Market Outlook October 2019

market Outlook October 2019

Highlights:

  • S&P 500 recorded a modest gain of 0.9% in the third quarter of 2019
  • Ten-year treasury rate dropped to 1.5% before bouncing back to 1.75%
  • S&P 500 dividend yield is now higher than the 20-year treasury rate
  • Manufacturing index hits contraction territory

Economic Overview

  • The US economy continues to show resiliency despite increased political uncertainty and lower business confidence
  • The consumer sentiment – The US consumer is going strong. Consumer sentiment reached 93 in September 2019. While below record levels, sentiment remains above historical levels. Consumer spending, which makes up 68% of the US GDP, continues to be the primary driver of the economy.
Market Outlook October 2019 Consumer Sentiment
Consumer Sentiment
  • Unemployment hits 3.5%, the lowest level since 1969
  • Wage growth of 2.9% remains above-target inflation levels
  • Household debt to GDP continues to trend down and is now at 76%.
Market Outlook October 2019
Household debt to GDP
  • Fed rate cuts – Fed announced two rate cuts and is expected to cut twice until the end of the year.
  • The 10-year treasury rate is near 1.75%
  • The 30-year mortgage rate is near 3.75%
  • While low-interest rates and low unemployment continue to lift consumer confidence, the question now is, “Can the US consumer save the economy from recession’?
  • The probability of recession is getting higher. Some economists assign a 25% chance of recession by the end of 2020 or 2021.
  • The ISM Manufacturing index dropped to 47 in September, falling under for a second consecutive month. Typically readings under 50 show a sign of contraction and reading over 50 points to expansion. The ISM index is a gauge for business confidence and shows the willingness of corporate managers to higher more employees, buy new equipment and reinvest in their business.
  • Trade war – What started as tariff threats in 2018 have turned into a full-blown trade war with China and the European Union. The Trump administration announced a series of new import tariffs for goods coming from China and the EU. China responded with yuan devaluation and more tariffs. France introduced a new digital tax that is expected to impact primary US tech giants operating in the EU.
  • A study by IHS Markit’s Macroeconomic Advisers calculated that gross domestic product could be boosted by roughly 0.5% if uncertainty over trade policy ultimately dissipates.
  • Chinese FX and Gold reserves – China’s reserve assets dropped by $17.0b in September, comprising of $14.7bn drop in FX reserves and a $2.4bn decline in the gold reserves. China has been adding to its gold reserves for ten straight months since December 2018.
  • Political uncertainty – Impeachment inquiry and upcoming elections have dominated the news lately. Fears of political gridlock and uncertainty are elevating the risk for US businesses.
  • Slowing global growth – The last few recessions were all domestically driven due to asset bubbles and high-interest rates. This time could be different, and I do not say that very often. Just two years ago, we saw a consolidated global growth with countries around the world reporting high GDP numbers. This year we witness a sharp turn and a consolidated global slowdown. EU economies are on the verge of recession. The only thing that supports the Eurozone is the negative interest rates instituted by the ECB. China reported the slowest GDP growth in decades and announced a package of fiscal spending combined with tax cuts, regulatory rollbacks, and targeted monetary easing geared to offset the effect of the trade war and lower consumer spending. So even though the US economy is stable, a prolonged slowdown of global economies could drag the US down as well.

Equities

US Equities had a volatile summer. Most indices are trading close to or below early July levels and only helped by dividends to reach a positive quarterly return. On July 27, 2019, S&P 500 closed at an all-time high of 3,025, followed by an August selloff. A mid-September rally helped S&P 500 pass 3,000 level again, followed by another selloff. S&P 500 keeps hovering near all-time highs despite increased volatility, with 3,000 remaining a distinct level of resistance.

In a small boost for equities, the dividend yield on the S&P 500 is now higher than the 10- and 20- year US Treasury rate and barely below the 30-year rate of 2%.

