The end of the second quarter marked the best first half performance in 22 years for the S&P 500. The index reached multiple new highs making up for the losses experienced in the fourth quarter of last year. The US economy grew at an annualized rate of 3.1% in the first quarter, but economist expect that growth to slow in the second quarter. Unemployment remains low at 3.7% and inflation has continued to hover around 2%. While the stock market’s performance and the economy’s slow but steady growth is great news, there are always a few reasons to be cautious.

Global Trade

Trade talks between the U.S. and China broke down in May but the two sides reached a trade truce at the end of June. This puts a hold on the 25% tariffs that were scheduled to be applied to $300 billion of Chinese imports. While this is a step in the right direction, it is by no means a deal. This means that the two countries are back at the negotiating table. This is similar to what occurred in December of 2018. This new development could be the beginning of a deal or it could be the next chapter in this trade war. Keep in mind that the US reached a trade truce with the European Union in July of 2018 and a deal has yet to be reached. Trying to predict if or when a deal will be reached is a fruitless exercise. Instead, we need to keep a long-term perspective that eventually a mutually beneficial deal will be reached.

US Monetary Policy

The Federal Reserve held interest rates throughout the quarter and is now expected to reduce interest rates, potentially as early as this month. This is a turnaround from last year when there were two rate increases planned for 2019. Even with a strong labor market and solid economic growth, the Federal Reserve has concerns about slowing growth in the future and the impacts of trade disputes. Instead of remaining patient, the Fed “will act as appropriate to sustain the expansion.” This is very accommodative and should help the economy. However, one may ask why economic growth isn’t higher after 10 years of low interest rates and a tax stimulus? While this is the longest economic expansion, it hasn’t had the same level of economic growth as previous expansions (See the light blue line below). Perhaps this is why inflation has remained low and the Federal Reserve feels compelled to stimulate the economy with low interest rates.

Fixed Income and Inflation

US interest rates continued their decline with 10-year government bonds ending the quarter yielding 2%. This is close to their historical low of 1.35% reached in 2016. The below chart is concerning because current inflation is 2% which makes the current real yield (adjusted for inflation) zero. Inflation can be as big of a risk to an investor’s retirement as the next recession. As investors enter retirement, many want to reduce their exposure to stock market volatility but are now forced to accept zero real yields in their safe investments. Historically, these government bonds provided an average real yield of 2.34%. Fortunately, there are other options in fixed income.

Conclusion

Investors keep identifying now as the late stage of this market rally but what does that really mean? It means that we are possibly closer to the end of this rally than the beginning. There isn’t an imminent reason for a recession, but this is the longest running market rally, and these don’t go on forever. With that being said, the last 10 years of news is littered with people calling for the next recession and the market has continued to grind higher.

Ultimately, the stock market is efficient. That means as soon as new information is made public, it’s immediately reflected in stock prices. Unless you can predict the future, timing the next recession is incredibly difficult. Fortunately, we don’t need to predict the future because we can prepare for different outcomes. The U.S and China may reach a deal, or they may not. The Federal Reserve may lower interest rates or may hold them steady. The stock market may continue higher or we may enter a recession. Your portfolio and financial plan have been built to sustain each outcome.

When you leave for a road trip, all the stop lights won’t be green. There will be some stops but that is why you manage expectations and prepare. Inevitably, we will reach a red light but that could be 3 months or 3 years from now. All we can do is remain disciplined and focus on what we can control.