Markets in the third quarter of 2019 looked surprisingly similar to the second quarter as more U.S.-China trade war uncertainty and a lack of clarity on future interest rate policy caused a sharp increase in volatility in the middle of the quarter, but the S&P 500 remained resilient and ultimately recouped those losses to finish the quarter not far from the new all-time highs established in late July.
The third quarter started strong as news of a “trade truce” between the U.S. and China, which was announced at the G20 meeting in late June, combined with better-than-expected second-quarter corporate earnings to propel the S&P 500 to new all-time highs in July. Also helping markets rally was anticipation of the first interest rate cut by the Federal Reserve since 2008, which became reality on July 31st when the FOMC cut the Fed Funds Rate by 25 basis points.
But that strong start to the quarter was quickly undone in early August thanks to increased tariffs between the U.S. and China (the trade truce was short-lived), uncertainty over future Fed policy, and concerning signals from the bond market regarding economic growth and inflation.
The U.S.-China trade truce that was agreed to in late June didn’t last much more than a month as President Trump announced new 10% tariffs on $300 billion worth of Chinese imports on August 1st, citing a failure by the Chinese to fulfill promises to increase purchases of U.S. agricultural products. Then, in late August, China retaliated by levying various new tariffs on $75 billion worth of U.S. imports, and President Trump immediately responded by increasing existing tariffs on all $550 billion of Chinese imports. The tariff tit-for-tat weighed on markets throughout August.
Also pressuring stocks in August was uncertainty regarding U.S. monetary policy. As mentioned, the Fed cut interest rates by 25 basis points on July 31st, but they did not definitively signal more rate cuts were coming, and disappointment from that lack of clear guidance, combined with growing worries over future economic growth, added to the volatility in August.
Finally, a closely watched part of the U.S. Treasury yield curve, the “10s-2s spread,” inverted (meaning that yields on shorter-term notes exceeded those of longer-term notes) for the first time since 2007. This signal has historically preceded a recession by an average of 18 months, although admittedly, it’s not a perfect indicator. Regardless, seeing this signal for the first time in over a decade led to a deterioration in investor sentiment and added to the August volatility.
Despite this trifecta of headwinds, markets again showed impressive resilience in the final month of the quarter, just as they did in the second quarter of 2019.
Early in September, there was improvement in U.S.-China trade relations as President Trump authorized a short delay on the implementation of some of the recently announced tariff increases, and both the U.S. and China agreed to face-to-face meetings in October in another attempt to end the now 18-plus-month trade war.
Additionally, the Federal Reserve cut interest rates for a second time on September 18th and clearly signaled more willingness for future cuts if conditions warranted further action.
Finally, after a brief period of being inverted, the yield curve normalized in early September in part due to better-than-expected U.S. economic data and subsequently easing concerns of a future recession.
Due to the improving market fundamentals listed above, the S&P 500 rebounded solidly in September and came close to matching July’s all-time highs, although the initiation of an impeachment investigation by the House of Representatives on President Trump caused a modest pullback late in the month.
In sum, the volatility we witnessed in the third quarter, which remains historically typical, was not surprising due to the numerous macroeconomic uncertainties facing this market and the economy.
But the third quarter was also a reminder that volatility does not automatically mean poor performance. Resilient corporate earnings, stable U.S. economic growth and an accommodative Federal Reserve combined with rising optimism towards U.S.-China trade to offset the volatility and deliver another quarter of positive returns.
FOURTH QUARTER MARKET OUTLOOK
Once again, the S&P 500 successfully weathered an increase in volatility this past quarter, as positive current economic fundamentals, interest rate cuts, better-than-expected corporate earnings and renewed hope for resolution on U.S.-China trade helped the S&P 500 maintain strong year-to-date gains.
However, the increase in volatility we saw in May, and again most recently in August, is an important reminder that while markets remain broadly resilient, risks to investment portfolios and the economy need to be carefully monitored. There are still multiple unknowns currently facing investors as we begin the final three months of 2019.
First, the ongoing U.S.-China trade war is clearly the most important influence on the markets. And while there has been rising optimism for some sort of temporary resolution, the fact remains that the U.S. and China still have substantial tariffs in place on imports, with more potentially coming in December. Those tariffs continue to be a headwind on global economic growth, and slowing global growth is a risk to markets that we will continue to watch closely.
Turning to the economy, the outlook remains uncertain. Currently, U.S. economic growth is solid and the envy of the world’s developed economies. And, accommodative policy by the Federal Reserve will continue to support that growth. However, Fed rate cuts don’t bring guarantees of sustained periods of economic growth, and the ongoing U.S.-China trade war paired with the reappearance of some concerning indicators, such as an inverted yield curve, mean we must remain vigilant in detecting any potential future economic slowdown.
Finally, both domestic and geopolitical dramas require close watching over the coming months. Domestically, the impeachment inquiry of President Trump has the potential to weigh on investor sentiment, while internationally U.S.-Iran tensions are as high as they’ve been in years, and any conflict between the U.S. and Iran will almost certainly be a negative for stocks, broadly speaking.
Bottom line, U.S. markets were resilient in the third quarter and the performance of most markets year to date remains impressive. However, our experience has taught us that while markets may be resilient, risks still need to be monitored closely, and so we will continue to do so as we have all year.
What happens next with the U.S.-China trade war (will there be a trade truce?), Federal Reserve policy (will the Fed cut rates again in 2019?), and future economic growth (does the yield curve invert again?) will likely determine whether markets maintain, and potentially add to, year-to-date gains—or whether we see similar bouts of volatility like we did in May and August of this year.
We understand that markets always face uncertainties at the start of a new quarter, and we are committed to monitoring these situations and their impact on the markets and your portfolio. Positively, current corporate and economic fundamentals remain solid, and it is those factors that determine the longer-term path of markets, not the latest political drama or salvo in the U.S.-China trade war.
We understand that volatility, regardless of the cause, can be unnerving, even if it is historically typical. That’s why we remain committed to helping you navigate this ever-changing market environment, with a focused eye on ensuring we continue to make progress on achieving your long-term investment goals.
Our experience in all types of markets (calm and volatile) have taught us that successful investing remains a marathon, not a sprint. Therefore, it remains critical to stay invested, remain patient, and stick to a plan. That’s why we’ve worked diligently with you to establish a personal allocation target based on your financial position, risk tolerance, and investment time horizon.
The strong market performance notwithstanding, we remain vigilant towards risks to portfolios and the economy, and we thank you for your ongoing confidence and trust. Rest assured that our entire team will remain dedicated to helping you successfully navigate this market environment. While market volatility can be nerve-racking for investors, reacting emotionally and changing long-term investment strategies in response to short-term declines could prove more harmful than helpful. By adhering to a well-thought-out investment plan, ideally agreed upon in advance of periods of volatility, investors may be better able to remain calm during periods of short-term uncertainty.
Please do not hesitate to contact us with any questions, comments, or to schedule a portfolio review.