a Registered Investment Advisory firm. Under no circumstances does this article represent a recommendation to buy or sell stocks. This article is intended to provide information and analysis regarding investments and is not a solicitation of any kind. References to historical market data are intended for informational purposes; past performance cannot be considered a guarantee of future performance. Neither the author nor Vista Investment Management, LLC has undertaken any responsibility to update any portion of this article in response to events which may transpire subsequent to its original publication date.