The first half of 2019 was mostly positive for equity markets, which recovered quite nicely from the decidedly negative fourth quarter in 2018. These favorable results are despite a highly volatile second quarter of 2019 where equity markets vacillated between rallies and rough patches.
April’s continuation of first quarter’s advances faded quickly in May following the collapse of trade negotiations with China, as well as the threats of new tariffs on Mexico as a means of engaging them in stemming the flow of migrants at the border. Markets rebounded in June when the Fed, along with the world’s major central banks, shifted its tone toward an easing bias in response to global trade pressures and some weakening economic trends. Markets also breathed a sigh of relief as President Trump suspended proposed tariffs on Mexico, and the U.S. and China were able to come to a trade truce at the G-20 summit in Osaka.
For the quarter, the S&P 500 rose 4.3% while U.S. small cap equities (Russell 2000) were up a more modest 2.1%. Developed international stocks (MSCI EAFE) rivaled U.S. large caps, gaining 3.7%, while emerging markets (MSCI EM) were about flat, up .6%. Real estate (REITS) also struggled to remain positive, ending the quarter up .8%.
Fed policy continued to favor fixed income investors, with the BarCap Aggregate having another excellent quarter, up 3.1%, and money markets (Fidelity Money Market Fund Premium Class-FZDXX) maintaining their recent pace, currently yielding 2.26%.
While the U.S. expansion has become the longest on record as of July, recent economic data is mixed and recession fears seem to be emerging. U.S. GDP expanded at a tepid 1.4% in the second quarter, and we have witnessed the slowest manufacturing expansion in three years, as well as the lowest reading for the service economy since the Great Recession. That said, U.S. consumers are in relatively good financial shape. Recent retail sales numbers have been strong. The unemployment rate remains at a 49-year low of 3.7% as of June 2019, while average hourly earnings climbed 3.1% from a year earlier.
We see two main drivers of our short-term economic fate: 1) Whether the U.S. resolves various trade skirmishes, especially with China, and 2) the direction of Fed policy. While current trade issues are a timely topic, we would like to share our perspective on monetary policy.
Let’s begin with a few facts about the Federal Reserve (Fed) that will help put an analysis of current monetary policy into perspective. The Fed was established in 1913, when the public had little faith in the banking system. At the time, there were over 30,000 different currencies in the U.S., some backed by silver and gold or government bonds, and others issued by local vendors on a promise. Before the Fed, banks routinely collapsed, and the economy went through repeated booms and busts. The Fed’s original purpose was to organize, standardize, and stabilize the U.S. monetary system.
Today’s Fed does the following:
The Fed has two divisions. One group, the Board of Governors, is responsible for setting monetary policy and managing the nation’s money; the other group, the 12 regional Reserve Banks, acts as the service division that carries out the policy and oversees financial institutions. Both of these entities have the same mandate—maintain stable prices and seek maximum employment and production output. They achieve these goals indirectly by raising or lowering short-term interest rates. Although these are two separate Fed duties, the desired result of each is the same: a stable economy. Jerome Powell, the current Fed chairman, is responsible for seeing that the Fed’s mandate is carried out.
The Fed vigilantly monitors a number of economic indicators to assess the state of the economy. It categorizes each of them as Leading (future), Coincident (current), or Lagging (past). By studying these indicators in their respective categories, the Fed seeks to determine the phase of the business cycle that the economy is in at a given time in order to determine which Fed tools are appropriate to achieve its mandate.
There is an intricate and delicate relationship between interest rates, inflation, the dollar, and economic activity that the Fed must consider in making policy decisions. This is further complicated by the inter-relationship between the U.S. economy and the rest of the world.
The Fed has the impossible job of accurately measuring and assessing indicators so it can take action in a manner that serves the mandate, while also judging how its actions might affect other global economies and vice versa. Adding to the complication is the time frame of 6-18 months for policy moves to have their full impact on the economy. The result of all of this is that Fed monetary policy can be a very blunt instrument in managing our global economy, especially when combined with other geopolitical variables.
