There hasn’t been a shortage of excitement this quarter, and the markets took note with global equities showing heightened volatility over the past six weeks. After dropping nearly 7% in May, domestic markets bounced back in June resulting in a 4.30% return on the S&P 500 for the quarter. Year to date, the S&P 500 has gained 18.54%. Global uncertainty around trade and interest rates has kept international returns more subdued but nonetheless positive. The MSCI EAFE Index is up 3.93% for the quarter and 14.53% year-to-date. Falling interest rates have led to positive returns across the bond market with the Barclays Aggregate Bond Index returning 3.08% for the quarter and 6.11% year-to-date.
Geopolitical headlines around trade generated much of the disruptions across the market. Trade worries, in addition to mixed economic fundamentals, have led markets to speculate that a protracted trade dispute will lead to slower economic growth. However, in another twist, President Trump and President Xi met at the G20 in late June and agreed to a restart stalled trade discussions. Markets responded positively to the announcement of continued talks between the countries and a delay to the additional U.S. tariffs of 25% on $300 billion worth of Chinese goods. But the risks are certainly high as a deal is still not certain and further escalation uncertain; estimates place the aggregate impact of a China trade war at ~0.5% of U.S. gross domestic product, and likely double that for China. Translating this into U.S. equity earnings, the negative impact is likely 2-3%, but could double as companies incur costs to shift supply chains. A negative outcome could weigh on global equity markets, though central banks have marked international trade headwinds as a clear circumstance for more accommodative policies.
At the June 19th meeting of the Federal Reserve Open Market Committee, Chairman Jerome Powell acknowledged that muted inflation and uncertainty due to the trade war have boosted the case for potential interest rate cuts. Fed officials will monitor incoming data to determine if a more accommodative policy is necessary in the near future. Markets took the Fed’s comments as dovish with the 10- year Treasury yield ending the quarter at 2.00% down from 2.41% just three months prior. Additionally, Fed funds futures now imply a 100% probability of a 25 basis point rate cut in July in addition to a 68% probability of at least 75 basis points of easing by year-end.
Central banks around the globe are reacting in similar ways to low inflation data and trade tensions. European Central Bank President Mario Draghi stated that the central bank would be willing to apply stimulus measures as early as July. The Bank of Japan (BOJ) also met in mid-June and left policy unchanged, though expressed a willingness to lower rates. The Bank of England (BOE) acknowledged that the UK growth outlook was weakening but is less eager to shift to further accommodations. Given the new Brexit deadline on October 31st of this year, the BOE will be an interesting case study to watch as uncertainty seems highest surrounding the future of the British economy.
Here at Hills, we expect lower interest rates to offset the softer growth environment, allowing risk assets (stocks) to remain attractive. Market volatility, however is likely to remain elevated. Focus remains on two key risks: (1) negative outcomes due to trade conflicts and (2) missteps by central banks – not responding appropriately to slower global growth due to tariffs.
While the outlook continues to favor stocks over bonds, we are reducing exposure in light of the fact that returns have been strong year to date and risk remains elevated. After increasing equity exposure following declines in the fourth quarter of 2018, we are now reducing our overweight exposure by 2% from 5% to 3% overweight.
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