Separating the Signal from the Noise

This is part of an ongoing series of articles published by Johnson Financial Group. This issue is written by Kelsey Ellsworth, Assistant Vice President, Wealth Portfolio Manager.

"Trade wars are good, and easy to win” President Trump famously announced in March of last year. Almost a year and a half later, a renewed escalation in the trade tensions with China began when the administration indicated that they would add a 10% tariff on $300 billion worth of Chinese exports, effective September 1. On Monday, China retaliated by devaluing its currency to an 11‐year low against the dollar, resulting in Treasury Secretary Steven Mnuchin declaring China to be a “currency manipulator”. This caused the U.S. equity markets to post their worst decline of the year as the S&P 500 slipped nearly 3%. So why, given the volatility and these geopolitical issues, do we remain near long‐term target allocations in our equity and fixed income positioning? The answer is two‐fold. The current economic data is softer than last year, but does not reflect the kind of contraction that leads to a recession. Second, we continue to believe that the Fed's stance on interest rates supports above average stock valuation and that a stable interest rate environment supports the use of average maturity to maximize bond portfolio yields.

The Signals

Through the end of July, the S&P 500 was up about 20% and since the July 26th high, the S&P 500 is down approximately 6%. Over the same time period, high yield bonds are down 1.5% and the 10 year U.S. Treasury is .03% higher in price and 0.35% lower in yield. Despite this correction, U.S. stock and bond returns remain strong year‐to‐date with the S&P 500 Index up about 16% and the Bloomberg Barclays U.S. Aggregate Index up almost 8%.

Recent U.S. economic data remains resilient with 2.1% real GDP growth, 3.7% unemployment, 3.2% year‐over‐year wage growth, and declining but still expansionary Purchasing Managers' Index (PMI) manufacturing indices. Job growth is healthy albeit at a slowing pace as private industries added 164,000 jobs in July, following revisions lower in May and June.

Earnings growth is flat year‐over‐year, but is in line with lowered expectations. With approximately 83% of S&P 500 companies already reporting second quarter earnings, the results have been slightly better than expected. About 74% exceeded analysts' estimates, and compared with the same point in time for Q1, revenues are beating by a larger amount.

Central banks have been easing financial conditions to provide the stimulus that is needed for growth to extend beyond the current soft patch. Fed rate cuts have never immediately turned the data around. Even with interest rates falling, it will take well over a year for these lower rates to help reaccelerate leading economic indicators.

Neutral Positioning

While the economic data is softer than last year, the S&P 500 has remained resilient. Lower interest rates have helped to drive the index. With stock market valuations still at reasonable levels, we believe that equity allocations should remain at their neutral long‐term targeted levels. We continue to position fixed income portfolios neutrally with respect to average life and interest rate sensitivity, despite lower interest rates. Maintaining interest rate exposure in high quality bonds is a good complement to corporate bond holdings that may be impacted in the near‐term by increased volatility due to trade conflict and slowing global growth.

Looking Ahead

We are continuing to monitor economic and market conditions closely, but still do not expect a recession prior to 2021; however, volatility will likely continue as financial markets grapple with the impact of the trade dispute combined with already slowing global growth. While we do not believe that the new higher level of tariffs will cause the U.S. economy to slip into a recession, we expect some further weakening in economic growth prospects for the remainder of the year. We must separate the true economic signals from the noise.

ABOUT THE AUTHOR

Kelsey Ellsworth

AVP Wealth Portfolio Manager | Johnson Financial Group

As Assistant Vice President, Wealth Portfolio Manager, Kelsey works with clients to achieve their unique goals and objectives.