Economic and Market Overview: Third Quarter 2019
The following commentary summarizes prior financial market activity, and uses data obtained from public sources. This commentary is intended for one-on-one use with a client’s financial advisor only, as a resource to manage assets and evaluate investment portfolio performance.
The US economy’s growth slowed modestly in the quarter. The Bureau of Economic Analysis reported its third estimate of second quarter 2019 gross domestic product (GDP) of 2.0%, in line with the prior estimate, but lower than the first quarter’s 3.1% reading. The employment situation moderated further in the latest month, with an average of approximately 156,000 jobs added each month of the quarter. The unemployment rate held steady at 3.7%. The Federal Open Market Committee (FOMC) modified its interest rate policy by lowering the federal funds rate target two times, to a range of 1.75% to 2.00%. Economists expect the FOMC to lower the fed funds rate at least once more by the end of the year.
The global economic environment continued to decelerate, driven by trade uncertainty, the lingering questions regarding how Brexit will be resolved, and heightened geopolitical risks. Eurozone economic growth slowed after growing in the prior two quarters, led by a decline in household consumption. China’s economy has also decelerated significantly since the onset of the trade frictions with the US. The country’s most recent real GDP growth was and annualized 6.2%, the slowest rate in 27 years.
Highlights and Perspectives
GROSS DOMESTIC PRODUCT (GDP)
The Bureau of Economic Analysis released the third estimate of the second quarter 2019 real GDP, a seasonally adjusted annualized rate of 2.0%, lower than the first quarter’s 3.1% annualized growth, and in line with the prior estimate. It was the lowest annualized growth rate in the past eight quarters, with the exception of the fourth quarter of 2018. Trade issues were the primary driver of the quarter’s slowdown, but the effects of last year’s fiscal stimulus have also dissipated. Corporate profits rose by 3.8% (not annualized) during the quarter, while real disposable income rose by 1.8%. Economists pointed to the fading benefits from 2018’s deficit-financed tax cuts and the Trump administration’s trade war with China and other trading partners as being the key reasons for the slowdown, as they combined to undermine business sentiment. Some analysts estimate that the trade war with China has resulted in a reduction in real GDP of 0.3 percentage points, and a loss of 300,000 jobs. Since the economic impact of the trade war arguably has been worse for China, economists hope that some sort of rapprochement may be in the offing, particularly as President Trump heads into an election year.
The housing segment continued its steady improvement of the past nine months. One of the primary reasons for the recovery from the 2018 drop is the decline in mortgage rates, which have fallen approximately 120 basis points since November 2018. Existing-home sales for August (the latest monthly data available) grew at an annualized rate of 5.5 million units, 1.3% higher than the results from July, and up about 2.6% from year-ago levels. The inventory of existing homes was at about four months of supply, in line with levels of the prior year. Existing-home prices in August increased 4.7% from August 2018. In the new-home segment, the NAHB Housing Market Index, a measure of homebuilding activity, ended the quarter at 68, slightly higher than both the prior month’s and year-ago levels. The data indicate that homebuilders are very positive on the outlook for the housing market.
The employment situation deteriorated somewhat in August, continuing the slowing experienced much of 2019. Employers added 130,000 jobs during the month, below the consensus expectations of 158,000 new jobs, and below the prior month’s gain of 159,000. Waning business and consumer confidence resulting from uncertainty around frictions with various trading partners contributed to the lackluster gains in payroll growth. The three-month moving average actually rose modestly despite the lower-than-expected gains in August, coming in at 156,000. The unemployment rate in May remained at 3.7%, and the labor force participation rate rose to 63.2%, its highest level of the year. Average hourly earnings increased by 3.2% from the year-ago level.
