After declining more than 6 percent in May, stocks rallied in June to extend 2019’s strong advance. Bonds also gained in anticipation of Federal Reserve interest rate cuts. While second quarter economic growth probably slowed to less than 2 percent, the current expansion now registers as the longest ever at more than 10 years.
- WHY HAVE BOTH STOCKS & BONDS POSTED ABOVE AVERAGE RETURNS IN 2019?
Bond returns have been much stronger than expected, delivering a full year’s worth of gains in the first six months of the year. The primary driver of outperformance is the significant decline in interest rates tied to a growing expectation of Fed interest rate cuts. The benchmark 10-year Treasury note yield has fallen from 2.66 percent to 2.00 percent since the start of the year, pushing bond prices up. Given low current yields, bonds are likely to return less in the second half of the year.
Stocks continue to benefit from improvement in two key areas: trade negotiations with China and Fed interest rate policy. While the trade issues have yet to be resolved, news flow has been trending more positively. Meanwhile, the decline in interest rates caused stock valuations to rise. Markets have reacted positively to both of these developments.
- HOW ARE CORPORATE PROFITS HOLDING UP IN 2019?
Corporate earnings rose a modest 3 percent in the first quarter, and should post a low- to mid-single digit increase in the second quarter as well. The boost that tax cuts provided in 2018 is now being “lapped,” reducing the year-over-year growth rate. But with valuations at reasonable levels, even slower profit growth should allow stocks to continue their uptrend. Share buybacks continue to have a positive effect on earnings per share, while disruption caused by tariffs has been a negative offset in certain industries.
- WITH THE UNEMPLOYMENT RATE AT 3.7 PERCENT, WHY IS THE FEDERAL RESERVE CONSIDERING INTEREST RATE CUTS?
The economy appears to be on solid footing, with first quarter growth of 3.1 percent and unemployment at the lowest level in decades. Forecasters expect the longest expansion in history to continue for the foreseeable future. So why is the Fed considering interest rate cuts? The main reason is the economic damage and uncertainty caused by the ongoing trade conflict, which reignited in early May. This has caused economies to weaken around the world, especially in the manufacturing sector. So the Fed is considering “insurance cuts” to help the expansion continue, similar to what occurred in 1995 and 1998.
The bond market currently expects a total of 1 percent in rate cuts through next year. Subdued inflation gives the Fed room to cut rates. But this degree of easing has historically only occurred when battling recession. With the market expecting significant cuts, anything less might cause a market correction. On the other hand, if the Fed lowers rates too much, it risks creating a bubble and stoking inflation. While the Fed’s next move is very likely to be a cut, the degree and timing of additional action remains uncertain.
- WILL THE TRADE CEASE-FIRE LEAD TO AN AGREEMENT, OR WILL THE CONFLICT CONTINUE INTO NEXT YEAR?
Our base case has always been that an agreement will be reached, yet the conflict with China has persisted longer than expected. An argument could be made that the upcoming U.S. presidential election will prompt an agreement. Presidential election outcomes are heavily influenced by the strength of the economy, and the trade conflict has had a negative impact on that front. Another breakdown in negotiations, or more tariffs, would have a negative effect on the markets and economy. That scenario would likely create headwinds for the President’s reelection bid.
While this argues for a more speedy resolution to the conflict, there are still big differences to overcome. While an agreement is more likely than not by year end, the path to the finish line looks to be bumpier than first thought.
- INVESTMENT RETURNS HAVE BEEN STRONG SO FAR IN 2019—WHERE DO WE GO FROM HERE?
Year-to-date returns have been exceptionally strong. But remember that the majority of these gains serve to offset the significant declines from the fourth quarter of 2018. While the market is near record highs, so are corporate earnings, keeping the price-to-earnings (P/E) ratio at a reasonable 17 times 2019 expected earnings.
Market volatility has increased over the past year. The 19 percent decline in stock prices at the end of 2018 has been followed by a similar-sized rise in 2019. These extreme swings have largely been caused by the ebb and flow of two factors: the ongoing trade dispute with China and Federal Reserve interest rate policy. The latter has had the biggest effect on stock prices this year. When interest rates fall significantly as they have recently, the present value of future earnings rises. The result is that investors become willing to pay more for a dollar of earnings. This has translated into a rise in the forward P/E multiple for U.S. stocks from 14.5 to 17 since the start of the year. This expansion in the P/E multiple accounts for about two-thirds of the total rise in stocks this year.
The economy and corporate profits are still growing, albeit at a slower pace than last year. An environment of growth supports the prices of financial assets. Historically, a dovish Fed has also been positive for the markets. Having said that, returns in the second half of the year should be more modest than the first, as the adjustments in interest rates and valuation aren’t likely to repeat.
A number of external factors continue to move in and out of the headlines and have the potential to affect markets throughout the remainder of the year. Our economy also will eventually experience another recession—that is natural to the business cycle. But diversification offers protection, allowing investors to participate in the good times and weather the bad, all while progressing toward their long-term financial goals. Volatility can be unsettling, but it also affords some of the best opportunities to rebalance portfolios.
The investment environment will continue to evolve. For now we are maintaining neutral risk exposure in terms of asset allocation, while modestly increasing the quality of the bond portion of portfolios.
Have a great summer, and thank you for the confidence you have placed in the BKD Wealth Advisors team!
Jeffrey A. Layman, CFA® – Chief Investment Officer
Andrew Douglas, CFA® – Senior Portfolio Manager
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks and it should not be assumed that future performance of any investment or investment strategy or any non-investment related content will equal historical performance level(s), be suitable for your individual situation or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.