U.S. equity investors sold in May—will they go away?

Brian Nick

The last week’s market highlights:

Quote of the week:

“The future is no more uncertain than the present.” – Walt Whitman
Each week, we present our featured topics in the context of the major themes listed below from Nuveen’s 2Q 2019 Outlook :
  • U.S. economy: Late cycle but no recession
  • Global economy: Slower this year than last  
  • Policy watch: A dovish turn for global central banks  
  • Fixed income: Rates likelier to rise than fall
  • Equities: Get defensive, stay invested
  • Asset allocation: Still favorable to emerging-market assets

Looking at global markets from both sides now  

In her 1968 hit single, “Both Sides Now,” Joni Mitchell sang, “Something's lost, but something's gained/In living every day.”
Sounds like a description of the 2019 U.S. stock and Treasury markets.
Despite May’s slide in equities amid concerns over the U.S.-China trade war and slowing global growth, the S&P 500 Index (+9.8%), Europe’s STOXX 600 Index (+9.3%) and MSCI China Index (+4.7%) remain solidly in positive territory for the year to date. These gains represent relatively bullish outlooks for the global economy.   
The bond market, in contrast, seems downright pessimistic on the prospects for growth. The yield of the bellwether 10-year note has fallen from 3.24% on November 8 to 2.14% on May 31. (Bond yields and prices move in opposite directions.) Meanwhile, the closely watched spread between the 3-month Treasury bill and the 10-year note has inverted, declining from +94 basis points (0.94%) in early November to -21 basis points as of month end—its lowest level in 12 years. Such inversions have preceded every U.S. recession in the past 50 years.
Although diversified investors may be pleased with 2019’s stock and bond performance, the two asset classes rarely move in tandem for an extended period of time. One common factor in this year’s rally: Investors believe the Federal Reserve will step in if needed with dovish monetary policy to sustain the economic expansion. Indeed, the market-implied odds of one and two rate cuts by December 2019 reached 95% and 72%, respectively, on May 31. Back in March, only the staunchest doves would have bet on even one hike.  
The stock market, in particular, is banking on Fed support to get back on track. In our view, this means shareholders think the Fed may be quicker than it’s been in the past to loosen policy based on market signs, such as fed funds futures and movements in the yield curve. Investors also anticipate that the White House won’t escalate the trade war with China or start a new one with the European Union for fear of damaging the economy one year prior to the 2020 presidential election. (Of course, President Trump’s May 31 decision to hit Mexico with tariffs “unless and until Mexico substantially stops the illegal inflow of aliens coming through its territory” may test that theory.)
To illustrate the equity market’s confidence, consider financial stocks’ performance in the second quarter thus far. Financials often struggle when the gap between short- and long-term Treasury yields narrows or inverts, as it’s done over the past week. That’s because profit margins for banks are squeezed under such circumstances. (Banks earn a profit on the difference between what they pay on deposits and what they charge for loans, which are based on short- and long-term yields, respectively.) Yet they’ve outperformed the broad S&P 500 by 250 basis points (-1.2% to -3.7%) over the course of April and May.     
A year ago, both fixed income and equity investors agreed that the U.S. economic outlook was bright and that the expansion was likely to last quite a bit longer. Today, they’re in far less agreement.  Assuming the Fed is willing to act as a backstop in case the economy slows materially, we see policy risk in the form of new tariffs, debt ceiling drama and government shutdown brinksmanship as the biggest hurdle for the U.S. over the rest of 2019.

It’s not just stocks and bonds taking a different view   

U.S. private-sector sentiment surveys have sent a clear picture: Businesses are worried, consumers…not so much. In May, for example, Markit’s Composite Purchasing Managers’ Index (PMI), a broad gauge of business activity, dropped to its lowest level in three years. And durable goods orders (aircraft, machinery, computer equipment and other big-ticket items) fell in April, as did orders for “core” capital goods, a measure of business investment.
In contrast, the Conference Board’s index of consumer confidence rose to a nearly 18-year high last month. Another gauge, the University of Michigan consumer sentiment index, found consumers were still upbeat in May, even as the final reading was lower than the preliminary one due to global trade concerns. Lastly, consumer spending stayed solid in April after a robust March, when it posted its biggest monthly increase since 2009.
Why the different levels of concern for businesses versus consumers? We think it’s because businesses are operating in a cloud of uncertainty as the Fed weighs its next move and the global trade war shows no signs of relenting. For their part, consumers are enjoying strong balance sheets, healthy savings rates and rising incomes, and they may not yet be directly exposed to tariff-driven price increases. Against that backdrop, we expect consumer spending to drive U.S. economic growth in the second half of 2019. Business investment, however, may not bounce back. If it doesn’t, annualized GDP growth may be capped at around 2% for the July-December period, with risks clearly skewed to the downside.
Although tariffs clearly fit in the “downside risks” category, it’s important to remember that trade makes up a relatively small part of the U.S. economy. Therefore, the negative effects of U.S. import taxes won’t directly push the U.S. into recession. But the potential knock-on effects of the tariffs could be substantial, coming in the form of lost business and consumer confidence, and tighter financial conditions driven by a stronger dollar, lower equity prices and wider corporate bond spreads.
This material is prepared by and represents the views of Brian Nick, and does not necessarily represent the views of Nuveen LLC, its affiliates or other Nuveen staff.
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