The third quarter began with a continuation of market strength as trade war tensions seemed to deescalate following the June meeting between the U.S. and China. Corporate earnings came in higher than expected with 77% of S&P 500 companies beating estimates, above the five-year average, and the market enjoyed a brief reprieve from the volatility of the first half. Following a widely expected interest rate cut by the Fed, momentum was cut short as the trade war returned in force with the addition of new tariffs from the U.S., which triggered the first tariff response by China. Although we expect earnings to once again surprise to the upside in Q3, the environment has become more challenging for both corporate and consumer sentiment.
The Fed is expected to continue cutting rates and incorporating easing measures, leading longtime market participants to struggle to reconcile how this path could exist without a recession. Market bears have also resurfaced, citing signals such as the inverted yield curve, which historically have preceded a recession though its predictive power may not be as strong in this unprecedented environment of low global growth and continued easing by central banks worldwide. The most likely explanation for the inversion lies in relative valuations across global credit markets. With over $16 trillion worth of global bonds now trading with negative yields, the U.S. bond market serves as one of the most attractive options for international investors, driving yields lower as a result of an environment that simply hadn’t existed in the past. Investors and trading algorithms that rely on historical patterns without adjusting to new paradigms may very well find themselves on the wrong side of this trade.
International events have also increased volatility in markets, including the ongoing Brexit drama, with October 31st serving as the latest deadline for a hard exit. At this point, much of the damage from Brexit has likely been priced into markets, and the E.U. may continue to offer extensions to avoid the consequences of a no-deal exit. The European Council is also in the process of nominating IMF President Christine Lagarde to succeed current European Central Bank President Mario Draghi, a move that is expected to continue Draghi’s policies of quantitative easing. Prolonged economic weakness in Europe has taken a toll, though a de-escalation in the U.S. and China trade war would likely provide a secondhand boost to the Eurozone which relies on trade from both nations.
U.S. politics have also caused a stir, with the U.S. House commencing an inquiry into events that could precede impeachment. It’s crucial to remember that impeachment in the House is akin to a trial while the Senate handles the actual decision to remove or not. Given the Republican majority in the Senate, the probability of this resulting in anything more than a distraction is low. With the 2020 election season on the horizon, we remain cognizant of the risks arising from drastically differing views among all candidates, and will continue positioning portfolios more defensively ahead of this heated election cycle.
A recession is not imminent simply because of uncertainty, though there is a line where negative sentiment can blur reality into a self-fulfilling prophecy. With the upcoming earnings season on the horizon, investors will gain clarity on whether the market’s anxieties have become a reality or if the sudden collapse in expectations proved too bearish. Given this year’s economic and corporate data, as well as the absence of any structural threats to the financial markets, we believe the latter. Many structural tailwinds are still at the back of the market’s leadership sectors; one only needs to navigate the waters of volatility until they flow through.
