economic perspective

July 2019


By Thomas Dillman

Through the end of June, as U.S. equity markets continued their bullish rise to all-time record highs, bond prices also moved higher. Mutual of America Capital Management LLC takes a look at the reasons for the movement of stocks and bonds and the impact that this, and the potential for interest rate cuts, might have on the direction of the U.S. economy moving forward.

During the first half of 2019 (as measured through June 28), the S&P 500® Index advanced 18.5%, following a nearly 15% decline during the last quarter of 2018. Most other equity indexes around the world also posted strong advances. According to the respective MSCI, Inc., country indexes, Europe was up 13.2%, China came in at 11.5%, Japan increased 6.6% and the U.S. jumped 17.6% (including all stocks, not just the stocks that comprise the S&P 500 Index). The MSCI World Index – which represents the performance of large- and mid-cap stocks across 23 developed markets – jumped 15.6%. Of note, these advances came at a time of slowing growth across the globe.

Bond prices also advanced. However, rising bond prices, which translate into falling yields, are generally indicative of rising concern that the economy is heading toward recession. This rare circumstance of rising prices both for stocks and bonds suggests that stock and bond investors had far different outlooks. The yield on the benchmark 10-year Treasury note dropped from a peak of 3.23% in early November 2018, to 2.00% at the end of the second quarter of 2019. That drop in yield represents about an 11% advance in bond prices over a seven-month period, a dramatic move by historical standards, underscoring the bond market's pessimistic perspective.

Why the discrepancy? In the case of the stock market, the bear market correction at the end of last year was prompted by mounting fear that the Federal Reserve's interest rate increases had gone too far and threatened a recession. Interestingly, bond prices began their assent at the same time stocks started to plummet, suggesting that both markets were in agreement during that period. However, in December, after the Fed's last rate hike, and under pressure from not only the markets but also the Trump administration to lower the fed funds rate, members of the Fed began to signal a more receptive tone to at least putting rates on hold. Over the first half of 2019, the Fed's statements after each successive meeting in January, March, May and June became increasingly dovish, to the point of almost guaranteeing one or more rate cuts during the second half of 2019. The market-determined probability of at least a 25-basis-point cut at the upcoming July meeting is 82%, while the probability of a 50-basis-point cut is 18%.

Rising expectations of one or more Fed rate cuts largely account for the stock market's ebullience over the past six months. The setback in trade talks with China in early May caused a 6% pullback in the S&P 500. However, expectations of fruitful talks between President Trump and President Xi prior to the G20 summit in June propelled stocks to new highs. And, as a result of productive talks, the two countries struck a truce, whereby the U.S. agreed to delay its threatened additional tariffs of $300 billion on Chinese imports in return for promised purchases of U.S. agricultural goods. The détente between the U.S. and China, coupled with the near certainty of Fed rate cuts, seems to justify the stock market behavior for the first half of 2019.

The bond market, however, remains skeptical, as indicated by the fact that the 10-year Treasury yield is lingering around the 2.00% level. Likely explanations include concerns about global growth, near-term and long-term prospects for trade, and as a result, fear that a recession is on the near-term horizon. Recently announced strong and above-expectations reports on hiring and retail sales failed to generate more than a modest rise in the 10-year rate, which subsequently reversed. Even the strong likelihood that the Fed is going to cut short-term rates, an action designed to stimulate the economy, is not eliciting a meaningful response from bond investors.

Ultimately, the question of which market is right will depend upon whether the delayed effects of rates having risen too high will cause a recession, or whether the Fed's reversal of monetary policy will provide enough stimulus to extend the expansion.

Thomas Dillman is the former President of Mutual of America Capital Management LLC.

The views expressed in this article are subject to change at any time based on market and other conditions and should not be construed as a recommendation. This article contains forward-looking statements, which speak only as of the date they were made and involve risks and uncertainties that could cause actual results to differ materially from those expressed herein. Readers are cautioned not to rely on our forward-looking statements.

Mutual of America Capital Management LLC is an indirect, wholly owned subsidiary of Mutual of America Life Insurance Company. Mutual of America Life Insurance Company is a registered Broker-Dealer.

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