We feel investors should have an information outlet for the financial markets that is thorough, but does not require a prerequisite degree in economics. We hope this makes our commentary informative and educational for all levels of investors.
|Asset Class†||2nd Quarter 2019 Return||Past 12 Months|
|U.S. Small Cap Stocks||2.1%||-3.3%|
|U.S. Large Cap Stocks||4.3%||10.4%|
Quarter in Review
The 2nd quarter provided a bit of a breather for stock investors as returns were far less volatile than the previous quarter’s big swings. While stocks were relatively placid, the downward move in interest rates caused bond markets to rally (interest rates move inversely to bond prices). Interest rates now stand near their 3-year lows, reversing the steady increase in rates which had reflected a sentiment that the economy had reached sound footing.
Among the biggest stories in the 2nd quarter were the large number of Initial Public Offerings (IPOs) that hit the market. According to IPO gurus Renaissance Capital, the 63 IPOs in 2nd quarter of 2019 represented the most in one quarter in over 4 years. So far in 2019 many familiar companies have debuted, including ride-sharing companies Uber and Lyft, pet food supplier Chewy, and social media company Pinterest. Perhaps the most exciting company to go public was Beyond Meat, the plant-based meat maker looking to upend how carnivores eat. The stock (ticker: BYND) started trading at $25/share and rocketed up over $200/share, eventually ending the quarter around $160/share. A wild ride that indicates stock market investors still have an appetite for risk 10 years into a bull market.
Interest Rates, the Economy, and the Stock Market
The continual rise in the stock market in the U.S. since the 2008 financial crisis can be attributed to many factors both at the macro (e.g. continually low unemployment and inflation) and micro (e.g. innovation and a healthier banking system) levels, however at this stage in this bull cycle, interest rates are taking center stage. Two important indicators are the spread of rate between short-term and long-term bonds and the Federal Reserve’s rate decision.
Common sense says that the rate demanded from a longer-term bond should always be higher than that of a shorter-term bond, all else being equal. In economic terms this is called the yield curve premium and such a scenario exists during most points in the economic cycle. In simplistic terms, a loan (or bond) due a number of years from today is riskier than that of one due in the coming weeks or months. You may lend a friend money if they say they’ll pay it back tomorrow, but you may be less willing if they tell you they want to pay you back next year.
However, there is a scenario where interest rates for both short and long term rates converge or even flip, where interest rates on longer-term borrowings are lower than those rates for the shorter-term, which is called an inverted yield curve. This has little to do with the borrower’s ability to re-pay the loan, but rather a perception by those in the market that interest rates will continue to decline. This perception is a signal by the bond market that the economy will weaken.
As the chart below illustrates, the last two instances where the yield curve inverted were just prior to recessions (gray bars). While the curve has not entered inverted territory yet, it is nearing that mark.
Federal Funds Rate
The current state of affairs with the Federal Reserve looks more like a remake of a classic thriller rather than a new script–and if it is indeed a remake, the bull market may be losing some oxygen.
As a review, interest rates had been very low following the 2008 financial crisis until late 2015 when the Federal Reserve wanted to combat the effects of an ailing economy. By lowering rates, the Federal Reserve was able to combat high unemployment which encouraged spending since lower rates make it “cheaper” to finance business expansion and big-ticket household purchases like housing. While the lower rates can act to spur growth, it is often accompanied by the undesirable effect of increased inflation.
However, inflation had been benign enough to allow the Fed to keep their rate at near-zero. Then in late 2015, as unemployment was no longer a threat to a healthy economy and inflation started ticking up, the Fed began making steady increases to their target interest rate. This policy seemed to be working by gently suppressing the economy in order to avoid a bubble that could lead to a crash. However, as the stock market tumbled in late 2018, some (including President Trump) questioned the policy of rising rates as market prospects dimmed and inflation has remained relatively tame.
This has led the market to anticipate the Fed is done raising rates and even potentially cutting rates to boost the economy.
While the timing and actors involved have changed in each economic cycle, the current scenario is surprisingly nearly identical to the past two recessions in our economy. As the chart below shows, in both 2000 and 2007, just before recessions hit the U.S. economy, the Fed lowered rates despite unemployment remaining low.
Some take-aways from this scenario are:
- Despite the intent of the Fed to maintain a policy course for low employment and inflation, it seems as though the stock market performance does play a role in their policy, especially in the periods just prior to, and after, a recession.
- The Fed and their ability to set interest rates may not be powerful enough to combat an economy at the late stages of a bull market cycle.
- The Fed has the unenviable job of trying to reduce market exuberance to avoid a crash, but in doing so, they could easily be viewed as the reason for a market downturn.
While this commentary on interest rates paints a dismal picture of the future of the current bull market, it is not necessarily an indication that a recession is around the corner. Other statistics such as consumer sentiment and personal savings rates are at levels that indicate that the economy is still on sound footing. Searching for the pothole that leads to the next market crash has become a sport to market commentators (this commentator included). Statistics and trends that have occurred in previous downturns will likely play a large role in the next downturn, but the markets are constantly evolving, making it very difficult to predict the future.
Federal Reserve – The United States’ central bank, which is responsible for regulating the banking industry and controlling the money supply through monetary policy.
Federal Funds Rate – Interest rate used by the largest banks to lend money in the shortest time periods, usually overnight.
† Indices used to represent asset classes:
U.S. Large Cap Stocks – S&P 500
U.S. Small Cap Stocks – Russell 2000
International Stocks – MSCI ACWI ex-U.S.
U.S. Bonds – Barclays Aggregate
Commodities – Bloomberg Commodity
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