Third Quarter Highlights

 Global equity and fixed income markets were mixed in the third quarter, although most major averages edged higher. Precious metals rose, while other commodities fell, despite events such as the drone attack on Saudi oil facilities in early September. The U.S. dollar continued to defy skeptics, posting a gain for the period.

A Continuation of Cross Currents

 Similar to the second quarter, stocks initially rallied on earnings that beat lowered expectations.  But early August saw a market drop as new Administration tweets threatened a 10% tariff on the remaining $300 billion of Chinese imports. Optimism returned, however, as the two sides agreed to restart formal talks on October 10th.

Currently, expectations hinge on hope for a “mini-deal” which would involve more of China’s agricultural imports such as pork and soybeans. More contentious items such as intellectual property rights and national security concerns will probably be addressed over time. At quarter’s end, the initiation of impeachment proceedings against the President also adds to the mix of uncertainties.

During this quarter, Europe was very much in the news. The possibility of a hard Brexit was reduced as British PM Boris Johnson’s attempts to force a Halloween deadline were stymied. Meanwhile, the European Central Bank (ECB) delivered one last bout of monetary easing under outgoing leader Draghi, while hopes for a German fiscal stimulus faded as government officials cooled towards the idea. All the while, economic data from the Eurozone was weak as Germany likely heads into an economic recession.

The Federal Reserve figured prominently during the summer by lowering interest rates for the first time in a decade. Though many had hoped for a more aggressive easing, the U.S. central bank did lower the Federal Funds Rate by 25 basis points (0.25%) twice during the quarter. It should be remembered that Chairman Jerome Powell must try to formulate a consensus among the voting members, a task that has proven to be more difficult in recent months. The September meeting featured three dissents: two voters opted for no rate cuts while one wanted a 50-basis point decrease.

A Tale of Two Economies

The current dichotomy in the American economy is major part of the dilemma among

Fed members. The consumer sector is doing well, with confidence surveys moderate but still strong and unemployment near 50-year lows. The average hourly wage is growing and the quits ratio, a measure of worker confidence in finding better paying jobs, is near multiyear highs. Also, people have money to spend — the savings rate is over 8% and home equity is steadily building for the average homeowner.

The manufacturing sector, on the other hand, is weakening rapidly due to a slumping global economy. Trade tensions, chiefly between the U.S. and China, are a major source of angst for exporters of industrial goods. The effects extend down the supply chain, with many other manufacturing companies involved in the slowdown. A strong U.S. dollar has also not helped the situation.

Fortunately, the consumer makes up close to 70% of the U.S. economy, while manufacturing composes most of the rest. The key question is the spillover effect of manufacturing to the consumer sector. If unemployment picks up significantly and consumer confidence falls precipitously, a recession will become a real possibility. However, if some progress is made on the trade front, especially with China, the global economy may trough soon after and the deterioration in U.S. manufacturing may be halted.

The Yield Curve and Negative Interest Rates

The yield curve is still partially inverted, but now positively sloped past the one-year maturity. At the risk of saying it might be different this time, due to this the yield curve’s predictive accuracy of a future recession may be muddled this time around. Also, there is the new phenomenon of negative interest rates in many countries. Both the ECB and the Bank of Japan (BOJ) have formally instituted this policy and over $15 trillion in global debt is now negative yielding. Foreign investors in search of a positive yield have bought massive amounts of American debt, depressing yields on longer maturity instruments.

The implications for the pricing of assets due to negative interest rates are wide ranging. Many mathematically-based pricing formulas, such as the Black-Scholes model used to price financial instruments, break down when negative numbers are part of the calculation. Negative interest rates also provide little incentive for banks to extend credit, a necessary condition for economic growth. Indeed, the recent decision of the BOJ not to buy longer maturity debt may be an admission that negative interest rates are too low and could actually hinder economic growth.

The Outlook for Year end

  • Our neutral asset allocation remains unchanged.
  • It is too soon to know how impeachment proceedings in Washington will evolve, although ultimately, the economy is the key to the markets.
  • Trade talks with China, along with continued Fed accommodation, will be the most important thing to watch in the months ahead. If the trade situation does not improve over the next several months, an eventual recession is a distinct possibility.
  • If there is some progress with trade, economic growth should trend higher again, an environment very positive for the markets.