High Level Commentary

MARKET PERFORMANCE-As Of Friday, February 21, 2020

Last 3 Last 12
Major Benchmark Performance: Months+ YTD Months+
Since: February 10/31/19 12/31/19 12/31/18
As Of: 2/21/20 2/21/20 2/21/20 2/21/20
US Large Cap-S&P 500 3.48% 10.43% 3.44% 25.94%
US Small Cap-Russell 2000 4.00% 7.83% 0.66% 13.58%
Foreign Developed-MSCI EAFE 1.16% 3.42% -0.96% 13.39%
Foreign Emerging Mkts-MSCI EEM 2.80% 5.18% -1.99% 6.72%
US Bonds-Barclays Aggregate 0.22% 2.02% 2.14% 9.89%
Long Treasury-20 Yr+ US Treasury Bonds 1.47% 4.89% 8.56% 24.24%
High Yield-Bloomberg 0.91% 3.30% 0.94% 10.40%

Equity markets have been volatile since the outbreak of the coronavirus in China.  The S&P 500 was at a then all-time high on January 17th of 3,329.62 before publicity emerged about the outbreak of the coronavirus in Wuhan, China. Markets promptly sold off over 3% due to fears of reduced economic growth from the coronavirus. The virus spread rapidly as Chinese people traveled to visit their families during the Lunar New Year. Chinese GDP is now being adversely impacted as citizens hunker down to avoid further spread of the virus. Global travel bans and airline flight restrictions to China are also reducing Chinese economic activity. Moreover, Wuhan is a major steel producer and manufacturer, and economic restrictions in Wuhan will impact global industrial supply chains. The virus has spread beyond China, and the World Health Organization has designated the coronavirus outbreak a public health emergency. This is the fifth time that the WHO has taken this action since 2007 when global regulations went into effect.

Although it is difficult determine the global impact, the Severe Acute Respiratory Syndrome-SARS epidemic reduced Chinese GDP by an estimated -0.8% in 2003. Analysis by Charles Schwab found that for the 13 global epidemic outbreaks since 1981, the MSCI World Index gained 0.8% in the month after the outbreak, and 7.1% after six months. Morningstar examined the companies that they followed after the SARS outbreak and found no significant long-term effect. In addition to SARS, other notable outbreaks that did not have a significant global impact include the avian flu in 2006, swine flu in 2009, Ebola in 2014, and Zika in 2016.

Recent analysis from Goldman Sachs and Deutsche Bank indicates that the virus will reduce Chinese GDP by -1.5% for the first quarter of 2020 and by -0.3% for calendar year 2020. US GDP is seen being reduced by as much as -0.5% in the first quarter and by -0.1% for the full year. On a global basis, GDP is seen down -0.2% for 2020. This analysis essentially sees a negative impact in the first quarter and then a recovery. Only time will tell.

Although equity markets traded down modestly through the end of January, they resumed an upward trajectory based on the belief that the number of new infections had peaked and would begin trending downward. During February, new records were set for the S&P 500, Nasdaq, the Dow Jones Industrial Average, and the European Stoxx 600.

History indicates that the market overreacts to short-term headlines and these outbreaks do not have a negative impact on longer-term performance. Nevertheless, the current coronavirus may prove to have a bigger impact because China represents a much larger share of the global economy. Data from the World Bank shows that China’s GDP was at $1.3 Trillion in 2003 during the SARS outbreak and now GDP is $13.6 Trillion. In addition, global exports grew from $438 billion in 2003 to $2.5 Trillion in 2018. Finally, visitors from China to the U.S. grew from 157,000 in 2003 to 2.8 million in 2018.  Consequently, there is much greater downside potential than the market currently perceives.

The Chinese trade deal. After nearly two years of negotiations, the trade agreement was signed on January 15. The deal called for China to increase U.S. purchases by $200 billion over the course of 2020 and 2021. The deal requires China to open their markets to financial services companies and it provides new protections for trade secrets and intellectual property. The deal surprised some observers because it left in place tariffs on $370 billion of Chinese imports to the U.S. Since these tariffs remain in place, it is seen by some as reducing the prospects for growth in business investment.

