Second Quarter Newsletter
July 5, 2019
“You can’t have your cake and eat it too”
This old English proverb has been so popular over the centuries for good reason. After all, how can one possibly enjoy both of two desirable but mutually exclusive alternatives at the same time?
Apparently in the financial markets is how. Take the middle of June, for instance. While interest rates were falling on growing economic pessimism, stocks in the U.S. were fast approaching record levels on the optimism of a Federal Reserve backstop. Pessimism and optimism can both be a good thing for stocks, evidently.
First, the pessimism: In the wake of Federal Reserve Board Chairman Jerome Powell’s statement following the Fed’s June 19th meeting, the widely followed yield on the 10-year Treasury note slid to 1.997% on June 20th, its lowest level in almost three years. Although the Fed voted to hold the Fed Funds rate steady, their commentary indicated that a rate cut could come soon, a notable shift from the prior meeting when the Fed said it saw no basis for a rate change. In explaining their shift in stance, Powell cited trade tensions and concerns about global growth. While it’s certainly not a foregone conclusion that rates may come down further, most investors in the futures market, as tracked by CME FedWatch, now put a high probability on at least two Fed Funds rate cuts before the end of this year, from the current rate of 2.25%-2.50% down to 1.75%-2.00%.
Certainly recent data from the manufacturing sector back up Powell’s concerns. The widely followed Institute for Supply Management’s Purchasing Managers Index fell 0.7% in May from April to 52.1. A reading above 50 indicates the economy is still expanding; however it appears to be doing so at a more modest pace. According to the ISM’s press release June 3rd, many respondents to the survey expressed concern with the escalation in the U.S.-China trade standoff, which they say is impacting costs and disrupting supply chains. This pessimism has been seen flowing through to analyst estimates. As of the third week of June, earnings for the S&P 500 are expected to decline 2.6% for the second quarter, which will mark the first time the index has reported two straight quarters of year-over-year declines since the first half of 2016.
For a dose of optimism, take a look at the consumer, who continues to show remarkable resilience at this late stage of the economic cycle. Retail sales rose 0.5% in May from April, slightly below the 0.6% that economists had expected, but still a healthy pace. On a year-over-year basis, sales jumped 3.2%. That’s an encouraging trend, particularly considering the fact that consumer spending accounts for two-thirds of economic activity, and it marked a reversal from weakness seen earlier in the year.
So it seems that even mixed messages on the economy can keep stocks afloat: on the one hand, data on the consumer is robust enough to scuttle the argument that the U.S. economy is headed for recession; on the other hand, weakness from the manufacturing sector means that there is little chance for the economy to overheat and ignite inflation. Not only that, but with the Fed poised to lower interest rates, the stock market has once again become a relatively more attractive investment opportunity. The S&P 500 Index rallied to within a smidgen (less than two tenths of one percent) of its all-time high by the end of the quarter, marking an 18.5% year to date return (including dividends). That surge was once again led by the technology sector, which on a price basis is up 28.8% through the second quarter. But other sectors participated as well, including industrials and consumer discretionary stocks (including retailers) which both rallied over 20% through June 30th.
The strong performance through the second quarter this year was not limited to U.S. stocks, either. Even international stocks rebounded, rising over 11.4% through June 30th as measured by the iShares MSCI All-World ex-US Index.
Likewise, bonds enjoyed a boost thanks to the decline in interest rates. The iShares Core U.S. Aggregate Bond Index is up 5.8% on a total return basis (price plus yield)—the best bond market rally we’ve seen in five years.
As always, we make sure that we maintain well-diversified portfolios that are aligned with our clients’ investment objectives and tolerance for risk. We have been trading more actively lately in order to rebalance portfolios and position them appropriately for the economic uncertainty ahead. For instance, we’ve taken advantage of the strong performance in bonds so far this year to upgrade credit quality.
Turning to planning issues, although partisan politics seems to be dominating the headlines from Washington, Congress has actually been hard at work on legislation that could impact many of us. In May, the House passed retirement legislation called the SECURE Act (Setting Every Community Up for Retirement Enhancement) overwhelmingly 417-3. The Senate has a similar bill under consideration called the RESA Act (Retirement Enhancement Savings). Given the overwhelming support in the House for its bill, and the fact that Senate Finance Chairman Senator Chuck Grassley has publicly described it as a top priority, one would think there’s a reasonably good chance that some version gets passed this year. Either way, we believe there are a few provisions worth highlighting that could be relevant for our clients:
- Increase in Required Minimum Distribution Ages. Today the law requires that most individuals take out required minimum distributions (RMDs) from their retirement accounts in the year you reach 70 ½. The SECURE Act would delay this requirement to age 72 starting in 2020. The Senate bill pushes the RMD requirement further to age 75.
- Removal of Age Limitation on IRA. For years there has been a rule that discouraged retirement savings in IRAs for people who continued to work later in life. At age 70 ½, you could no longer contribute to a traditional IRA (but you could contribute to a Roth IRA). The SECURE Act would repeal the age limitation for traditional IRA contributions.
- Removal of “Stretch” Inherited IRA Provisions. Current law allows beneficiaries of Inherited retirement accounts to spread the RMDs over their own life expectancy, meaning it would take the IRS longer to collect tax revenues on those distributions. The new bill would require most beneficiaries to distribute the account over a ten year period.
As always, if you have any questions about your investment portfolio or planning issues, including those related to the potential legislation highlighted above, please don’t hesitate to reach out to us.
The Cribstone TeamShare