Market Watch

| August 08, 2019
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This summer has been interesting. U.S. large-cap stock indexes are hovering near record levels, while other asset classes like investment-grade bonds and gold have also participated in gains with little volatility in recent weeks.

In a normal economic environment, stocks, bonds and gold typically do not experience simultaneous growth. But, these are not normal times:  Domestic economic growth is steady, global demand is weakening, trade uncertainty prevails, and central banks around the world are once again lowering interest rates—more than 10 years after the economic and financial crisis!

Indeed the prices of many other asset classes reflect these abnormalities. U.S. high yield bonds have not returned to new highs since 2013. U.S. small-cap stocks are down 12% since their highs in August of 2018. U.S. mid-cap stocks are down 6.7% since their highs last September. International developed stocks have declined more than 15% since their record close in January 2018. Emerging market stocks are the worst performers of all major asset classes as they're almost 23% below their most recent highs of January 2018.  The contrast between the positive returns of just three asset classes and the negative returns of all others can inform us as investors with globally diversified portfolios.

The U.S. economy has exhibited trend-like growth around 2.5% for the first half of 2019. Despite weaker business investment due to trade uncertainty, growth has been supported by a fully employed consumer. These trends have led activity in the developed world, where Europe struggles with Brexit, and Japan, where demand is wobbly ahead of the looming consumption tax. Consequently, global investors have not found favor with risk assets. Is this a sign of a lack of confidence in global economic activity? Will the world’s central banks continue lowering rates in efforts to boost global demand and support asset prices? A tactic that clearly has not worked in the past year outside of the United States.

The U.S. Federal Reserve just reduced interest rates by one quarter of a percentage point (0.25%), and indications are that at least one more rate cut is coming before year-end. The European Central Bank and the Bank of Japan also have committed to more accommodative policy actions. Lower interest rates can boost economic activity by reducing financing costs for home and auto loans, while also factoring into improved valuations of financial assets. However, such "medication" comes with side effects including lackluster future economic growth if not bolstered by productivity gains, and I believe Europe and Japan are experiencing such side effects right now. Eventually, poor economic performance will cause them to reverse policies hindering growth and progress, and capital will rotate into their undervalued assets.

Unfortunately, the uncertain international trade situation has caused businesses to limit investment, pressuring global growth. Until clarity on trade emerges, markets will probably focus on decreasing interest rates, rather than increasing activity. This may lead to temporary bouts of volatility, potentially weighing on asset prices and investor sentiment. However, once trade agreements are reached, and current uncertainty evaporates, look for emerging market stocks to potentially outperform all other asset classes for a while.

It’s important to continue to focus efforts on the underlying fundamentals supporting economic activity—and remember that while the U.S. economy is slowing, it is still growing. Solid economic prospects can keep corporate profits afloat, especially if there is progress in U.S.-China trade talks and global activity rebounds.

Please contact me if you have any questions, and enjoy the rest of the summer.

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