The Road Ahead | Third Quarter 2019

Peter A. Sorrentino, CFA

Texas State Capitol building

The wild card for the closing months of 2019 will be the degree of strength exhibited by the US Dollar.



Third Quarter 2019 Review

Equity Market: Optimism Gives Way to Caution

Still riding the crest of optimism following the announced monetary policy easing by the Federal Reserve, the domestic equity market began the quarter in positive fashion but then lost ground because of renewed anxiety over trade tariffs and news that the German economy had contracted during the second quarter. This produced three subsequent declines in US stock prices in August followed by a recovery.

  • The most severe of the three sell-offs took the company indices down 3.24% from the beginning of the quarter.
  • The market then recouped these losses to finish the quarter with a gain of 1.6%. 

Reflecting their inherent volatility, small-company stocks were more adversely affected, declining roughly 7% in August after they too had rallied during July. Investor caution limited their September recovery, which left the segment at quarter’s end 2% below where it had begun.

Value holds its own versus growth. While size was a determining factor for 3rd-quarter performance, style was not. Unlike most of 2017 and 2018, growth stocks displayed a much smaller performance margin over value-oriented stocks – only 0.6% of an advantage, a fraction of the performance differential experienced in 2017 and 2018. Unlike prior periods, the decline in interest rates did not spark investor preference for growth over value. This was also evident in equity sector performance where defensive themes carried the defensive sectors over the cyclical and technology related sectors.

More defense. Further indicating a defensive shift in investor attitude and a resignation to lower-for-longer interest rates REITs, Utilities and Consumer Staples gained 7.5%, 8.5% and 5.8% respectively. Even within the former market-leading Consumer Durable stocks, we witnessed a shift to defensive leadership as Netflix, Discovery and Amazon gave way to Target, Dollar General and Newell Brands.

Energy and Health Care wobble. The biggest drag on the 3rd-quarter domestic market was the energy sector, falling 6.95% as US export volumes continued to flood the global market during a time of limited global growth. Even attacks on Saudi oil installations and the prospect of sanctions on Iran were not enough to parry the US onslaught. The only other area of material weakness in the US market was Health Care stocks, many of which continue to be under the cloud of opioid litigation and virtually all are subject to the political winds of an approaching national election.

Continued growth amid some cautionary news. Despite some softer economic data reports during the second quarter, the economy continued to deliver growth to jobs and wages. Housing and manufacturing data surprised to the upside and, despite the heated trade tariff rhetoric, US agricultural prices remained net positive for the year. These data support a continued constructive outlook for the US consumer, the principal driver of domestic growth, and therefore for the US economy.

To foreign returns, the dollar sustains headwinds. In international markets, similar to the behavior in the US, shares of the larger, more liquid markets performed better than those of the smaller, less liquid ones. When viewed in local currency terms, the Canadian, Brazilian, Columbian and most Western European equity markets scored low single-digit gains. For investors diversified globally, the relentless strength of the US Dollar has intensified the headwinds for gain, having risen between 3% to 7% against the currencies of its major trading partners during the period. Not that some of that weakness was not of their own doing. As previously stated, Germany appears headed into a mild recession, Brexit has devolved into a Parliamentary free-for-all, and Argentina has once again fallen prey to its darker angels, descending into political and economic disarray.

 

Fixed Income Markets: Continued Growing Demand

Municipal bonds buyers have poured a total of $68 billion of new money into the market, a relentless, if not unprecedented, 38 weeks of uninterrupted net inflows. Here’s why:

  • Unlike the first six months of the year, we saw a pickup in new issuance as issuers sought to lock in the lower rates afforded them by the Federal Reserve’s June 3rd change to monetary policy.
  • Investors sold stocks into the market declines and moved the proceeds to the comparative safety of Treasury obligations, driving down yields for the first half of the quarter.
    • By mid-August, however, the market was overbought, and rates rose gradually into the close of the period.
  • The new issuance corporate calendar picked up as CFOs sought to avail themselves of the lower rates, resulting in a slight widening in credit spreads as the supply of credits rose to better match the prevailing demand. 

Another quarter awash in red ink. The closing weeks of the quarter saw the first post-Crisis liquidity event as the Repo market required two weeks of Federal Reserve liquidity injection to help dealers cope with the swelling size of US Treasury auctions, fueled by the dramatic growth of the US fiscal deficit. By the end of the quarter, the US has issued twice as much debt as it did during all of 2017.

 

Commodity Markets: Mixed Bag

Most commodities lost ground during the period as trade concerns and a major correction by the USDA to US planting data roiled the markets.

  • As indicated earlier, energy markets were whipsawed by geopolitical issues ranging from new sanctions on Iran to attacks on Saudi oil facilities.
  • Energy prices were blunted by the continuing increase to US crude oil and natural gas production.
  • Among the metals, only gold and silver found traction as investors turned once again to these storehouses of wealth in response to the rising tide of global uncertainty, debt issuance and growth to the monetary supply.


