Monthly Investment Review — October 2019 Nov. 1, 2019
October was a good month for the stock market, as the S&P 500 rose 2.0% while the Nasdaq gained 3.7%. As the month came to a close, the S&P 500 and other major market indices were at or near their all-time highs. In the bond market, yields on ten-year Treasuries were roughly unchanged, ending the month at 1.69%. The main issues affecting the markets during the month were the economy, third quarter earnings reports, Federal Reserve policy, and hopes for a trade deal with China.
Figure 1 S&P 500 index – Stocks made solid gains in October
Economy and Earnings
As October began, stocks sold off sharply for a few days on worries that the U.S. economy might be slowing. Several economic reports were weaker than expected, raising worries that the manufacturing sector is being hurt by tariffs and the trade war with China. However as the month progressed, investors were reassured by a number of other reports. The unemployment rate fell to 3.5%, the lowest since 1969, and the gross domestic product (GDP) grew at a fairly healthy annual rate of 1.9% in the third quarter. On Friday, November 1st, the employment report for October was released, showing a stronger-than-expected gain of 128,000 jobs, and data for the prior two months were revised higher.
In general the U.S. is the only bright spot in the global economy. Europe and Japan have been weak, while China has been hurt by tariffs and disruptions to global supply chains. Within the U.S. economy, consumer spending is the strongest area, driven by low unemployment and rising wages, whereas capital spending has been hurt by uncertainty over the trade war with China.
Corporations began to report third quarter earnings in mid-October, and investors were relieved to see that many of the initial reports were better than expected. Earnings reports and higher guidance from many companies were some of the main factors supporting the market during the month. Although the average earnings increase was only in the mid-single digit range, expectations had also been low, so the modest gains were not a problem.
Federal Reserve Policy and Interest Rates
The Federal Reserve has dramatically changed policy over the past year. In October 2018, Fed Chairman Jerome Powell sparked a stock market selloff with comments suggesting that the Fed was planning to keep short-term interest rates on an upward trajectory. Since then the Fed has changed direction, and has now cut rates three times. This policy change has been driven by a number of factors, including the fact that long-term interest rates have come down sharply, worries about weakness in the global economy, trade uncertainty with China, and evidence that inflation remains very low.
In late October the Fed made the third of these interest rate cuts, bringing the Fed funds rate down to the range of 1.50% — 1.75%. Fed Chairman Powell suggested that no more rate cuts are likely in the foreseeable future, saying that the Fed will “assess the appropriate path” for short-term rates based on incoming data. Markets do not expect another rate cut at the Fed’s next meeting in December, although there is some possibility of a rate cut in early 2020.
Long-term interest rates have come down sharply this year. The yield on the benchmark ten-year Treasury bond ended 2018 at roughly 2.70%, but fell to the 2.0% level by June 2019, and then plunged in August, hitting a low of 1.43% in early September. Since then the yield has climbed up a bit, reaching 1.69% by the end of October. This is an extremely low level by historic standards, especially given the strength of the U.S. economy. Much of the decline in bond yields can be attributed to the fact that other countries, such as Germany and Japan, have negative interest rates, so by comparison a rate of 2.0% in the U .S. seems attractive to foreign investors.
The decline in long-term interest rates has led to a situation in which long-term rates fell below short-term rates, a situation known as an inverted yield curve. Earlier this year the inverted yield curve was becoming a big concern for stock market investors, because historically it has been a leading indicator of a recession.
However, in most of the past cycles over the past 60 years, the inverted yield curve was caused by the Fed raising short-term rates to an abnormally high level in an effort to curb inflationary pressures. In the current environment, inflation remains low and the Fed has been cutting rates, not raising them. Furthermore, long-term yields have become abnormally low due to global forces that were not present in previous cycles, such as negative interest rates in other countries. Thus in our view the inverted yield curve from earlier this year will not lead to a recession.
Trade with China
Trade talks between the U.S. and China took place in mid-October. The stock market rose sharply on October 11th, with a gain of 320 points in the Dow Jones Industrials, on news that Phase I of a trade agreement had been reached. Steps were taken to stop the forced transfer of U.S. technology, and China agreed to buy record amounts of U.S. agricultural products, in the range of $40 – $50 billion.
Tariff increases to 30% which were scheduled to take place on October 15th were cancelled. President Trump said that we are very close to ending the trade war with China, which will be a major positive for the world economy as a whole. The Phase I agreement will be put in writing and is expected to be signed by Presidents Trump and Xi sometime in November.
Conclusion
As November begins, the market has broken out to new highs, which bodes well for continued gains ahead. The market has now become somewhat overbought on a short-term basis, so a pullback is possible at any time, but we would view such a pullback as a buying opportunity, as the old highs from earlier this year will now become a support level.
The fundamentals remain generally strong. The U.S. economy remains healthy, inflation remains low, interest rates are low, and the Fed has been easing. The trade deal with China is a positive.
From a valuation standpoint, the market is not cheap, but it is not overvalued either. Seasonal tendencies are now positive, as the December – January timeframe is normally a good period for the market.
As always, there are a number of risk factors in the environment. One of these is the extremely acrimonious political climate in Washington, involving the impeachment of the President, a rare event in political history. Another is the possibility that the China trade deal could fall through, or that China might renege on the deal at the last moment, which would be a big disappointment to the market. The issue is made more complicated by the recent violence in Hong Kong.
However, despite the risk factors, we believe the market outlook remains generally positive, and portfolios are positioned with a higher than average level of equity exposure.
Jonathan Strauss, CFA
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