Trade wars, a global economic slowdown, and a recent cooling across U.S. economic data were overwhelmed by expectations for accommodative policy responses by global monetary authorities during the second quarter, unleashing a wave of investor asset-buying across the risk spectrum. Safe-haven assets, such as Treasuries and precious metals, posted handsome returns alongside solid performance from the risk corners of the marketplace, such as equities, high yield credit, and REITs. This somewhat confused market environment, in which both risk-on and risk-off asset categories experienced positive returns, occurred during a quarter that marked the longest U.S. economic expansion on record. Elsewhere in the markets, rising geopolitical tensions and an ongoing debate regarding the president’s influence on the (independent) Federal Reserve’s monetary initiatives helped drive volatility higher and likely contributed to the unusual market environment that characterized the quarter.
Recessionary Warning Signs Begin to Appear in the United States
Since early 2018, the global economy — excluding the U.S. — has been in the midst of a slowdown, much of which can be attributed to trade war-induced growth headwinds and capital outflows from international asset categories and into domestic equivalents.
Until the second quarter, the U.S. appeared to be resilient against this troubling global backdrop; however, over the past few months, the U.S. economy’s buoyancy has come under pressure, with incoming data suggesting the domestic economy may be in the early stages of succumbing to international weakness.
Initially, the housing market was the only major area of the economy that appeared to be slowing, as home price appreciation cooled to its lowest levels since 2012, mortgage application volume declined, delinquency rates appeared to have bottomed, and home affordability deteriorated.
Signs of more broad-based weakness surfaced in the second quarter, however, as the manufacturing and services sectors weakened to near contraction, previous labor market strength began to moderate. Despite mounting expectations for numerous cuts to the federal funds rate, most Treasury yield curve slopes had already inverted or were on the verge of inverting.
The European Central Bank, Bank of Japan, and Federal Reserve (Fed) have all responded to the unstable global backdrop by invoking dovish sentiment back into the market, which has aided in stemming what would presumably be an unfavorable market environment for incremental investor dollars.
Despite these policy efforts, recessionary fears continued to mount during the quarter, with market-based measures — such as the slope of Treasury yield curve, survey-based forecasts, and model-based estimates — reflecting an increasing probability of a U.S. recession on the horizon.
The Federal Reserve Bank of New York’s probability of recession 1-year ahead model, which is driven by the yield spread between 3-month Treasury bills and 10-year Treasury notes, ended the quarter at 32.9%, the highest probability of a recession in the upcoming 12 months as measured during any point of the current business cycle.
Over the past three cycles, each occurrence of a greater than 30% probability saw the U.S. economy tip into recession approximately 13 months later, on average. Consequently, a counterbalancing act between natural economic forces and the Fed’s best efforts at stalling an inevitable inflection from expansion to contraction is set to play out in the coming 12-18 months, with a U.S. presidential election also thrown into the mix.
To conclude, positive market performance was generated across nearly every corner of the liquid global investment universe, as both safe-haven and defensive sectors performed notably well alongside healthy returns from the opposite end of the risk spectrum. A critical set of events have the potential to transpire over the next 12-18 months, including the potential for a cycle turn, the return to accommodative monetary policy in the U.S., and easing conditions in other markets, in addition to the all-important 2020 presidential election.
Equity markets ended the second quarter strong after rebounding in June from a weak May. In the first half of 2019, the S&P 500 Index experienced its best six-month performance since 1997 and its eighth best since 1950.
All sectors in the U.S. market were positive for the quarter except energy. The energy sector posted a loss in the quarter amid a tense standoff between the U.S. and Iran over alleged attacks by Iran on oil tankers in the Gulf of Oman. Financials, materials and information technology were the strongest performing sectors due to favorable fundamentals.
In late June, market sentiment was buoyed after the U.S. and China agreed to restart trade talks, temporarily pausing tariff escalations from May.