This “phase one” deal is seen as a good start, and it sets the stage for further negotiations for a phase two deal. A phase two deal will deal with more difficult issues including forced technology transfer, theft of intellectual property and Chinese government support of their state-owned enterprises. President Trump said remaining tariffs “will come off” if they are able to negotiate a phase two deal. Critics of the deal are skeptical that China will actually increase imports of U.S. goods and services by $200 billion, and they are pessimistic about achieving a meaningful phase two deal. President Trump is clearly using tariffs in the short-term to secure hoped-for greater tariff reductions in the long-term. The trade dispute has already hurt manufacturing and business investment, and estimates of a negative impact on U.S. GDP range to as much as -1%. From a broader perspective, this deal clearly reduces the escalation of the trade war, and it should provide a boost to U.S. GDP.

The Federal Reserve reduced interest rates on October 30th for the third time in 2019, and the Fed Funds now stands in a range of 1.50% to 1.75%. The Fed indicated that no additional cuts will be forthcoming unless the economic data turns more negative. Although the Fed’s official position indicates no additional rate cuts, the market is pricing in two interest rate cuts through 2020.

Markets were strong over the course of last year. For 2019, the S&P 500 large cap index was up a solid 31.5%, and the Russell 2000 small cap index was up 25.5%. Foreign market performance for the year was positive but trailed the U.S largely due to stronger economic growth in the U.S. The MSCI-EAFE developed market index was up 22.0% and the MSCI Emerging Markets Index was up 18.4%. Corporate earnings provided support for the market. Although third quarter earnings were down on a year-over-year basis, they were not down nearly as much as many market participants had feared. In addition, 2020 corporate earnings are expected to increase 9.6% according to FactSet. U.S. stocks were also supported by continuing corporate stock repurchases and significant foreign demand.

U.S. Treasuries: Interest rates were particularly weak in 2019. The 10-year U.S. Treasury bond started the year at a yield of 2.66%, but it dropped to 1.46% on September 4th. In addition, the 30-year US Treasury fell to an all-time low of 1.94% on August 28th. Since then, interest rates recovered somewhat, and the 10-year bond finished the year at 1.92%. Based on these interest rate declines since the beginning of 2019, long treasury bonds total return performance was up a hefty 15.2% for the year as bond prices moved up with the decline in interest rates. High Yield Bonds were up 14.3% for 2019 based on reduced fears of an imminent recession. Interest rates have trended down so far in 2020. Long treasuries have been impacted by the fears of the coronavirus causing weaker global economic growth and by a flight to quality.

Inverted Yield Curve: Last summer market pundits and the financial press loudly touted the risk from an inverted yield curve-the abnormal situation where interest rates on longer-maturity 10-year US Treasuries are lower than interest rates on shorter maturities like the 2-year US Treasury note and the 90-day Treasury bill. Historically, an inverted yield precedes most U.S. recessions. Since last summer, short rates have moved down below the U.S. 10-year U.S. Treasury interest rate, so that the yield curve was no longer inverted. By January of this year, however, the yield curve inverted again as longer-term interest rates dropped sharply. Although an inverted yield curve may once again be a precursor to a recession, it is important to note that the timing is hard to predict. Analysis from Credit Suisse shows that a recession occurs on average 22 months after the inversion. Moreover, stocks often to do well after an inversion with an average gain of more than 15% in the 18 months following the inversion. This means that an inverted yield curve is not a time to make rash short-term portfolio changes. Instead, it is more prudent to maintain a disciplined long-term perspective that maintains proper asset allocation, diversification and portfolio rebalancing.

Big Picture:

-Although the U.S. economy has softened modestly during 2019, the employment situation remains strong. The payroll report released on February 7th showed continuing job growth of 225,000. The unemployment rate is now near a 50-year low level of 3.6%.

-U.S. economic data for consumer spending also remains strong at 2.6% for the third quarter.

-Manufacturing and capital spending in the U.S. have been anemic, largely due to uncertainty related to trade policy and tariffs.

-Corporate earnings for the 4th quarter are coming in up 5.1% year-over-year, better than expected. The earnings growth helps make Price/Earnings valuations more attractive as stock prices are being divided by a much higher earnings level. FactSet sees 9.55% consensus earnings growth for 2020, and it will be important to achieve growth near that consensus level to sustain the market.

