Q3 2019: PFM Quarterly Commentary
About 2,500 years ago, Greek philosopher Heraclitus of Ephesus wrote that “Change is the only constant.” We cannot think of a more fitting quote as we compare the events chronicled in our quarterly letters over the past 18 months with those which transpired in the third quarter of 2019.
In the recent past, we firmly asserted that the Federal Reserve’s considerable tightening of monetary conditions would lead to a disruption in both the investment markets and global economy, forcing a policy reversal. Categorizing our view as contrary to popular opinion was an understatement given the steady stream of rhetoric flowing from central bankers regarding their plans to steadily increase interest rates to begin draining excess liquidity from the financial system.
Our non-consensus contention has been borne out. The Fed last raised interest rates in mid-December of 2018. Their tightening actions resulted in the sharpest fourth quarter decline in the U.S. stock market in nearly 80 years, plunging interest rates to near Great Recession lows, a yield curve inversion, and a steep slowdown in global economic growth. Regarding the policy response to these events, much of what we predicted occurred. Most notably, in the third quarter of 2019, the Fed cut interest rates by a quarter percentage point on both July 31st and September 18th. While we were always confident that the Fed would begin lowering interest rates, we did not expect the committee members to take the bold step of expanding their balance sheet. After shrinking to $3.76 trillion on August 28th, 2019, the Fed’s balance sheet then grew by nearly $190 billion to $3.95 trillion by the end of the quarter. As discussed at length in our previous communications, the Fed engaged in a massive expansion of its balance sheet to combat the Great Recession through an experimental policy known as quantitative easing (QE). This is a process by which a central bank purchases assets, mainly government and agency bonds, to increase the quantity of money flowing into the financial system. Historically, central banks have embarked on QE during times of extreme financial strain, so the Fed’s timing is curious given that U.S. stock markets are near all-time highs, unemployment remains at historic lows, and by many other indications, the economy is standing on solid footing.
Additionally, the Fed is not acting alone. As of the end of this quarter, fifty-five percent of all global central banks have eased monetary conditions in 2019 (thirteen interest rate cuts globally in September alone), the highest percentage since the financial crisis in 2008. Amidst this sudden rash of dovishness, the European Central Bank (ECB) trumped all other central banks in mid-September when its outgoing chairman, Mario Draghi, announced that the ECB would re-start its quantitative easing program at $20 billion of asset purchases per month and cut its deposit rate further into negative territory to -0.5%. This was a clear indication that the ECB was making an all in effort to jumpstart the moribund European economy.
Despite warnings signs of a global economic slowdown, political turmoil here and abroad, and continuous media coverage suggesting an imminent U.S. recession, a look under the stock market “hood” yields a different narrative. We track various subsets of the S&P 500 to gauge the overall health of the economy, and our recent observations suggest a more positive spin than widely reported. For instance, many economically sensitive stocks are recording new 2019 price highs. Household durable goods (e.g. appliances), leisure products (e.g. entertainment), technology hardware, semiconductors, and construction/engineering firms are a few examples. Further, several other sectors are hitting all-time highs, such as specialty retail (e.g. home improvement, high end jewelry), construction materials, aerospace/defense, and real estate development/management companies. So, while these industries’ strong performance doesn’t guarantee that the stock market will build on its solid start thus far in 2019, it does question the widely accepted recessionary outlook.
This past quarter supports our core philosophy that diversification, rebalancing, and patience are all critical drivers of investment success. We are reminded again that any asset class can assume a leadership position and that our focus on diversification ensures that a wide range of asset classes are represented in client portfolios.
As always, please do not hesitate to contact the Peak team with any questions. Enjoy the autumn and we look forward to speaking with you soon.
Regards,
Peak Financial Management
Asset Class Quilt of Total Returns
Peak has created a monthly “quilt” of returns to track the performance of the major areas of the investment markets over time: We believe that this table best illustrates the fundamental tenets of Peak’s investment philosophy, namely the futility of predicting which investments will outperform over the short term and the unremitting cyclicality of markets. These truths support our firm belief that broad based diversification over many areas of the world economy is the best path to investment success over the long term.