Bucking the trend from the first two quarters of 2019, where positive returns were generated across most major global asset categories, third quarter market performance appeared less directional, as investors grappled with shifting central bank policy initiatives, mounting tensions between the U.S. and China, sharply declining interest rates, and weakening U.S. economic data, to highlight a handful of dominant themes.
The fundamental weakness since early 2018 that has plagued many of the U.S.’s primary trading partners bled further into domestic economic data throughout the quarter, with some measures pointing to the weakest U.S. manufacturing backdrop in a decade. This was partially counterbalanced by a historically strong labor market, including the lowest unemployment rate in 50 years. Importantly, both the Federal Reserve (Fed) and European Central Bank (ECB) took steps to ease monetary conditions during the quarter including the first Fed rate cut since 2008 and the announcement of a new round of quantitative easing by the ECB.
Despite a more accommodative monetary backdrop in the U.S. and euro zone—including forward guidance pointing to a continuation of this recent shift in policy—global equity performance for the quarter was tepid, with modestly positive returns generated in U.S. large cap, which outperformed both international developed and emerging market equities. A fragile global trade environment, including continued tensions between the U.S. and China and weak global trade related economic data, helped weigh on international equity performance during the quarter and year-to-date (YTD) periods.
Stylistically, U.S. mid cap and small cap value relatively outperformed their growth counterparts, while U.S. large cap value slightly underperformed growth. Sharp performance reversals among styles, market capitalizations, and geographies occurred in the first half of September, driven by (temporary) positive U.S.-Chinese developments and a related spike in U.S. Treasury interest rates. These short-term trend reversals proved short-lived, however, and moderated through the end of the quarter.
Bond returns were positive in aggregate, with rate-sensitive sectors, such as core bonds, modestly outperforming the credit-oriented sectors of the fixed income market. While credit spreads were little changed for the quarter, strong downward pressure on interest rates helped support the outperformance of the higher quality bond sectors, which tend to exhibit longer durations. The global economic trends that persisted during the quarter—pointing to slowing growth—helped send the yield on the 30-year Treasury bond to its lowest level on record, breaching sub-2% in late August. Record low long-end yields in the U.S. coincided with a new record share of negative-yielding global debt, which increased to more than $17 trillion, or roughly 30% of the global investment grade bond market. Fueling recessionary fears was an inversion of the widely-followed 2/10 Treasury curve slope, the first occurrence in the post-Global Financial crisis era.
In real assets, an accommodative interest rate backdrop and relatively stable real estate fundamentals helped support a strong rally across real estate investment trusts (REITs), which continued to be one of the strongest performing areas of the global investment universe. Energy prices spent the majority of the quarter in negative territory, but spiked mid-September following an attack on Saudi Ararmco’s processing facilities. Record U.S. crude oil production and global growth slowdown fears, however, helped to serve as a price ceiling on spiking oil prices, with West Texas Intermediate (WTI) crude concluding the quarter at $54.07, a decline of 7.5% from the second quarter. The announcement of the full restoration of production capacity by Saudi Aramco in early-October added to oil’s recent price woes.
Key Market Themes and Developments
U.S Economic Vulnerabilities Exposed
A dominant macroeconomic theme of 2019 thus far has been the sudden deterioration among many key components of the U.S. economy, most notably economically sensitive sectors. The fundamental weakness that has beleaguered many of the U.S.’s primary trading partners since the U.S. embarked its global trade rebalancing journey in early 2018 continued to seep into domestic data during the quarter, most notably impacting manufacturing-related data sets. In September, the Institute for Supply Management (ISM) reported the weakest manufacturing environment since 2009, as its manufacturing Purchasing Manager Index (PMI) sunk deeper into contraction territory.
The manufacturing weakness reported by the ISM was corroborated by the Bureau of Labor Statistics’ September Employment Situation report, which showed that the manufacturing sector shed 2,000 jobs during the month, one of just three negative monthly manufacturing job prints during President Trump’s time in office. However, the World Bank estimates that manufacturing comprises just 11% of overall U.S. gross domestic product—versus nearly 30% for China and South Korea, 21% for Japan, and 15% for the euro zone. Economies that rely on the services sector to drive GDP growth are presumably less sensitive to a continuation of global trade tensions, and vice versa.
Some market participants have shrugged at the deterioration taking place across the manufacturing base, accurately pointing out its relatively small share of the economy and the service sector’s disproportionately large share of aggregate GDP. However, the relationship between these two economic activity drivers appears strong. Comparing annual growth rates of the manufacturing PMI and the non-manufacturing (services) PMI shows a nearly 80% correlation since the inception of the services PMI in July 1997. The recent rollover, which stood less than three index level points away from contraction by the end of the quarter, should not come as a surprise and likely points to a continuation of slowing domestic GDP growth, which already cooled to a 2-year low through the second quarter.
Recent data suggests the U.S. may be succumbing to fundamental weakness abroad, which may partially be self-inflicted due to the Trump administration’s attempts at normalizing the global trade playing field. Forward-based measures of the potential for economic expansions to be sustained across the U.S., euro zone, and Japan—also known as the “G-3”—weakened considerably throughout the quarter, particularly in Japan, where annual growth across leading economic indicators (LEI) slid to -8.0% in August, the weakest reading since exiting the Global Financial Crisis. LEI growth across the euro zone, at -1.1%, cooled to the slowest annual pace since 2013, while the recent downward pressure on U.S. LEI growth has also intensified, with an apparent lag.
The G-3 Leading Economic Index Growth data series, which combines economic factors aimed at leading the business cycle—such as credit and labor market conditions, term structure slopes, and equity prices—points to dimming growth prospects for the world’s largest developed economies. With real GDP growth running near 2% in the U.S. and approximately 1% in the euro zone and Japan—and near-term growth rates potentially even softer—investors have turned their attention to policy makers’ responses and, perhaps more importantly, the means and scope by which these parties will respond to future downturns.
