Pendleton Street Advisors


insight & investment commentary


Investment Commentaries: Second Quarter 2019

Index Returns 2nd Quarter Year to Date Trailing 12 Months
S&P 500 US Large Cap Index 4.3% 18.5% 10.4%
MSCI All Country World Stock Index 3.0% 13.6% 1.3%
Barclays Capital Aggregate Bond Index 3.1% 6.1% 7.9%
US Core Consumer Price Index - (Inflation) 0.4% 0.9% 2.0%

     *All figures as of 6/30/2019 unless otherwise noted.

Markets climbed higher during the second quarter, albeit at a more moderate pace than the first quarter.  Diversified client portfolios benefited from continuing strength in underlying holdings across asset classes. Last quarter we suggested that developments in trade reform and the Fed’s monetary policy signaling would be the primary market drivers in the near-term, and that has certainly been the case over the last three months.  Here, we briefly recap the quarter, and discuss our focus for the second half of 2019.

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Coming out of a -19.8% drawdown at the end of last year, the S&P 500 index came to within 3% of its previous high in the first quarter. During the second quarter, the index reached new highs four times. Many investors and journalists view this as an all-clear for markets in general, but the strength of the S&P 500 belies continued weakness in small-cap and foreign stocks which are still more than 10% below their August and January 2018 levels, respectively (see chart below).

A top-performing market-segment benchmark so far this year has been Real Estate, which consists almost-entirely of Real Estate Investment Trusts (REIT’s) traded on public stock exchanges -  a welcome change as the Real Estate sector began lagging the overall market significantly after the Fed began raising short-term interest rates in late 2015.


Interest Rates, Trade Wars, & Markets

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REIT’s have outperformed other sectors so far this year primarily because of the expectation that dividend-paying companies - as alternatives to lower-yielding bonds - will benefit  from a steady-rate environment that began when the Fed signaled in late 2018 that it would reduce and ultimately halt any further rate increases in 2019. That message has benefited dividend-focused sectors the most, but it was a catalyst for stocks in general to begin another leg-up.

The only substantial interruption to the market’s rise after the Fed began signaling a pause in interest rate hikes was when President Trump indicated on May 6th that trade talks with China were going poorly and threatened to raise existing import tariffs on $200B of Chinese goods from 10% to 25%. From May 3rd through June 3rd, the S&P 500 index declined by close to 7%. As the index was approaching its low-point for the quarter on June 3rd, a Fed official was also publicly discussing the possibility of a rate cut for the first time. The next day, Fed Chairman Powell confirmed that rate cuts were on the table. Stocks subsequently rallied through the end of the quarter.

While it is most-often a fool’s errand to attempt explaining the cause of market movement in the short-term, it seems impossible to ignore the influence that the Fed’s monetary policy and the Administration’s trade negotiations appear to have on the daily behavior of markets.  Significant market movements occur merely at the suggestion of a change in either interest rate policy or the status of trade talks with China. 

Only time will tell what the long-term impacts of these issues will be on global commerce and capital markets; but, it is clear to us that markets believe tariffs are bad and lower interest rates are good in the same way that a toddler believes vegetables are bad and ice cream is good.  The biggest difference: toddlers have parents - markets don’t.  

The Economy & The Business Environment

From our perspective, the biggest risk to portfolios of a prolonged trade war is a negative impact on business outlooks, which in turn influence companies’ appetites for continued investment in projects and people to drive growth and maintain profitability.

  • 43% of respondents to the McKinsey Global Outlook Survey say economic conditions have worsened in the last 6 months – up from 22% a year ago.  The last time responses approached this level of negativity was in September 2011 at the height of the European sovereign debt crisis.

  • According to the June CFO Magazine Global Business Outlook Survey, nearly half (48.1%) of US CFOs believe that the US will be in recession by the 2nd quarter of 2020 and 69% believe that a recession will have begun by the end of 2020.

  • The negative (“inverted”) yield curve (i.e. short-term rates lower than long-term rates) on US Treasury bonds that began in April has continued into July. An inverted curve has historically preceded most economic recessions.  But as we discussed in last quarter’s commentary, recessions have historically begun anywhere from 5 to 18 months after the yield curve inverts.  According to that range, the inverted yield curve suggests a recession will begin sometime between September 2019 and October 2020.

Some leading indicators are showing signs that declining optimism is already influencing economic activity. Indicators such as the Architectural Billings Index, Cass Freight Index, and US Manufacturing and Service Purchasing Managers Indexes (PMI) have deteriorated significantly year-to-date.

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US Manufacturing PMI in particular has shown considerable weakness so far this year, but unlike Global Manufacturing PMI which has drifted into contraction territory (PMI of less than 50 indicates contraction), the US index has remained above 50 indicating continued expansion.

Declining sentiment and weakening leading indicators are concerning, but high-level indicators still suggest a healthy economy: growth in Personal Consumption Expenditures (representing around 70% of GDP) continues at a healthy pace, consumer sentiment is strong, and the Unemployment Rate and Jobless Claims remain low by historical standards.

There are pockets of the economy that indicate slower growth going forward, but by most traditional measures the current likelihood of a recession in the next six months remains low.

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A recession requires falling GDP (i.e. a negative growth rate) for at least two consecutive quarters. Economists participating in the WSJ Economic Forecasting Survey expect 2.2% GDP growth in 2019, compared to 3.0% last year. Similarly, the Federal Reserve Bank of Atlanta’s GDPNow indicator suggests 1.3% growth in GDP for the second quarter, compared to 4.2% growth in Q2 of 2018.

The overwhelming message is that the economy is growing… SLOWER. But slow growth is nothing new: at 121 months with 2.4% annualized GDP growth, this may be the longest post WW-II economic expansion but it has also been the slowest.

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Bottom Line: Currently, the economy and corporate profits are still growing, profit margins remain healthy, and valuations are broadly reasonable. That said, unless the clouds of slowing global productivity, worsening business confidence, elevated volatility, and an inverted yield curve dissipate, we expect markets will eventually pick up on the gathering storm and run for cover.  

As we watch for developments in the broader environment, we will continue to assess and adjust holdings based on quality and value, which we believe to be the best indicators of a company’s ability to thrive in the good times and stand firm against challenges. We value frequent communication with our clients to discuss changing conditions and to ensure that we understand and stay updated on your objectives. We do not take lightly your patience or the trust you place in us as advisors, and we look forward to speaking with you soon.

Matt A. Morley, CVA, CEPA
Chief Investment Officer