Published on Apr. 15, 2019
First Quarter 2019 | Equity Commentary
Stocks enjoyed a strong start to the year, as the S&P 500 advanced about 13.7% during the 1st quarter. We believe that optimism regarding a potential US China trade deal and an increasingly dovish Federal Reserve likely helped to drive these gains. While economic activity appears to have weakened of late, there are reasons for us to believe that growth may reaccelerate during the remainder of the year.
We believe that an increasingly dovish Federal Reserve was one of the key factors impacting markets during the first quarter. As recently as last October, Fed Chairman Jerome Powell was anticipating a steady course of interest rate hikes for the foreseeable future. At the moment however, the central bank appears to be have put further interest rate hikes on hold, and we believe that market-implied odds suggest a realistic possibility that the Fed might even cut rates later this year. Expectations may have also shifted with regards to the balance sheet normalization process, where it now appears that the Federal Reserve will ultimately maintain a larger balance sheet than many economists previously anticipated. In addition, Chairman Powell has suggested that he would like to see inflation modestly above the Fed’s 2% target for a period of time. While that objective has yet to be achieved, the mere fact that the Fed would like to see it happen is another dovish development, in our view.
In our view trade negotiations between the US and China have been a focal point for investors for some time now. While the discussions are ongoing, we understand that the tone coming out of the Trump administration has been much more conciliatory in recent months. We believe that increasing optimism among investors that a deal will be reached has helped to boost stocks. However, failure to reach an agreement could roil global capital markets. In our view, the most likely outcome is that a deal will be reached, though it is premature to speculate on its impact without knowing the granular details.
Global economic activity appears to have slowed during the first quarter. We believe that investors were particularly disconcerted by the Eurozone manufacturing PMI for March which came in at 47.5, a level which implies that the sector may be contracting. Germany’s number was weak at just 44.1, well below consensus expectations. While the US manufacturing PMI of 52.5 appears to be healthier, it too missed expectations. Bond yields sank in the wake of these releases, temporarily inverting the yield curve and exacerbating investor growth concerns.
While we view the temporary yield curve inversion as a yellow flag, we are not overly concerned that it was signaling an impending US recession. We have noticed that in the past, the yield curve has typically inverted during periods in which the Federal Reserve had been raising rates, suggesting a monetary policy mistake. That is not the case today as the Fed has not increased interest rates since December, and market indicators suggest that the Fed’s next move appears to us more likely to be a rate cut rather than an increase. Secondly, prior yield curve inversions which have foreshadowed recessions have persisted for a much longer duration, and were of a greater magnitude than March’s inversion which only lasted for a couple of days, and inverted by just a few basis points. Technical factors also may have played a role, as a recent large issuance of short-term Treasuries probably resulted in higher yields at the short end of the curve. Finally, we note that European bond yields are currently quite low and even negative in some cases and are likely pressuring US yields. Therefore, elevated US bond prices may be as much a function of relative value compared with European bonds as they are indicative of flagging domestic growth. For all of these reasons, while we are keeping an eye on what remains a flattish yield curve, we do not believe that the recent inversion is a sign that the US economy will be falling into recession anytime soon.
We think that the risk-reward dynamic for equities is reasonably balanced at the current time. While we expect that economic growth will likely pick up in the coming quarters, we believe the recent run-up in stock prices largely encompasses this view. Our optimism on future economic activity is based on several factors. We believe that the first quarter was pressured by certain non-recurring issues such as extreme weather and the government shutdown, the impact of which are unlikely to persist. We expect that benign financial conditions should also help to support the economy, as stock prices have risen, interest rates remain quite low, and credit spreads have tightened. Lower interest rates have also favorably impacted mortgage rates, which currently sit at just over 4% for a 30-year fixed rate mortgage, a considerable drop from just a few months ago. We think that this dynamic has boosted the housing market, as new home sales, starts, and affordability are all trending favorably. Lastly, measures of consumer confidence are close to 12-month highs, unemployment claims are at very low levels, and bank loans have been picking up. In our view, these indicators suggest that growth is likely to reaccelerate moving forward.
International growth however, remains a key concern. One need look no further than the European government bond market, where anemic yields are reflecting investor anxiety regarding the region’s growth prospects. As noted above, purchasing manager indices reflect a contracting European manufacturing sector, and the ECB recently downgraded its projection for 2019 Eurozone GDP growth to just 1.1% from an earlier estimate of 1.7%. Brexit remains an unresolved issue which we think has been at least partly responsible for the Eurozone’s weakening profile, as management teams hold off on making important investment decisions given the heightened levels of uncertainty. The deceleration of China’s economy may be an even larger factor impacting European growth. We believe that a US-China trade agreement could help reinvigorate the world’s 2nd largest economy, though structural issues internal to China have likely played a larger role in its growth challenges.
As we put all of these pieces together to assess the current investment environment, we want to be more or less fully invested, but with an emphasis on companies that are not overly dependent on a strong economy and that we believe can perform well in a low interest rate environment. We believe that this should help to buffer the portfolio against potential market downside should the domestic economy fail to strengthen, or if international growth were to decelerate further.