Credit: stoplights, long exposure, colorful
- The major equity indices ended a four-month streak of gains following an end to the U.S. - China trade truce.
- Stock and bond markets reacted to an expected slowing of the global economy.
- Rates plunged across the curve with the 10-yr yield falling the most since January 2015.
- The entire rates curve out to the 10-year yield is trading below the overnight Fed Funds rate.
- The 10yr – 3M Treasury spread inverted to a low of -22bps.
- Markets are pricing a greater than 80% probability for at least a 50bps rate cut by year end.
Market Recap
A steady four month streak of gains for the large cap equity indices came to a “tweeting” halt in early May when the U.S. – China trade truce ended. Both countries accused each other of backing away from previous commitments resulting in announced tariff increases. Hope remains the presidents of the world’s two largest economies will have constructive talks at this month’s G20, however that optimism faded on the final day in May when Trump set his tariff crosshairs on Mexico.
The major equity benchmarks each declined between 6.5% and 8.5%, which absent the noise and relative to the prior YTD gains is not unhealthy. More unusual was the prior steep rise with very minimal pullback. The Dow Jones Industrials (INDU) ended May down 6.7% and a streak of six consecutive weeks in the red. Since the start of the 20th century it has never made seven consecutive weekly declines. The Nasdaq 100 (NDX) saw the biggest drawdown (-8.4%) but for 2019 remains the top performer, +12.6% YTD. The small cap Russell 2000 (RTY) declined 6.9% and closed out the month down 20% from its 52-week highs.
Outside of the U.S. the exchanges of the leading global economies also saw steep declines including China’s Hang Seng (9.4%) and Shanghai Composite (-8.2%), the Euro Stoxx 600 (-6.2%), the MSCI World Index (-6.1%) and the MSCI EM Index (-7.5%).
Sector Performance
Defensives outperformed cyclicals with the bond proxy REITs (+1.2%) the only sector in the green, followed then by utilities, (-1.3%), and healthcare (-2.6%). Energy (-11.7%) was the worst performing sector as the escalating trade war dampened expectations for future demand and crude oil (WTI) declined more than16%. Meanwhile the technology sector (-8.9%) registered its worst monthly decline since the heart of the financials crisis in November 2008.
Crude oil (WTI) maintained its positive correlation to equities and ended its own four month steak of gains with a decline of 16.3% (WTI) and 11.4% (Brent). The Bloomberg Commodity Index (BCOM) registered its third consecutive month in the red with a decline of 3.6%. Spot gold gained a modest 1.7% but continues to face stiff resistance below the 1,350 – 1,400 resistance line in place since Q4 2013.
The 10-year U.S. Treasury yield saw its biggest monthly decline (-38bps) since January 2015. It ended May at 2.12%, down 114bps from its October highs. The 10yr – 3M spread returned to negative territory in early May and finished the month at a negative 22bps. While the 10yr – 2yr spread remains positive, everything to the left of the 30-year bond is trading below the overnight fed funds rate. To boot the 3-year yield finished May more than 50bps below the overnight rate.
After reaching a 30+ year high last November, the 10yr US Treasury - Bunds spread broke down below a key 12-month support line, 240bps, in the final days of May. The 240 bps support represents the neckline of a textbook shaped topping pattern (H&S) and as expected the break was followed by an accelerated move lower.
Will the Fed cut rates?
One of the potential reasons that equities have not seen further downside of the oft-repeated belief that the Fed will cut rates one or more times in 2019. The chart below depicts the implied probabilities of various FOMC interest rate target levels in December based on CME Fed Fund Futures.
Fed Fund futures have reacted to an expected slowing of global economic growth based on economic data, trade headlines and overseas interest rates. For example the German 10-year “Bund” has seen steadily declining rates, slipping into negative territory in March for the first time since late 2016. As mind-bending as negative rates can be, they exert downward pressure on U.S. rates because investors bid up the prices of Treasuries in the search for yield. In late 2018 the 10-year note yielded 3.2% and was heading higher. Rates have fallen steadily since, with the yield falling sharply from 2.43% to 2.13% over the final ten days of May.