Chairman Powell’s recent dovish tone has caused many investors to believe that the Fed sees something in its data that is concerning. In his latest Congressional testimony, Chairman Powell said that “uncertainties about the outlook have increased in recent months,” adding that “a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling and Brexit,” referring to Britain’s negotiations to exit the European Union.
One of Chairman Powell’s newly expressed worries is his continued frustration with the fact that after 10 years of easy monetary policy, the Fed has not been able to hit its 2% inflation target. In fact, one of the Fed’s long-standing economic rules of thumb, the Phillips curve, an economic model suggesting there is an inverse relationship between rates of unemployment and inflation, does not seem to be holding true.
In June’s testimony, Powell revealed that “the connection between the level of unemployment and inflation was very strong if you go back 50 years, and it’s gotten weaker and weaker to the point where it’s a faint heartbeat. We really have learned that the economy can sustain much lower unemployment than we thought without troubling levels of inflation.” This is significant because it had been one of Powell’s justifications for tightening monetary policy earlier in his tenure. With U.S. unemployment under 5% for over three years, and inflation persistently under the targeted 2% threshold, it might be a key factor in the Fed’s recent dovish turn.
Another important aspect of the Fed’s recent stance is its possible response to the recent inversion of the yield curve. The yield curve is a curve showing the change in interest rates across different contract lengths for similar debts. Typically, the longer the term of a loan, the more interest you will pay. If you plot this on a graph, it will form a curve, which is higher as you move from left to right.
The Fed can affect this curve through monetary policy. At times, the Fed will cause short-term rates to become higher than long-term rates, which is referred to as an inverted yield curve. A yield curve inversion can demonstrate that the Fed has been too aggressive in raising short-term rates. As a result, inversions have historically been a rather potent predictor of an impending recession. The yield curve inverted in December 2018, so many are speculating that the Fed will take back a few of its recent rate hikes to restore the curve to a more normal shape, thus helping to reduce the likelihood of recession at the hands of the Fed.
If these issues were not enough for the Fed, they are occurring in the face of competing global monetary policy where four other nations have 10-year government debt with negative yields. Imagine lending someone a dollar, and they pay you back 95 cents ten years from now! To the extent our rates continue to trend higher than other global rates, it causes the U.S. dollar to rise against these currencies, making goods and services more expensive to foreign buyers, which puts further pressure on U.S. exporters.
After a 10-year expansion, it is reasonable to assume there will be headwinds in keeping our economy on course. The Fed and other monetary leaders around the globe will be using every tool at their disposal to promote economic expansion and to mitigate downturns when they present themselves. At Wealth Dimensions, we believe that attempting to predict these cycles or time markets will continue to prove futile. That said, we continue to make subtle changes to our portfolios as the economic and market landscape changes. For instance, we have been adjusting the relative durations of our fixed income portfolios, and have been adding an equity instrument designed to dampen downside volatility while participating in long-term equity returns.
We do not have any reason to believe the U.S. economy will not continue its pursuit of balanced economic growth. However, we also remain prepared for the next downturn, whenever it may present itself. In light of the inevitable changes in economic trends and government responses, the most certain path to continued personal prosperity is to practice conservative consumption, have a well-crafted plan, and have the discipline to stay with it. We remain committed to helping you do so.
We live in a complicated, unpredictable world, yet we remain confident that over the long run, we will be able to capture positive market returns regardless of short-term circumstances.
Thank you for the continued confidence in our services.
For informational purposes only. Not intended as legal or investment advice or a recommendation of any particular security or strategy. Information prepared from third-party sources is believed to be reliable though its accuracy is not guaranteed. Opinions expressed in this commentary reflect subjective judgments of the author based on conditions at the time of writing and are subject to change without notice. For more information about Wealth Dimensions, including our Form ADV Part 2A Brochure, please visit https://adviserinfo.sec.gov or contact us at 513-554-6000.
Please be advised that this material is not intended as legal or tax advice. Accordingly, any tax information provided in this material is not intended and cannot be used by any taxpayer for the purpose of avoiding penalties that may be imposed on the taxpayer.
 The Washington Post, “The Finance 202: Powell has some bad, good and ugly news for Trump”, July 11, 2019.
 AP News, “One reason for a Fed cut: Powell now fears too-low inflation”, July 11, 2019.