For many income investors equities become an alternative to generate extra income over safer instruments such as bonds

Market Outlook October 2019
S&P 500 dividend versus 20-year treasury rate

Growth versus Value

Investing in stocks with lower valuations such as price to earnings and price to book ratios has been a losing strategy in the past decade. Investors have favored tech companies with strong revenue growth often at the expense of achieving profits. They gave many of those companies a pass in exchange for a promise to become profitable in the future.

However, while economic uncertainty is going up, the investors’ appetite for risk is going down. The value trade made a big comeback over the summer as investors flee to safe stocks with higher dividends. As a result, the utilities and consumer staple companies have outperformed the tech sector.

The IPO market

The IPO market is an indicator of the strength of the economy and the risk appetite of investors. In 2019, we had multiple flagship companies going public. Unfortunately, many of them became victims of this transition to safety. Amongst the companies with lower post IPO prices are Uber, Lyft, Smiles Direct Club, and Chewy.com. Their shares were down between -25% and -36% since their inception date. Investors walked away from many of these names looking for a clear path to profitability while moving to safety stocks.

Market Outlook October 2019, Uber and Lyft since IPO

Small-Cap

Small caps have trailed large caps due to increased fears of recession and higher market volatility. Small caps tend to outperform in a risk-on environment, where investors have a positive outlook on the economy.

Market Outlook October 2019, Small Cap versus Large Cap

International Stocks

International stocks continue to underperform. On a relative basis, these stocks are better valued and provide a higher dividend than US stocks. Unfortunately, with a few exceptions, most foreign stocks have been hurt by sluggish domestic and international demand and a slowdown in manufacturing due to higher tariffs. Many international economies are much more dependent on exports than the US economy.

Fixed Income

The Fed continued its accommodative policy and lowered its fund rate twice over the summer. Simultaneously, other Central Banks around the world have been cutting their rates very aggressively.

The European Central Bank went as far as lowering its short-term funding rate to -0.50%. As a result, the 30-year German bund is now yielding -0.03%. The value of debt with negative yield reached $13 trillion worldwide including distressed issuers such as Greece, Italy, and Spain.

Investors who buy negative-yielding bonds are effectively lending the government free money.

In one of my posts earlier in 2019, I laid out the dangers of low and negative interest rates. You can read the full article here. In summary, ultra-low and negative interest rates change dramatically the landscape for investors looking to supplement their income by buying government bonds. Those investors need to take more risk in their search for income. Low rates could also encourage frivolous spending by politicians and often lead to asset bubbles.

The Yield Curve

The yield curve shows what interest rate an investor will earn at various maturities. Traditionally, longer maturities require a higher interest rate as there is more risk to the creditor for getting the principal back. The case when long-term rates are lower than short-term rates is called yield inversion. Some economists believe that a yield inversion precedes a recession. However, there is an active debate about whether the difference between 10y and 2y or 10y and 3m is a more accurate indicator.

Market Outlook October 2019, Yield Curve

As you can see from the chart, the yield curve gradually inverted throughout the year. Short-term bonds with 3-month to maturity are now paying higher interest than the 10-year treasury

Credit spreads

The spread between AAA investment-grade and lower-rated high yield bonds is another indicator of an imminent credit crunch and possible economic slowdown.

Market Outlook October 2019, Credit Spreads

Fortunately, corporate rates have been declining alongside treasury rates. Spreads between AAA and BBB-rated investment grade and B-rated high yield bonds have remained steady.

Repo market crisis

The repo market is where banks and money-market funds typically lend each other cash for periods as short as one night in exchange for safe collateral such as Treasuries. The repo rates surged as high as 10% in mid-September from about 2.25% amid an unexpected shortage of available cash in the financial system. For the first time in more than a decade, the Federal Reserve injected cash into the money market to pull down interest rates.

The Fed claimed that the cash shortage was due to technical factors. However, many economists link the shortages of funds as a result of the central bank’s decision to shrink the size of its securities holdings in recent years. The Fed reduced these holdings by not buying new ones when they matured, effectively taking money out of the financial system.

Gold

Gold has been a bright spot in our portfolio in 2019. After several years of dormant performance, investors are switching to Gold as protection from market volatility and low-interest rates. In early September, the precious metal was up nearly 21% YTD, but since then, retracted a bit.

