11 Jul Risk on or risk off?
The second quarter concluded with the S&P 500 in record territory, actually hitting its all-time daily high on June 20th. Despite a small pull back in the last week of trading, the US index closed out the quarter with a total return of 4.3%, pushing the total return for the first half of 2019 to a staggering 18.5%. Equity markets around the world followed suit, as witnessed by gains in the Canadian S&P/TSX, MSCI Europe and MSCI Emerging Market indices of 2.6%, 3.4% and 0.2%, respectively (in local currencies). However, it was not all smooth sailing, as evidenced by the risk-on and risk-off monthly performance of the US market: April +4.0%, May -6.4% and June +7.0%. The equity market largely traded on positive sentiment based on expectations that the global economic slowdown will not lead to a recession in the short term, the earnings slowdown is temporary, corporations are generally healthy, unemployment is low and the ability of the current cycle to continue. Additionally, and this quarter in particular, equity markets have been buoyed by central bank support. The month of May saw sentiment turn negative in response to the vagaries of the trade dispute between the US and China. Until this issue is resolved, volatility will likely remain elevated.
On the other hand, the bond market has taken a different view of the current environment. In the face of slowing economic growth and low inflation, government bond yields across the world have been steadily falling during the quarter. For example, the US 10 year bond yielded 2.01% at the end of June versus 2.41% at the end of March; the 10 year German bund fell deeper into negative territory with a yield of -0.33%, compared to -0.07% three months prior. The bond market is also taking its cue from the central banks, be it the Fed or the ECB, which have become more dovish and accommodative. Consequently, the market is effectively pricing in 2 to 3 rate cuts by the Fed before the end of this year and the US treasury curve has inverted (short term rates are higher than the long term rates). An inverted yield curve is often considered as a precursor to recession. In light of this context, the bond performance has been strong this quarter, with the Barclays Global Aggregate index returning 3.3% in USD. Meanwhile, the credit market has reacted more in line with the stock market, with yield spreads on both investment grade and high yield issues increasing in May (during the equity market pullback) and subsequently decreasing by the end of the quarter.
On the currency front, the US dollar has suffered this quarter, mostly due to the stance of the Fed, resulting in gains of 1.38% and 1.95% (vs the USD) for the Euro and Canadian dollar, respectively. Meanwhile, the British pound lost 2.6 % versus the US dollar on the back of more Brexit uncertainty following the resignation of Prime Minister Teresa May.
The impact of a global economic slowdown could be felt in the commodity market during the quarter, with the prices for oil, natural gas, and copper, among others, all falling substantially. Conversely, the price of gold was up 9.0%, partly because of its safe haven status, and also thanks to a weak USD and negative real interest rates in many regions of the world.
What can we conclude from this quarter, which saw both risky assets (equities and credit) as well as traditionally safe haven assets (government bonds, gold and the Yen) all rallying together? Certainly, there is a clear dichotomy in the views of the current and future economic environment. As such, we can infer that either the equity market, or the bond market, must be wrong and, therefore, the investors on the wrong side of that trade are in for disappointment. This leads us back to two of the main tenets of our investment philosophy, namely diversification and prudence, to ensure that our clients’ portfolios are built to safely navigate these types of uncertain, volatile, and contradictory risk-on and risk-off markets.
Have a great summer!