This quarter, both equity markets and interest rates have been on an up-and-down roller-coaster ride. In addition to deflation concerns, which pushed the U.S. dollar higher, markets have been reacting to the ups and downs of the U.S.-China trade war saga. Now we can add a formal impeachment inquiry into the mix.
Amidst this backdrop, stocks rose in July, fell in August, then rallied in September. In the end, larger-cap U.S. stocks gained 2% in the third quarter. They are now up over 20% year to date. Smaller-cap U.S. stocks suffered more acutely during the market drops and ended the quarter down 2.3%. For the year, they are still up a healthy 14.1%.
Foreign stocks outperformed in the September rebound, but it wasn’t enough to see them keep pace with U.S. stocks for the quarter. Developed international stocks fell 0.9%, European stocks fell 1.8%, and emerging-market stocks fell 4.1%. The uncertainty around Brexit continues to hang over Europe. The aforementioned rise in the U.S. dollar also hurt the foreign investment returns of dollar-based investors. Still, developed international and European markets are up by double digits this year (13.2% and 13.6%, respectively) and emerging-market stocks are up close to 8%.
Due to declining interest rates, core investment-grade bond returns have been strong. The core bond index gained another 2.4% this quarter and is up over 9% in 2019! Interestingly, below-investment-grade sectors of the income world shrugged off economic worries to also do well. Floating-rate loan funds and most of our flexible bond investments delivered quarterly gains.
The environment continues to feel like a game of tug of war between trade policy and monetary policy. On one hand, the unpredictability of the trade war has hit U.S. business sentiment and slowed corporate spending. On the other hand, global central banks continue to take action in response to the real impacts the trade war is having, in addition to the weak global economic picture. The Federal Reserve twice cut the federal funds rate by 25 basis points during the quarter. The European Central Bank also cut its policy rate and announced it would launch new stimulus measures.
Recession fears seemed to crescendo in August. We saw a report at the time that Google searches for “recession” had spiked to levels not seen since 2008. We think the currently inverted yield curve played a role in pushing recession into the public consciousness. An inverted yield curve means long-term interest rates are lower than very short-term rates, which is an unusual occurrence. One interpretation is that bond markets are telling us: “Good times are here … but bad times are coming.” Indeed, an inverted yield curve has preceded the last seven U.S. recessions, albeit by a widely varying time period. This is why many investors are concerned.
No single indicator, no matter how reliable, is sufficient to make an investment decision. An inverted yield curve doesn’t have a perfect prediction record. But we’ve seen several other data points that indicate recession risks have risen: CEO confidence has declined, U.S. manufacturing activity is contracting, interest rates have fallen hard since November of last year, etc. When we increased our exposure to core bonds in our balanced portfolios earlier this year, it was in consideration of all these factors.
We shouldn’t be all doom and gloom, however. There could very well be another cyclical rebound that extends this cycle. Global central banks are easing financial conditions, which may boost growth. Though U.S. manufacturing is slumping, it has contracted twice before since the 2008 financial crisis and turned up each time; it could do so again. Plus, the services sector is still in expansion territory, and it makes up 80% of the U.S. economy. Household balance sheets and consumer spending remain healthy, supported by low unemployment and solid wage growth.
To sum up, we see two widely divergent, if not binary, market outcomes from here: a recession-type slowdown or a cyclical rebound. The economic data is “mixed.” This explains our balanced portfolio approach. Low-risk alternative strategies and high-quality bond holdings should prepare portfolios to weather a recession. While the more economically sensitive international and value stocks we own on the equity side should help portfolios participate strongly if global growth rebounds. It’s also worth remembering our portfolios have already been modestly underweight to equity risk overall, leaving them less exposed to a market drop like what happened late last year (or worse). Together with the broad diversification we employ across asset classes and investment strategies, our balanced tactical positioning should make your portfolio resilient to a range of economic and market scenarios.