Market Outlook October 2019, Gold

Gold traditionally has a very low correlation to both Equities and Bonds. Even though it doesn’t generate income, it serves as an effective addition to a well-diversified portfolio.

The Gold will move higher if we continue to experience high market volatility and uncertainty on the trade war.

Final words

The US economy remains resilient with low unemployment, steadily growing wages, and strong consumer confidence. However, few cracks are starting to appear on the surface. Many manufacturers are taking a more cautious position as the effects of the global slowdown and tariffs are starting to trickle back to the US. An inverted yield curve and crunch in the repo market have raised additional concerns about the strength of the economy.

Despite the media’s prolonged crisis call, we can avoid a recession. The recent trade agreement between the US and Japan could open the gate for other bilateral trade agreements. Given that the US elections are around the corner, I believe that this administration has a high incentive to seal trade agreements with China and the EU.

The market is expecting two more Fed cuts for a total of 0.5% by the end of the year. If this happens, the Fed fund rate will drop to 1.25% – 1.5%, possibly flattening or even steepening the yield curve, which will be a positive sign for the markets.

Those with mortgage loans paying over 4% in interest may wish to consider refinancing at a lower rate.

Market volatility is inevitable. Keep a long-term view and maintain a well-diversified portfolio.

The end of the year is an excellent time to review your retirement and investment portfolio, rebalance and take advantage of any tax-loss harvesting opportunities.

About the author:

Stoyan Panayotov, CFA, founder of Babylon Wealth Management

Stoyan Panayotov, CFA, MBA is the founder of Babylon Wealth Management and a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning and investment management for growing families, physicians, and successful business owners.

If you have any questions about the markets and your investments, reach out to me at stoyan@babylonwealth.com or +1-925-448-9880.

You can also visit my Insights page, where you can find helpful articles and resources on how to make better financial and investment decisions.

Subscribe to get our newest Insights delivered right to your inbox

Latest Articles

Market Outlook July 2019

Market Outlook July 2019

Breaking records

So far 2019 has been the year of breaking records. We are officially in the longest economic expansion, which started in June of 2009. After the steep market selloff in December, the major US indices have recovered their losses and reached new highs. The hopes for a resolution on trade, the Fed lowering interest rates and strong US consumer spending, have lifted the markets.  At the same time, many investors remain nervous fearing an upcoming recession and slowing global growth.

S&P 500 in record territory

S&P 500 hit an all-time high in June, which turned out to be best June since 1938. Furthermore, the US Large Cap Index had its best first quarter (January thru March) and the best first half of the year since the 1980s.

S&P 500 Performance since January 2018
Market Outlook July 2019

US treasuries rates declined

Despite the enthusiasm in the equity world, fixed income investors are ringing the alarm bell. 10-year treasury rate dropped under 2%, while 2-year treasuries fell as low as 1.7%.

10-year Treasury versus 2-year treasury and 3-month treasury.

We continue to observe a persistent yield inversion with the 3-month treasury rates higher than 2-year and 10-year rates. Simultaneously, the spread between the 2 and 10-year remains positive. Historically, a yield inversion has been a sign for an upcoming recession. However, most economists believe that the 2-10-year spread is a better indicator than the 3m-10-year spread.

Gold is on the move

Gold passed 1,400. With increased market volatility and investors fears for a recession, Gold has made a small comeback and reached $1,400, the highest level since 2014.

Bonds beating S&P 500

Despite the record highs, S&P 500 has underperformed the Bond market and Gold from October 2018 to June 2019 S&P 500 is up only 1.8% since October 1, 2018, while the 10-year bond rose 8.7% and Gold gained 16.8%. For those loyal believers of diversification like myself, these figures show that diversification still works.

S&P 500 versus 10-year treasury and Gold

Defensive Stocks lead the rally in Q2

Consumer Staples and Utilities outperformed the broader market in Q2 of 2019. The combination of lower interest rates, higher market volatility and fears for recessions, have led many investors into a defensive mode. Consumer staples like Procter & Gamble and Clorox together with utility giants like Southern and Con Edison have led the rally in the past three months.

