Stocks moved higher during February, with the S&P 500 returning 3.2% for the month. We believe that expectations for a favorable resolution to US/China trade disputes and dovish signs from the Federal Reserve helped to drive these gains. While we are encouraged by these dynamics, we are concerned that the market’s strength this year has left little margin for any deterioration in fundamentals or potential macroeconomic shocks.
We believe that optimism surrounding a potential trade agreement between the US and China has been one of the key factors benefitting stocks over the last several weeks. This would be beneficial for both countries’ economies, and could boost corporate earnings expectations, particularly for those companies whose guidance incorporates the tariffs remaining in place. While much of the good news may already be baked into current stock prices, we would expect that a mutually beneficial trade agreement between the world’s two largest economies would be warmly received by global capital markets.
Monetary policy has also aided stocks in our view. Investor focus has shifted to the balance sheet normalization process, which now appears likely to conclude more quickly and with the Fed holding more investment securities than investors were previously anticipating. In this regard, at his recent testimony to Congress, Fed Chairman Jerome Powell suggested that the central bank would maintain a level of reserves that is significantly greater than it had prior to the financial crisis. All else equal, more reserves and a larger balance sheet denote a more dovish monetary policy, which we believe has given a boost to stock prices. We anticipate that the Fed will continue to proceed with patience and caution. With regards to interest rates, it is possible that the Fed may be done hiking for the current cycle. While this remains to be seen, we do note that fixed income markets are signaling that the next Fed interest rate action is just as likely to be a cut as it is to be a hike.
While stocks have started the year in robust fashion, we are somewhat concerned that investors may be a bit too cavalier regarding uneven economic data in the US and abroad. GDP forecasts for Q1 are underwhelming, with projections that we monitor ranging from 0-1% annualized growth. Earnings estimates are also quite weak, as analysts are currently expecting a year-over-year profit decline for the first quarter. It appears as though markets are looking through these projections, anticipating that Q1 will be an anomaly with growth picking up thereafter. While we view this as plausible, it does suggest that stocks may be vulnerable, should this scenario prove to be overly optimistic. Moreover, the 2020 presidential election campaigning season is already underway, and we think this carries with it headline risk for stocks. Topics including the health care system and climate change are likely to garner a great deal of media attention. We think that various sectors of the market may be vulnerable as these issues come into greater focus.
That being said, certain key macro risks do appear to have lessened of late. As noted, negotiations between the US and China appear to be going well and the Fed has shifted to a considerably more dovish stance over the last few months. Moreover, a 2nd US government shutdown has been averted, and overseas the odds of a worst case Brexit scenario appear to have decreased considerably. We are also encouraged that signals out of the fixed income markets have improved, as the yield curve has steepened and credit spreads have contracted. These indications give credibility to the aforementioned notion that economic growth may improve following what is shaping up to be a weak first quarter. A strong labor market and healthy consumer may also benefit economic growth for the remainder of the year.
Ultimately, we are optimistic that fundamentals may improve as the year progresses, but we are concerned that at current levels this scenario is already largely priced into the market. Moreover, while we do expect that the US and China are likely to reach a trade agreement, a failure to do so could create quite a bit of turbulence for capital markets. We therefore think that the risk reward dynamic is slightly unfavorable for stocks at the moment. Should markets consolidate, or earnings prospects improve, we would likely upgrade our assessment.
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