2nd Quarter Economic Update 2019

July 24, 2019, by John Norris

The 2nd Quarter of 2019 wasn’t quite as strong as the 1st, but the markets still managed to post solid absolute returns. After a horrible month in May, investors climbed back on the rally bandwagon in June, and the party which started in January has kept up through the first couple of weeks in July. It has been quite a ride.

So, what gives? Why has this year been so good for the stock market?

Wall street

The biggest difference between the last three quarters has been the markets’ outlook for future Fed policy.

  • During the 4th Quarter of 2018, investors were anticipating future rate hikes.
  • During the 1st Quarter of 2019, the markets thought the Fed was ‘on hold’ for the foreseeable future.
  • During the 2nd Quarter of 2019, the Street began to ‘price in’ several rate cuts by the end of the year.

Interestingly, the economic data during the quarter didn’t suggest the need for easier money in the US. In fact, it appeared the economy continued to grow a modest, arguably sustainable pace. So, again, what gives? For whatever reason, the yield curve did.

During the quarter, medium and longer-term interest rates fell sharply, inverting the yield curve at several places. This is when shorter-term rates are higher than longer-term ones, and this has traditionally slowed the pace of borrowing and lending in the US banking system. To be sure, a small drop in rates would have been understandable given the very slight softening in the economic releases. However,  a 70 basis point decline in the 10-Year suggests much slower future economic activity than what is currently apparent.

Why is the bond market saying one thing, namely slower economic times ahead, and stocks are screaming something else altogether? Let me give you an answer in five short bullet points.

  • Despite decent US economic data during the quarter, long-term interest rates fell sharply on concerns the trade war with the Chinese would slow global growth.
  • This drop in interest rates led investors to believe the Fed would cut the overnight lending target rate sooner rather than later to produce a ‘fabled’ soft landing in the economy.
  • This change in sentiment about the future of monetary policy made equity investors feel better about the future.
  • If it sounds circular, it kind of is.

 

When push comes to shove, the Fed can’t afford to be cavalier about a sharp decline in longer-term interest rates a. While an inverted yield curve doesn’t always mean a recession, recessions always have an inverted yield curve. As such, the path of least resistance for the Fed is to cut the overnight rate once or twice, maybe three, times to keep banks extending credit and expanding the money supply. That has always been better than the alternative for economic growth and, therefore, corporate profits.

So, what gives? It appears as though the Fed will, perhaps as early as the end of July. This has been almost a complete about face from the end of 2018, and the markets really like it. Now, whether it makes sense and the bond market is correctly forecasting future economic growth are topics for cocktail party conversations, boring ones.

In the end, regardless of the complicated reasons, investors made money in the 2nd Quarter of 2019, and that is always a good thing.