Utilities and Consumer Staples performance versus S&P 500.

Small-Cap lagging

Small cap stocks are still under all-time high levels in August of 2018. While both S&P 600 and Russell 2000 recovered from the market selloff in December o 2018, they are still below their record high levels by -13.6% and 10% respectively

S&P 600 and Russell 2000 9-month performance.

International Stocks disappoint

International Developed and Emerging Stocks have also not recovered from their record highs in January of 2018.  The FTSE International Developed market index is 13.4% below its highest levels. While MSCI EM index dropped nearly 18.3% from these levels.

International stocks performance

The Fed

After hiking their target rates four times in 2018, the Fed has taken a more dovish position and opened the door for a possible rate cut in 2020 if not sooner. Currently, the market is expecting a 50-bps to a 75-bps rate cut by the end of the year.

As I wrote this article, The Fed chairman Jerome Powell testified in front of congress that crosscurrents from weaker global economy and trade tensions are dampening the U.S. economic outlook. He also said inflation continues to run below the Fed’s 2% target, adding: “There is a risk that weak inflation will be even more persistent than we currently anticipate.”

Unemployment

The unemployment rate remains at a record low level at 3.7%. In June, the US economy added 224,000 new jobs and 335,000 people entered the workforce. The wage growth was 3.1%.

Consumer spending

The US consumer confidence remains high at 98 albeit below the record levels in 2018. Consumer spending has reached $13 trillion. Combined with low unemployment, the consumer spending will be a strong force in supporting the current economic expansion.

Manufacturing is weakening

The Institute for Supply Management (ISM) reported that its manufacturing index dropped to 51.7 in June from 52.1 in May. Readings above 50 indicate activity indicate expanding, while those below 50 show contraction. While we still in the expansion territory, June 2019 had the lowest value since 2016. Trade tensions with China, Mexico, and Europe, and slowing global growth have triggered the alarm as many businesses are preparing for a slowdown by delaying capital investment and large inventory purchases.  

Trade war truce for now

The trade war is on pause. After a break in May, the US and China will continue their trade negotiations. European auto tariffs are on hold. And raising tariffs on Mexican goods is no longer on the table (for now). Cheering investors have lifted the markets in June hoping for a long-term resolution.

Dividend is the king

With interest rates remaining low, I expect dividend stocks to attract more investors’ interest. Except for consumer staples and utilities, dividend stocks have trailed the S&P 500 so far this year. Many of the dividend payers like AT&T, AbbVie, Chevron, and IBM had a lagging performance. However, the investor’s appetite for income could reverse this trend.

The 3,000

As I was writing this article the S&P 500 crossed the magical 3,000. If the index is able to maintain this level, we could have a possible catalyst for another leg up of this bull market.

The elections are coming

The US Presidential elections are coming.  Health Care cost, rising student debt, income inequality, looming retirement crisis, illegal immigration, and the skyrocketing budget deficit will be among the main topics of discussion. Historically there were only four times during an election year when the stock market crashed. All of them coincided with major economic crises – The Great Depression, World War II, the bubble, and the Financial crisis.  Only one time, 1940 was a reelection year.

S&P 500 Returns During Election Years

YearReturnCandidates
192843.60%Hoover vs. Smith
1932-8.20%Roosevelt vs. Hoover
193633.90%Roosevelt vs. Landon
1940-9.80%Roosevelt vs. Willkie
194419.70%Roosevelt vs. Dewey
19485.50%Truman vs. Dewey
195218.40%Eisenhower vs. Stevenson
19566.60%Eisenhower vs. Stevenson
19600.50%Kennedy vs. Nixon
196416.50%Johnson vs. Goldwater
196811.10%Nixon vs. Humphrey
197219.00%Nixon vs. McGovern
197623.80%Carter vs. Ford
198032.40%Reagan vs. Carter
19846.30%Reagan vs. Mondale
198816.80%Bush vs. Dukakis
19927.60%Clinton vs. Bush
199623.00%Clinton vs. Dole
2000-9.10%Bush vs. Gore
200410.90%Bush vs. Kerry
2008-37.00%Obama vs. McCain
201216.00%Obama vs. Romney
201611.90%Trump vs. Clinton

Final words

The US Economy remains strong despite headwinds from trade tensions and slowing global growth. GDP growth above 3% combined with a possible rate cut lat and resolution of the trade negotiations with China, could lift the equity markets another 5% to 10%.

