Risk assets remained largely positive for the month of July even as markets were somewhat disappointed by the end-of-month Fed rate cut and associated speech by Chairman Powell. Stocks took a hit from a sharp escalation of trade tensions between the U.S. and China in the first several days of August.
- The S&P 500 held on to gains of 1.44% for the month of July.
- A material rise in the dollar at month-end pushed international stocks and bonds into the red.
- Stocks fell and U.S. Treasuries rose in the first several days of August as the United States announced increased Chinese tariffs, and China retaliated by devaluing the yuan.
With roughly two-thirds of S&P 500 companies reporting, Q2 is looking like a repeat of Q1’s roughly flat earnings growth. Trade wars may make it even harder for companies to grow earnings in the second half of 2019.
All U.S. assets remained in the green for the month of July, while a dollar rally pushed commodities and international stocks and bonds into the red.
The Fed delivered a rate cut, but it was only 25 basis points (bps), and Chairman Powell’s comments were not quite as dovish as expected. The Fed also announced an early end to the shrinking of its balance sheet. A smaller cut means a smaller stimulus, and a larger balance sheet means more suppression of longer-term interest rates. And, from the actual economy, the core Personal Consumer Expenditure (PCE) Deflator fell to 1.4%. The result: Interest rates fell across the entire curve, and the curve remains inverted.
The core Personal Consumer Expenditure (PCE) Deflator index measures the prices paid by individuals for goods and services, excluding food and energy.
After this, the U.S. announced more Chinese tariffs, and the Chinese devalued the yuan, and U.S. Treasuries rallied further. For those seeing the beginning of a severe global recession, buying longer duration U.S. Treasuries seems like a good bet. With the yield curve inverted even further, the reward for owning longer duration Treasuries is— wait for it—lower yield. Only a further fall in longer-term Treasuries could make owning them more lucrative than short duration bonds.
Given this conundrum, high yield bonds look interesting. The high yield bond curve is not inverted. Yields for longer duration high yield bonds are higher than short duration high yield bonds.
That’s because spreads are wider for longer duration high yield bonds. Single B-rated bonds with a 10-year maturity have a spread of around 400bps, while those with a 1-year maturity have a spread of around 150bps. Wider spreads offer an incentive to invest in longer-duration high yield bonds, but the inverted Treasury curve presents a disincentive.
The inverted Treasury curve also provides an opportunity. When the Treasury curve is inverted, hedging the interest rate risk of a longer duration high yield bond, rather than costing money, can make (a small amount of) money.
Through August 2, close to 80% of the S&P members have reported earnings. Roughly three quarters of those names have reported a positive earnings surprise while approximately 60% have reported a revenue surprise. That’s the good news. But dig a little deeper, and some concerns appear. Namely, year-over-year earnings growth continues to decelerate. After several quarters where we saw 20% advances, the blended earnings decline for Q2 currently stands at 1%.
This follows a Q1 result where earnings were flat to slightly down. And the trade war may make it even harder for stocks to grow earnings in the second half of 2019.
Even with extremely low interest rates supporting stock prices, and the trade-war-driven modest pullback in stocks, stocks are near full valuation.
Companies with pricing power—perhaps evidenced by consistent dividend growth—may be able to weather the tariff storm and other headwinds, and perhaps even generate some modest earnings growth in an environment where many companies will be unable to do so. Companies that exhibit capital efficiency—also likely evidenced by consistent dividend growth—may also fare relatively well, particularly companies that are able to generate strong returns on capital with modest income statement margins.
Source for data: Bloomberg, FactSet and Morningstar.
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