FEDERAL RESERVE POLICY
The FOMC ended its recent September meeting by announcing that there would be a reduction in the federal funds rate target range to 1.75% to 2.00%. This was the second 25 basis point reduction in the quarter, following the one approved at the FOMC’s July meeting. The move was widely expected, and had been fully priced in to the market. For the first time since 2016 there were three dissenters on the committee, with one seeking a more aggressive cut of 50 basis points, and two others not seeing the need for a reduction. Economists viewed the cuts in the quarter as an insurance policy against further slowdown caused by trade developments. The consensus among analysts is that there will likely be one more reduction this year, perhaps at the FOMC’s October meeting.
Fixed income securities’ prices and yields were buffeted by several factors during the quarter, foremost of which was the deceleration in economic growth resulting from the escalation in the trade war with China. Other issues prompting investor concern were the ongoing drama surrounding the UK’s Brexit decision, and geopolitical tensions with nations such as Iran. The FOMC responded to the moderating growth in the US by lowering interest rates twice during the quarter, bringing the target federal funds rate range to 1.75%-2.00%. The slowing growth produced a rally in bond prices, and a drop in yields. Economists expect this trend to continue, as seven FOMC committee members anticipate cutting the fed funds rate by an additional 25 basis points this year. The fed funds rate is now expected to end 2020 at current levels, as opposed to an expectation of 2.4% three months ago.
The Treasury yield curve continued to maintain a “trough” shape during the third quarter, with yields on the shortest- and longest-term maturities being higher than yields in the intermediate-term “belly” of the curve. Overall, the Treasury curve moved lower from the prior quarter. In addition, the yield curve briefly inverted during the quarter, meaning that the yield on the 10-year Treasury declined below the yield on the 2-year Treasury. Historically, yield curve inversions have predicted economic recessions 9-12 months in the future. Some analysts, however, point out that the current situation may differ from previous instances in that there is heavy demand for U.S. Treasury debt because of low (or negative) yields on sovereign debt issued by other nations. Such demand drives up the prices of the securities, and lowers the yields. By the end of the quarter, the yield on the benchmark 10-year US Treasury note was lower, ended at 1.67%, compared to 2.01% on June 30.
Interest rates spent much of July in a tight range hovering around the 2% yield level on the 10-year Treasury. In August, however, yields declined sharply as the trade war escalated. Yields bottomed out early in September after there appeared to be some softening of the trade rhetoric between the US and China. Investors also grappled with the seemingly never-ending Brexit theater, as the new UK Prime Minister, Boris Johnson, has so far failed to deliver a solution palatable to all parties. Geopolitical tensions also spiked during the quarter, as Iran responded to heavy economic sanctions by firing missiles at Saudi Arabia’s oil infrastructure. Against this backdrop, yields at the short end of the yield curve (up to three years) ended the quarter generally about 30-40 basis points lower than in June, while those on the longer end were lower by approximately 40 basis points. The yield on the 3-month Treasury Bill settled at 1.82% at the end of the quarter, down about 25 basis points from the end of the previous quarter. The yield on the 5-year Treasury Note ended the quarter at 1.55%, compared to 1.8% on June 30, and as mentioned above, the yield on the 10-year Treasury Note fell to 1.67% from 2.03% over the same period. At the same time, the yield on the 30-year Treasury Bond declined, ending the period at 2.11%, compared to its beginning level of 2.55%. Inflation expectations were somewhat lower, with the Fed’s gauge of five-year forward inflation expectations declining slightly from 1.80% on June 30.
Total returns on fixed income securities were positive across most of the market segments. The Bloomberg Barclays Treasury 5-7 Yr. Index rose by +1.7% for the quarter. The Bloomberg Barclays US Corporate 5-10 Yr. Index gained +2.4% during the three months. High yield securities, which often follow the performance of equities, climbed, posted a return of +1.3%. Municipals also rose, as the Bloomberg Barclays Municipal Bond Index gained +1.6% during the quarter. Prices of non-US fixed income securities were lower in the quarter, as the Bloomberg Barclays Global Aggregate ex-US Index declined -0.6%. Emerging markets bonds continued their positive trend, with the JPM EMBI Global Index gaining +1.3%.