Another market pullback is possible but I would see it as a buying opportunity if the economy remains strong.

If your portfolio has extra cash, this could be a good opportunity to buy short-term CDs at above 2% rate.

Reach out

If you have any questions about the markets and your investment portfolio, reach out to me at stoyan@babylonwealth.com or +925-448-9880.

You can also visit my Insights page where you can find helpful articles and resources on how to make better financial and investment decisions.

About the author:

Stoyan Panayotov, CFA, MBA is a fee-only financial advisor in Walnut Creek, CA, serving clients in the San Francisco Bay Area and nationally. Babylon Wealth Management specializes in financial planning, retirement planning, and investment management for growing families and successful business owners.

Market Outlook April 2019

Market Outlook April 2019

In my last commentary in early January, right after the December vortex, I gave 30% chance that the bull market will recover and 50% chance that we will see more volatility in the upcoming six months.  My view of the economy was still positive. And I didn’t see reasons for a recession at that time. I was somewhat right and wrong. My market outlook remains cautiously positive. Let’s break it down.

Equity markets

The markets were a little bit choppy at the beginning of January and the end of March. But overall all major equity markets in the US and abroad posted impressive quarterly performance. In fact, it was the S&P 500’s best quarter in decades. The S&P 500 index rose by 13% in the first three months of the year. Russell 2000 added 14.3%. The international stocks grew by about 10%.

Major markets' performance between January 2018 and Match 2019.

However, to put that in perspective, the S&P 500 is still a few percentage points below its all-time high in September of 2018. At the same time, Small caps are nearly 13% below its highest mark. While International Developed and Emerging Market stocks have been in a steep decline since their highs in January of 2018 and haven’t even come close to these levels.

So, I was wrong because, despite a few volatile trading days, the market remained relatively calm. The Q1 standard deviation was well below the 10-year average. After the Fed chair Jerome Powell stated that the Fed would be more cautious in raising interest rates in 2019 after their initial forecast of three rate hikes, the market took a leap of faith.

The US and international markets continue to diverge. The chart above shows the difference in performance between these two markets.

Growth versus value

Another interesting story is the growing gap between Growth and Value stocks. Value stocks have done pretty much nothing in the past 15 months while growth stocks have been a power horse.

Equity markets show a gap between Growth versus value stocks .

The trade wars

We also got mixed but mostly positive news from the US-China trade negotiations. The investors want the deal, and both sides seem motivated to strike one. The truth is that the US is the biggest market for Chinese export and China is the biggest market for US tech and industrial giants.  However, a lot of the issues with intellectual property and copyright protection, government subsidies and influence on corporate boards, privacy concerns, limited market access to China for US companies and so on, have accumulated for decades. But It will take more than a handshake to get these issues resolved.

Fixed Income Markets

The fixed-income traders have probably seen better days. For the first time in over a decade, the 10-year treasury rate is lower than the 3-month treasury rates. The maturity premium is now negative. This type of rate tightness is known as an inverted yield curve. The yield inversion has historically preceded all economic recessions. But not all inverted yield curves have led to a recession.

Fixed Income Markets are in turmoil. Comparing 3-month, 2-year and 10-year treasury rates.

This second chart below shows the gap between the Fed and Wall Street on their view of the world. The Fed who can only influence the short-end of the curve by its lending window has pushed the short-term rates by nearly 39% in the past 12 months. Those of us with saving accounts are finally seeing decent rates after ten years of drought.

Change in 3-month, 2-year and 10-year rates between January 2018 and Match 2019.

However, the long end of the curve, which is primarily determined by market supply and demand has declined by almost 12%

Soft landing or recession

The fixed income markets are waiving the red flag while the equity market remains positive. Somebody must be wrong.

