Market Update: Q2 2019

After a very strong first quarter for global stocks, the U.S. stock and bond markets are telling very different stories. The stock market continues to lurch higher, driven by expected earnings, economic growth, and investor optimism. The bond market, on the other hand, is not so positive. A flattening and even inverted yield curve shows pessimism in the U.S. economy from bond investors.

The “right” take is probably somewhere in between these two extremes, which is the economic data indicates. Jobless claims are at a 50-year low, but payroll gains in March came in lower than expected. The ISM Manufacturer’s Index was up sharply in March, but retail sales and durable goods orders fell.

The international picture is a mixed bag too. We continue to watch the UK Brexit proceedings and the country’s wrestling match with the European Union (and itself). First quarter stock returns were very strong abroad as well, but a key leading indicator shows that trouble may be brewing. This quarter’s market review will tackle all these topics, in addition to a very strong quarter for real estate investment trusts (REITs).


Three Oaks Capital Market Update Q2 2019 World Stocks.PNG
Three Oaks Capital Market Update Q2 2019 World Asset Classes.PNG

U.S. Stocks

The big news in the U.S. markets last week was the IPOs of Pinterest and Zoom. Both rose sharply after their debut, with Pinterest up 28% after one day of trading, and Zoom up nearly 80% at one point. There was a time when investing in IPOs was in vogue. Bankers would take executives of companies about to go public on “road shows” around the country, to spread the news about how great the company was and why you should invest in them. They’d tout growing markets for their products & services, and why their shares are bargain.

Come to find out, investing in IPOs usually only works out well when you can buy shares before the public offering. Despite all the buzz in the news and the first day “pop” after trading opens, investors who pick up shares on the open market do so at higher prices, and tend to get pretty poor returns. It’s also incredibly difficult to obtain pre-IPO shares. There are a select few institutional investors who are granted access at a discount to the public’s offering price. But for the rest of us, we’re stuck buying shares on the open markets.

Moral of the story? Try to stay away from the hot new IPOs. If you’re a believer in broad diversification and index investing like I am, this won’t be a problem.

Aside from the new shares now trading in public markets, the news has been all positive for U.S. stocks thus far in 2019. Small cap stocks led the way, up 14.58% in the first quarter. While corporate earnings continue to be strong, there’s been a significant “P/E” expansion in 2019. P/E is the ratio of price to earnings, and is a valuation measure I like to keep my eye on. It’s helpful for evaluating both individual securities and entire stock markets, as it helps determine whether an investment is cheap or expensive. Higher ratios of price to earnings mean that a stock or an index is more expensive, relative to the earnings it produces.

As I mentioned, corporate earnings (the denominator of the P/E ratio) have been strong, and increased in Q1. Even so, stock prices rose by enough to outpace the increase in earnings and drive up the P/E ratio further. With the economy on relatively strong footing right now, this makes the stock market susceptible to a drawback. A hiccup in earnings or string of bad news could easily send stocks into a correction.


International & Emerging Markets Stocks

Just like stocks here in the U.S., equities in both the developed and emerging international markets had a tremendous quarter. Markets in the UK and other developed European economies continue to chug along and produce strong returns, despite all the ongoing Brexit turmoil. At this point there are three main possibilities for how the Brexit fiasco will unfold:

  1. Hard UK Brexit. In a hard exit, the UK would leave the EU entirely and abruptly. The UK has until October 31st to reach a deal avoiding this outcome after being granted another extension last week. If the UK parliament isn’t able to reach a deal for a “soft” exit by then, the EU is unlikely to agree to another extension (French president Macron strongly opposes extending the date further). This would be a bit of a surprise outcome, but would force the UK out in a “hard” exit. This would very likely send UK stocks (and probably other European countries’) downward.

  2. Soft UK Brexit. Prime Minister May is still working hard to reach an EU-approved agreement for a soft exit. This option would allow the UK to leave the EU but remained aligned in a number of ways, including trade channels and supply chains. May needs help from the UK’s Labour party to make this happen. If she’s successful I’d expect European stocks to post modest gains.