The ECB announced intentions for further quantitative easing (QE) to induce economic stimulus. QE could provide a tailwind to risk assets in the euro zone, which has seen weak manufacturing and labor data in recent months.
Brexit uncertainties persisted in the UK over the quarter. Theresa May announced her resignation as party leader in early June, leading to an early transition of the nation’s leadership in July. The weakening of the pound against the dollar, on the back of weak PMI data, contributed to performance in the second quarter.
Japanese equities were adversely affected by a decrease in business confidence due in part to a proposed value-added tax (VAT) rate hike.
After a strong first quarter, global trade tensions induced headwinds for emerging markets performance in the second quarter. However, central banks in several emerging economies, including China, seemed prepared to push stimulus measures through to alleviate the slowdown.
The Fed continued its more dovish stance during the second quarter of 2019. Following the Fed’s June meeting in which rates were left unchanged, Fed Chair Jerome Powell highlighted the Fed’s intention to “act as appropriate to sustain the expansion” considering increased economic uncertainties, causing markets to anticipate potential rate cuts as early as July of this year. However, the strong jobs report released on July 5 slightly moderated expectations for a rate cut in the near term.
Additionally, the composition of the Fed may be shifting. On July 2, President Trump announced two additional nominees to serve on the Federal Open Market Committee (FOMC). Trump, who has on numerous occasions shared his views on monetary policy, has already appointed four of the five sitting appointed governors of the body.
10-year Treasury yields hovered at 2% at the end of June, after dropping over 40 basis points (bps) in the second half of the quarter as the market priced in potential rate cuts. While the 3-month/10-year spread remained in negative territory for a large part of the quarter, the 2-year/10-year spread nearly doubled quarter-over-quarter, increasing from 14 bps to 25 bps.
Although Japan has had lower yielding bonds for decades, the yield on the German bund — considered a benchmark for bonds in Europe — hit a historical low of -0.4% in July.¹ Additionally, French long-term bonds traded at 0% for the first time since inception in June and fell further in early July, drawing concerns that lower bund yields were causing investors to reach for yield elsewhere.
Weakening economic data in Europe caused the European Central Bank (ECB) to announce that it was considering several stimulus measures, including the resumption of its bond-buying program and further trimming of already negative rates.
¹ Bloomberg, L.P.
During the second quarter, U.S. REITs benefited from stable economic growth, low unemployment, and low interest rates, which provided a favorable environment for real estate. The largest gains within REITs came from the industrial sector, which continues to benefit from growth in online retailing. Self-storage, residential, and data centers also outperformed.
Oil prices continued to experience significant volatility during the second quarter due to concerns about the impact of trade wars on global economic growth and geopolitical tensions in the Middle East. Specifically, attacks on oil tankers in the Persian Gulf put upward pressure on prices, while concerns about record U.S. production and growing supply led to lower prices at quarter-end.
MASTER LIMITED PARTNERSHIPS
Midstream energy stocks benefitted from attractive relative yields and improving company fundamentals. Specifically, midstream companies now have lower leverage, higher distribution growth, and are less reliant on the equity markets to fund projects. The sector continues to attract private equity infrastructure buyers, as several midstream companies were taken private at a premium to their public values in 2019.
Mega deals in the U.S. set the pace for mergers and acquisitions (M&A) during the second quarter of 2019. Large U.S. companies took advantage of strong equity and debt capital markets to implement synergistic deals. The opportunity for M&A continues to be supportive given the strength of equity markets and the broader economy.
Trend following strategies enjoyed a strong quarter, mainly due to the emergence of trends in June. Long positions in interest rates and fixed income led the way, while long equity markets also contributed, following a rocky May.
Commodities were another source of profits for managers. Gold broke out of a recent trading band, climbing to its highest level since 2013. Lower global bond yields and a softer U.S. dollar sparked the rally. In addition, recent uptrends in crude oil aided performance due in part to increased U.S./Iran tensions and lower U.S. inventories.
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