One thing that stands out is that the implied odds of the U.S. Fed keeping rates at current levels (green line on chart below) have plunged from as high as 95% in March to the current odds of 6%. Notably, there is also 0% chance of a rate hike this year. Markets are therefore expecting at least one 25bp cut in rates (23% chance) with the odds of two cuts at 36% and three moves lower at 26%. At the beginning of May, the odds of three Fed cuts was only 1%. These market-based probabilities move around quite a bit but are clearly signaling that the market is expecting, with a 94% probability, that the Fed will ease rates in 2019.
To make these cuts a reality, the Fed needs to get on board. The FOMC is looking at an economy that is in a very good place, with unemployment at near 50-year lows, stable inflation and decent economic data. The Fed, therefore, looking (backwards) at economic data may not have caught up to the market based measures. Still, despite a mandate of maximum employment and stable prices, the Fed will need to monitor the low inflation readings and trade tensions that can slow economic growth. Stocks are therefore highly attuned to Fed statements about the path of future interest rates. If these turn out to be more hawkish than investors’ expect, then stocks could weaken if current trade tensions remain.
Earnings
First quarter earnings season ended in May and saw 76% of S&P 500 companies reporting a positive earnings surprise, in line with the one year average beat rates. S&P 500 earnings declined 0.4% in Q1, relatively better than the 4.1% decline initially expected.
Turning to Q2, analysts are expecting a 2.1% decline in earnings and revenue growth of 4.1%. This is lower than the 0.6% expected decline from a month ago. For Q2, 84 companies have reported negative guidance, with 26 reporting positive guidance. The 76% negative guidance ratio is above the 5-year average of 70%. On one hand some of the weakness expected in Q1 may have transitioned to Q2, but 1Q demonstrates that companies still often beat expectations so a flat second quarter is not out of the realm of possibility. Analysts still expect slight earnings growth in Q3 and single-digit growth in Q4.
Technology and Materials have seen the most downward Q2 revisions compared to March 31, with Energy stocks having the most positive revisions.
Returns by Index
Stocks fell sharply in May but are still up double-digits for the year. Looking at returns by Major Index gives some additional insight. For January, all indexes gained at least 7%, with small caps as measured by the Russell 2000’s 11% gain leading the way. The situation continued in February, as stocks continued to gain, led again by smaller stocks. This trend reversed itself in March, with the Russell 2000 the only index to decline and the Dow rising only 0.05%. This index is price-weighted and only contains 30 stocks so Boeing’s situation weighted more heavily on the Dow than on the S&P, which rose 1.8%.
April saw a return to gains and the rally in tech helped the S&P 500 and Nasdaq Composite to lead the way higher. May however saw the trade skirmish take on a much more serious tone and stocks fell across the board in a 6-8% range as “risk-off” again took the reins. Looking at year-to-date returns, stocks are still in positive territory, with the Nasdaq composite index up 12.3% despite having the weakest May performance among major indexes.
Looking Ahead
Looking ahead it is difficult to surmise how the trade war(s) will resolve and how policy makers will respond. Just one month ago the major large indices were trading at or near all-time highs and today they are already below their 200-day moving averages. While the pullback in stocks is relatively normal in comparison to the prior uptrend, the bond market is painting a much more concerning picture that historically has often signaled a looming recession.
The Fed may have gone too far into the tightening cycle despite a widespread decline in global asset prices in Q4, but uncertainty remains how and when they will adjust to the inverted curve, falling inflation, and the “Tariff Man”. Chairman Powell’s relatively short track record includes multiple miscommunications since the start of Q4 and one has to wonder how their next response or communication will be received. President Trump has moved into new territory with his willingness to leverage tariffs for non-economic goals (i.e. immigration) which only increases uncertainty for corporate executives and central bankers.
The information contained herein is provided for informational and educational purposes only, and nothing contained herein should be construed as , either on behalf of a particular security or an overall investment strategy. All information contained herein is obtained by Nasdaq from sources believed by Nasdaq to be accurate and reliable. However, all information is provided “as is” without warranty of any kind. ADVICE FROM A SECURITIES PROFESSIONAL IS STRONGLY ADVISED.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