– Eurozone 2019 GDP growth was recently reported at 1.2%, down from 1.9% in 2018 and 2.5% in 2017. Although the Eurozone economy has been weaker than the U.S., they have been able to avoid a recession.

Risk Factors:

-The spread of the coronavirus may prove much more troublesome compared to previous global epidemics because China now represents a much larger share of global GDP. Although U.S. growth has been strong, the preliminary “flash” Purchasing Managers Composite Index fell to 49.6, the lowest level since October 23. Surprisingly, the Purchasing Managers Composite for the Eurozone actually increased modestly to 51.6. Finally, the Purchasing Managers Index for Japan fell to 47.0 and their economy appears to be entering a recession.

-The killing of Qassem Soleimani and Abu Mahdi al-Mohandes on January2 caused a market downdraft and a spike in oil prices, but tensions have moderated since then. Only time will tell if there is additional retaliation and what will be the longer-term ramifications. This event follows the September 14th, 2019 attack on Saudi Arabia’s Abqaiq plant caused an oil price spike but oil supplies remain sufficient to meet worldwide demand. These two events are examples of geopolitical risk where the current level of complacency may give way to significant downside.

-The impeachment of President Trump has not currently impacting the markets because the Republican-controlled Senate did not convict the President. For historical perspective, stocks gained 28% in the year after impeachment efforts were initiated against President Clinton but they dropped 39% in the year after impeachment efforts were initiated against President Nixon.

-The 2019 federal government fiscal year budget deficit ballooned to $984 billion up 26.4% and up $205 billion from fiscal 2018. Although total receipts were up 4.0%, outlays were up 8.2%. Individual income tax receipts were up 2.0% and corporate tax receipts were up 12.3%. The budget deficit is the result of large government spending increases and the 2017 tax cut law. One particularly troubling aspect of the budget deficit is the rapidly increasing interest payments on the accumulated government debt. The federal government spent $380 billion on interest payments on the debt and this will continue to grow rapidly as ongoing budget deficits add to the government debt level. Moreover, interest rates are low but may well move up in the future, and this will make the interest payments even larger. It is unprecedented for the government to run such a large deficit during a period of economic growth because spending on unemployment and other safety-net programs are lower and tax revenues are higher. A future recession will cause even greater deficits due to lower tax receipts and higher safety-net spending.

– Despite the political rancor the U.S.-Mexico-Canada trade pact has been approved by both the House and the Senate. In addition, the $1.4 Trillion appropriations bill has been passed. This bill provides funding for domestic and defense spending through September 30, 2020.

-The Wall Street Journal lists the risk of recession within a year at 24%, a level that is down from 35% three months ago and is indicative of how the economic prospects are now viewed more favorably. Nevertheless, the recession risk is still higher than a year ago when the risk of recession was seen at 18%.

-Global economic growth has weakened in 2019, particularly in China and Germany.

-China’s third quarter GDP was reported as 6.0%, the lowest level in nearly three decades.

-Germany reported that 3rd quarter GDP was at a weak 0.3%, but better than the negative -0.1% reported for the 2nd quarter. Germany is particularly weak due to slumping auto exports.

-The UK reported third quarter GDP of 0.3%, modestly better than the -0.2% rate in the second quarter. Brexit uncertainty continues to weigh on both consumers and manufacturers.

-The International Monetary Fund released their July update of their World Economic Outlook and it shows a modest reduction in their growth forecast for 2019. The IMF reduced their global growth expectation down to a level of 3.2% for 2019. Growth was 3.6% in 2018 and 3.8% in 2017. They used the term global synchronized slowdown but not recession.

-The UK Brexit separation was completed on January 31 after Boris Johnson achieved a large Conservative Party election majority. The Brexit withdrawal process began in June 2016, and trade negotiations with the European Union will be the next big issue. Trade terms will need to be negotiated by year-end 2020, so Brexit will continue to be an ongoing issue. Nevertheless, a so-called hard Brexit has been avoided.

For more detail see:

Markets & Economics

Market Performance

Valuation

To summarize, economic growth momentum is currently slowing outside the US and this provides short-term concerns.

Cornerstone maintains significantly more data and graphs than what is presented in this website.  Contact Jeff Johnson regarding specific data questions and comments.

Yahoo Finance link is helpful for daily market activity:  http://finance.yahoo.com/