  3. No Brexit. There is a scenario where Prime Minister May allows a referendum, where British voters would have a final opportunity to choose between her “soft” exit plan or no Brexit at all. With the vote to proceed with the Brexit in the first place being such a surprise, there’s no telling how a subsequent referendum would turn out. If there is no Brexit at all, UK & European stocks would probably drive higher.

As you all know (if you’d read my market updates or other writings), I make it a point NOT to invest clients or my own money based on near term issues like Brexit. The path to the best investment outcome is to employ a consistent and long term strategy aligned with your financial objectives.

That said, I also believe in keeping up with world events. I need to understand what’s going on in my clients’ accounts, and be able to field my clients’ questions when they ask about about their portfolio or specific funds or positions.

So what should we expect moving forward? The OECD (Organization for Economic Cooperation & Development) maintains a leading economic indicator of the global economy. This “index” is approaching a significant threshold: 99. The number 99 doesn’t mean anything in and of itself, of course. But its movements around that number have been. Over the last 50 years a drop to 99 seems to happen right around the beginning of global recessions. It happened in 2008, 2001, 1990, 1981, 1974, and 1970. The indicator has never crossed below 99 and NOT coincided with a global recession. It currently sits at 99.1.

Three Oaks Capital Market Update Q2 2019 Emerging Mkts Stocks.PNG
Three Oaks Capital Market Update Q2 2019 Country Performance.PNG

U.S. Fixed Income

While the stock market is showing absolute confidence in the U.S. economy, the bond market is telling a different story. The yield curve continues to flatten, and has even inverted recently. A yield curve “inversion” means that long term rates fall below short term rates. This happened more than once in Q1, and signals a lack of confidence in future economic growth opportunities. The longer that investors are willing to lock up their money at lower rates, the weaker the signal about the economy.

In Q1, high yield produced the greatest bond returns, with the Bloomberg Barclays US High Yield Corporate Bond Index up 7.26%. The flattening & inverting yield curve drove the sector’s returns in two distinct ways. First, bond prices rise when interest rates fall. This concept is known as duration. Think of it this way, if a bond is issued at 5% (because that’s the market level of interest), they start to look pretty good when interest fall to 4%. New investors are only getting 4% on their money, while you continue to earn 5% on yours. Falling long term interest rates drives bond prices up.

On top of that, investors tend to get more aggressive with credit risk when long term bond yields fall. Many investment managers are tasked with producing a certain level of income from their portfolio. When interest rates fall, their bond income may also fall below their desired level. To make up the difference, many investors decide to take more credit risk, often by moving into high yield bonds. This greater demand tends to drive up prices, which is exactly what we saw in Q1.

10 Year U.S. Treasury Yields ( Source: cnbc.com )

10 Year U.S. Treasury Yields (Source: cnbc.com)


Real Estate

Looking at the chart above showing world asset class returns in Q1, you’ll notice that real estate investment trusts (REITs) led the way, returning 15.72% here in the U.S. I wouldn’t say that this number jumped off the page at me, but it did stand out. My thought here is that the return is mostly driven by the falling long term interest rates. REITs usually rely on leverage to acquire holdings in their portfolios. Many invest in corporate real estate like shopping malls, commercial buildings, and hospitals that require a significant amount of financing. Because of this, changes in interest rates have a significant impact on their bottom lines. When long term rates fall, as they did in Q1, it reduces REITs’ borrowing costs and makes them more profitable.

Going forward, opportunity zones are an area to keep an eye on. Opportunity zones are economically deprived areas throughout the country. Development projects in these areas carry significant tax advantages, thanks to the Tax Cut & Jobs Act. I won’t go into the details here (look out for a future blog post), but suffice it to say that there’s a land rush toward these areas because of the tax advantages. Developers & investment managers are clamoring to put together funds, and I’m certain there will be publicly traded REITs available by the end of the year.

Three Oaks Capital Market Update Q2 2019 Real Estate.PNG
three-oaks-capital-attorneys.jpg

Subscribe to Investment Insights

Subscribe to the blog and receive a free copy of Living the Good Life: 5 Ways a Relationship with a Financial Planner Can Help You Live a More Fulfilling Life.