Negative signals

I see a mixed bag of both positive and negative signals. On one side, US and Chinese economies continue to grow steady though with a slower pace. US Q4 GDP growth was 2.4% down from 3.4% in the third quarter of 2018. The Chinese economy expanded 6.6 percent in 2018, which is the weakest pace since 1990.

Furthermore, according to FactSet, the S&P 500 EPS estimate dropped by 7.2% (to $37.33 from $40.21) during Q1 of 2019. The decline in EPS was larger than the 5-year average (3.2%), the 10-year (3.7%), and the 15-year average (4%) cut. Additionally, payroll slowdown below forecast in the third quarter, hitting an 18-month low in March.

On the other track, Germany posted only 0.6% YoY GDP growth in 2018 with a nearly zero growth in the Q4 of 2018. Japan reported a 0.3% annual growth, after contracting -0.6% in Q3 of 2018.  Earlier in March ECB’s Mario Draghi said that there had been a “sizable moderation in economic expansion that will extend into the current year.” The ECB lowered its growth forecast for 2019 from 1.7% to 1.1%. Furthermore, the ECB halted its plans to hike rates and introduced another round of financing for European banks.

Positive signals

On the positive side, new home sales posted the highest gain in February after a steep decline in the second half of 2018. The US unemployment rate remains low at 3.8%. The US consumer sentiment went up to 98.4 in March 2019 after diving in January. The Chinese PMI surpassed economists’ estimates. New orders climbed to their highest level in four months, while the index for new export orders returned to expansionary territory.

The big question remains if the US will follow the EU and Japan into a recession/stagnation mode. Or the Fed and the Trump administration will maneuver the economy into a soft landing with slower but still healthy earnings growth, high consumer sentiment and robust business spending.

What to expect

Predicting the markets could be a treacherous task. Even successful economists sometimes make wrong conclusions. Humbly, I thought that the UK and the EU will figure out a soft Brexit, while the outcome is still hanging up in the air. I also thought that the economy would not slow down so quickly, but the combination of volatile oil prices, high interest rates, and trade war rhetoric really moved the needle in the wrong direction.  The next three to six months will be crucial to see if we are indeed heading into a slowdown or the economy is just taking a deep breath before going into another growth spurt.

The first quarter market recovery created an opportunity to take some risk off the table and rebalance your portfolio to your original risk tolerance targets.

What to watch

I am going to watch the performance of Growth versus Value stocks. In a world of slowing global economy, companies with a wide moat, high earnings growth, and big margins will continue to drive the markets. Separately, the flat yield curve and interest rates could boost interest in higher dividend paying stocks.

Also, I am going to watch the yield curve for significant moves in either direction. With short-term rates effectively higher than 10-year treasuries, for those sitting on extra cash, it might be tempting to get into one of those high-interest CDs. Currently, a 1-year CD is paying anywhere between 2.65% and 2.85%.

Contact Us

If you’d like to discuss how the market impacts your investments, please feel free to reach out and learn more about our fee-only financial advisory and OCIO services. We will meet you in one of our offices in San Francisco, Oakland, Walnut Creek, and Pleasant Hill areas. As a CFA® Charterholder with an MBA degree in Finance and 15+ years in the financial industry, I am ready to answer your questions.

Stoyan Panayotov, CFA 
Founder | Babylon Wealth Management

CFA Charterholder. Everything yu need to know about the markets. Let's build a better world for investing.
Disclaimer: Past performance does not guarantee future performance. Nothing in this article should be construed as a solicitation or offer, or recommendation, to buy or sell any security. The content of this article is the sole opinion of the author and Babylon Wealth Management. The opinion and information provided are only valid at the time of publishing this article. Investing in these asset classes may not be appropriate for your investment portfolio. If you decide to invest in any of the instruments discussed in the posting, you have to consider your risk tolerance, investment objectives, asset allocation, and overall financial situation. Different investors have different financial circumstances, and not all recommendations apply to everybody. Seek advice from your investment advisor before proceeding with any investment decisions. Various sources may provide different figures due to variations in methodology and timing,