Policy Makers Dust Off Policy Easing Playbooks to Avert Slowdown Pressures
The Fed has been busy in the trailing 1-year period. After hiking interest rates in September and December of 2018, the Fed has completely reversed course, cutting interest rates at their July and September 2019 policy meetings, while also ending the balance sheet wind down process, or “quantitative tightening.” The 25 bp decrease to the federal funds rate in July was the first rate cut by the Fed since December 2008, in what Chairman Powell characterized as a “mid-cycle adjustment.” The Fed is no stranger to lowering policy rates in the middle of a business cycle, albeit from much higher starting levels, with recent examples including the mid-80s and mid-to-late 90s.
Market-based measures, such as pricing on short-term instruments—including federal funds and eurodollar futures—have incorporated additional Fed rate cuts over the next 12 months. Through quarter-end, for example, the fed funds futures market reflected a greater than 70% probability the Fed would lower interest rates by year-end, with eurodollar futures pointing to two additional rate cuts in calendar year 2020.
Anticipation for lower near-term policy rates should help moderate the pace of recent Treasury yield curve flattening, a theme that increased the specter of recession during the quarter. The commonly referenced 2/10 yield curve slope, which measures the yield difference between the 2-year and 10-year Treasury notes, inverted for the first time in the current economic expansion in August, before settling slightly higher to end the quarter with a positive slope. While not a perfect recession-timing tool, an inverted yield curve has preceded many prior recessionary environments.
The ECB took policy easing steps of their own during the quarter, announcing a lowering of the deposit facility rate by 10 bps to -0.50% and introducing a new quantitative easing (QE) program set to begin in November that will include monthly asset purchases of €20 billion/month. Already nearly 40% of the size of the overall economy and more than double the relative size of the Fed’s balance sheet, the ECB’s balance sheet is expected to expand further in the coming quarters.
Lower policy rates and asset purchases may not appease risk-seeking investors, however, as this growth stimulant now appears to be “old news” in the eyes of market participants. Moreover, already low interest rates and historically-elevated balance sheets likely limit the impact of further accommodative actions using these tools, potentially pressuring monetary authorities to resort to more unconventional and creative means to reverse the increasing number of growth headwinds facing economies around the world.
U.S. Interest Rates Drop to Near-Record Low as Global Negative-Yielding Debt Hits Record High
Fears of a global synchronized slowdown helped send already low interest rates even lower in the third quarter. In the U.S., the yield on the 30-year Treasury bond, which exhibits high sensitivity to changes in inflationary expectations, plunged to below 2% for the first time on record, buoying the performance of those asset categories that exhibit high sensitivities to changes in interest rates, such as long duration bonds, utilities, and REITs.
The benchmark 10-year Treasury note flirted with a record low yield as well, dipping to within 10 basis points of the all-time low established in July 2016 (1.36%). Just last year, concerns of a secular move higher in U.S. interest rates permeated the global investment community. Fast-forwarding to today, the opposite is true. Speculation has increased that U.S. nominal rates may join many developed countries abroad exhibiting zero, if not negative, rates of interest.
In a quarter that presented many new “records”—including long-end Treasury rates, the duration of the U.S. economic expansion, and the exchange rate value of liquid emerging market currencies versus the U.S. dollar—the amount of negative-yielding debt joined the party, pushing higher to more than $17 trillion of issuance. Relative to the size of the market, this $17 trillion stockpile of bonds with an attached negative nominal yield grew to 30% of the investment grade bond market before settling modestly lower to end the quarter.
What FEG believes is most disturbing about the immense downward pressure on U.S. (and global) interest rates is that the phenomenon has occurred outside of a sharp collapse in business activity or exogenous systemic shock. With a yield below 2% and a growing number of recessionary alarm bells, it is not outside the realm of possibility for negative interest rates to appear in the U.S. during the next downturn.
Following two consecutive quarters of positive returns across nearly every major global asset class and category, market performance in the third quarter exhibited less directionality, with muted-to-modestly-negative performance in global equities, solid returns in fixed income, and generally negative performance in real assets (ex-REITs).
Evidence of growth headwinds abroad was plentiful, but these pressures continued to surface in domestic economic data, including particularly weak manufacturing and industrial production data, downward pressure on service sector gauges of business activity and sentiment, and muted growth among leading business cycle indicators. Investors breathed a momentary sigh of relief in early October, however, when the BLS reported the lowest headline unemployment rate (3.5%) in 50 years through quarter-end—although this single data point, like most economic data, remains backward-looking.
On the policy front, the Fed lowered interest rates at their July and September meetings, with the July rate cut representing the first reduction in policy rates since 2008. The Fed was also forced to intervene in the Treasury repo market to ease liquidity strains, resulting in the first material increase in the size of their balance sheet since 2014. Market-based measures currently point to three more 25 bp rate cuts over the next 12 months. The ECB also took steps to increase the level of policy accommodation, including a lowering of the deposit rate and the announcement of a new QE program set to begin in November.
As the overall set of risks have remained tilted to the downside and market performance has greatly exceeded expectations to-date, FEG has tempered its enthusiasm for market performance over the cyclical horizon instead emphasizing a vetted suite of active managers with proven track records, the willingness to negotiate fee arrangements, and an ability to adapt and defend capital in challenging market environments. This discipline, combined with selective opportunistic exposures that offer attractive risk-return profiles, can provide a favorable stance for client portfolios to weather an anticipated volatile market environment over the next 12-24 months.
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Published October 2019
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