RoadAheadCharts1_2

US Dollar: Continued Strength

The first exhibit shows how the currencies of key US trading partners fared relative to the US Dollar during the third quarter. The Dollar’s strength is a recurring theme, with these implications:

  • A positive for US consumers because it holds down prices on imports
  • A challenge for US industry relying on exports because it makes their goods and services more expensive to foreign buyers
  • An inhibitor to the returns of US investors on foreign holdings

The second exhibit provides a longer-term perspective on this issue. Since the bottom of the financial crisis, the US Dollar has been on an upward trajectory (except relative to the Mexican Peso). We believe this trend will continue for the foreseeable future and must be considered as creating a possible chilling effect on offshore investments.

 

Fourth Quarter 2019 Outlook

Equity Market: A Continuing Emphasis on Quality

We remain constructive on the US equity market in large measure for these three reasons, two of which relate directly to the US consumer, who accounts for as much as 70% of the national GDP:

  1. An accommodative Federal Reserve
  2. Record consumer employment
  3. Solid wage growth

As is our view regarding bonds, we are stressing quality over yield and attractive valuation over price momentum. At the same time, we are cautioning investors that unlike past late cycle markets, investors may not find comparative safety in traditional “Value” stocks as many of these one-time havens have been leveraging up to repurchase shares in order support share price. In the event of a sustained slowdown, the ability to support that debt, or refinance it, will become problematic.

This current environment of uncertainty will reinforce the market leadership – that of large-company stocks over small companies and domestic stocks over international. We look for US economic and corporate growth to outpace that of the other developed economies during the period and therefore expect US equities to deliver better returns.

Much hinges on the Dollar. The wild card for the closing months of 2019 will be the degree of strength exhibited by the US Dollar. A sudden weakening of the Dollar would be a boon for emerging markets and commodity prices and possibly enough to swing investor attitudes around domestic small-cap stocks. As it is, the strong Dollar is suppressing US inflation, which in turn supports the strength in consumer spending.

Beware bond surrogates. As interest rates rebound, we look for a cooling of investor demand for bond surrogates and encourage investors to be mindful of this when considering them or additions to them.

 

Sector Outlook

Consumer Durables and Consumer Staples: The recent upturn in housing activity should support both in the coming quarters thanks to the spending associated with residential sales.

Health Care: With a 2020 political season already underway that is focusing on health care, these companies will continue to fall prey to headline risk and, more importantly, a cloudier forward-earnings picture.

Technology: Share prices have weathered considerable volatility resulting from the point-counterpoint relating to trade – so much so that prices are becoming increasingly resilient and less responsive to the news flow. One caveat: The sector is ground zero for the struggle between the US and China, and, historically, combatants on trade battlefields have not fared well once the conflict begins in earnest.

 

Fixed Income Markets: Shakier Ground

Our major concern going forward is the deteriorating fundamentals of corporate credits and the magnitude of refinancing that the market will need to absorb over the next three years. The broader market has now begun to voice the same concerns in light of an increase in leveraged loans and the massive growth of BBB, a segment of the market that is barely investment grade.

Corporates. With demand for coupon yield still running strong, there has yet to be a significant widening of credit spreads in the market. We therefore continue to stress higher credit quality and shorter portfolio duration for corporate bond holdings.

Munis. With the unprecedented demand for municipal bonds now being met by rising supply, we expect appropriate yield differentials to be restored to tax-exempt debt. For anyone making any investment in bonds, we urge patience, prudence and a focus on credit quality.

 

Commodity Markets: Favorable Environmental Signs

Livestock: The ongoing slaughter of infected livestock in Asia holds the prospect of rising demand and prices for US livestock exports.

Soybeans and Corn: Because food prices, already a major concern to China, could be further aggravated by limiting the supply of US soybean and corn purchases, there appear to be cracks in the government’s prohibition of their imports – possibly a favorable development for US farmers.

Metals: Industrial metals appear to have established a bottom, and with improved industrial fundamentals, we foresee a gradual price recovery for the balance of the year. Precious metals, having consolidated recent gains, should continue to build on those gains and move higher in the coming year.

Energy: Barring the outbreak of armed conflict, the best we can hope for is a stabilizing of energy prices as US production growth is set to continue to expand into the opening months of 2020. LNG exports will continue to ramp up into 2021.
 

TRA

For a PDF version of this publication, click here: TheRoadAhead_3Q2019

Peter A. Sorrentino, CFA, Senior Vice President and Chief Investment Officer of Comerica Asset Management Group

Peter A. Sorrentino, CFA

Senior Vice President and Chief Investment Officer, Comerica Asset Management Group

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