For the week ending June 7
Further Evidence of Slowing Economic Growth
We have mentioned on multiple occasions over the past few months that economic data has continued to weaken. This past week’s employment report for May 2019 further substantiates prior claims we have made that the economy is slowing.
In May, Nonfarm payrolls increased 75,000 compared to a revised lower 224,000 the prior month. Thus far in 2019, monthly job gains are averaging 164,000 compared to 2018’s much higher monthly average of 223,000. On the inflation front, wages grew a tepid 0.2% in May and 3.1% over the past year. After annual wage inflation hit 3.4% in February, it has trended lower over the past few months. Whether you are looking at wage inflation or the number of monthly jobs added, the labor market has slowed down this year.
While the recent weakness in the employment data is concerning to some extent, Nonfarm payroll data can fluctuate dramatically over shorter time periods. What we have not seen, which was quite apparent in the final stages of each of the last three economic cycles, is a series of weak monthly job gains in succession with at least one month of a contraction in the labor market. The chart below provides an illustration of this phenomenon.
Monthly Nonfarm Payrolls
(30 Years Ending 5/31/19)
Source: FactSet, Inc.
The Dichotomy Between Equity Markets and Economic Fundamentals
It would be reasonable to assume that the Trump Administration’s ongoing global tariff threats, in conjunction with weakening economic data, would have wreaked havoc on equity markets over the first few months of 2019. Surprisingly, equity investors have been rewarded during the first half of 2019, despite higher stock price volatility as compared to the first 12 months of the Trump Administration.
The S&P 500 Index rallied last week – gaining 4.5% – and has now appreciated 15.7% year-to-date. Large cap domestic equities have been the market leaders so far this year. Gains have been less robust within other segments of the equity markets (domestic small cap, international developed, emerging markets). Despite recent news about fears over the antitrust debate involving several large cap technology stocks, the information technology sector has been by far the market leader in 2019, like the trend we saw in 2017.
So, why are stocks gaining ground despite all the negative headlines? The deal the Trump Administration made with the Mexican government last Friday regarding the suspension of tariffs helped quell fears about further deterioration of global trade relations. However, the prevailing consensus of a more accommodative Fed and expectations of future rate cuts appear to be the main driver of the recent strength in equity markets. It seems as if the “Fed Put”, or belief that central banks can rescue the economy, is alive and well at the moment.
Bonds Continue to Rally as Rates Fall
The precipitous drop in interest rates across the yield curve has perplexed many investors, including us. The chart below, which shows the interest rates levels for the 10-year U.S. Treasury bond, 2-Year U.S. Treasury note, and the upper end of the Fed Funds target rate, illustrates how significant the decline in rates has been over the past year.
Interest Rates Trailing One Year
(As of 6/7/19)
Source: FactSet, Inc.
The Federal Open Market Committee (FOMC) meets in mid-June and investors are placing more than a 30% chance the Fed cuts rates at this meeting. The more likely scenario, based on federal funds futures trading, is that the Fed cuts rates at its July 31 meeting. Either way, the market continues to look for the Fed to step in and provide some stimulus to support the ongoing U.S. expansion.
The trade-related escalations pose some unique challenges that could clearly hamper growth, at least over the near term. While some of the macroeconomic data shows a deceleration, deterioration toward a recession is not a forgone conclusion. The more likely scenario is that growth approaches levels (approximately 2%) we saw prior to 2018.
The second quarter earnings season commences in the next few weeks. Our investment team will closely watch for indications that recent trade rhetoric has begun to adversely affect corporate profitability. Our outlook for equities remains cautiously optimistic, but we realize there is some degree of optimism reflected in the prices of higher risk assets. Our concerns would heighten if credit spreads begin to materially widen, or if the Fed takes a less dovish stance in terms of the administration of monetary policy.
We would not be surprised to see an increase in equity market volatility, especially as the seasonally weak period of the markets approaches. The importance of maintaining a diversified portfolio cannot be understated, particularly to hedge against volatility flare-ups that can prey on investor emotions.