MarketView 1st Quarter 2019
After closing 2018 with the worst quarterly decline in seven years and the worst December since the Great Depression, stocks staged an impressive comeback in the first quarter of 2019. The S&P 500 Index advanced by 13.1% marking the strongest quarterly result in almost 10 years. The dramatic and sharp equity market rebound can be attributed to the Federal Reserve’s newly adopted dovish stance on interest rate policy as well as progress towards a trade deal with China.
U.S. stocks led the charge in the first quarter. However, the rally was broad-based with international stocks (MSCI EAFE Index) advancing by 9% and global stocks (MSCI All-Country World Index) posting a 12.3% return.
While equity investors adopted an optimistic view in the first quarter, fixed income markets signaled a decisively more pessimistic opinion. Bond yields declined substantially with portions of the U.S. Treasury yield curve moving into “inverted” status, meaning longer-maturity bonds offered lower yields than shorter-maturity bonds. Historically, inversions of the yield curve have preceded many U.S. recessions.
The decline in bond yields translated into a strong quarter for fixed income markets with the Barclays U.S. Aggregate Bond Index advancing by 2.9%. However, lower bond yields also translate into a more challenging environment to generate attractive income levels going forward.
Below is a summary of the quarterly performance results for the major indices we review in each quarterly MarketView.
With the government shutdown dragging into January and unusually frigid weather across many parts of the country, first quarter economic data should probably be taken with a grain of salt. However, taken in aggregate, the data confirms well-anticipated expectations for a slowdown. While the U.S. economy appears to be downshifting back towards trend-like growth rates, other major economies such as Europe, Japan, and China are experiencing more dramatic slumps. Going forward, we recognize the risk of economic weakness outside of our borders having a greater negative impact on U.S. growth rates and corporate earnings.
While the economic picture does not look as strong as it did in 2018, we do we see some reasons for optimism. In four of the past five years, the first quarter has registered the weakest GDP growth rates with solid improvements as those years progressed. Trade tensions have been a major contributing factor to global economic weakness. Expectations are now firmly in favor of a trade deal between the U.S. and China. If a meaningful deal is reached, we would expect to see improvements in corporate sentiment and global trade. Also, the Federal Reserve’s recent pivot to a more accommodative stance and the corresponding decline in interest rates could help spur demand within interest rate-sensitive segments of our economy such as housing and auto sales. Judging by the dramatic recovery in the stock market, equity investors seem to be assigning very high probabilities to a positive outcome on these issues.
One of the most impactful developments in the quarter was the Federal Reserve’s about-face regarding future interest rate increases. If we rewind to October of last year, the “Fed” communicated intentions for four additional interest rate hikes in 2019. By late December, those projections fell to only two increases for 2019. And at their March meeting, the Fed’s estimates indicated zero hikes this year. Many prognosticators have proclaimed that we have seen the end of the interest rate hiking cycle and the bond market is pricing in a substantial probability that the Fed’s next move may be to cut interest rates. Describing these developments as an abrupt U-turn seems very accurate.
As we witnessed during the seven years of quantitative easing after the financial crisis, equity markets like low interest rates and easy money. We think it is accurate to conclude that the Fed’s change of course has been a major contributor to the stock market rally that started after Christmas. However, the change of direction has also come with a downgrade of economic conditions and expectations for near-term growth rates.
We entered the first quarter with an equity allocation at the one-step below mid-point level and a defensive cash position of roughly 13%-15%. We started to redeploy cash in early January as equity markets stabilized and we saw positive developments with the U.S. and China trade negotiations, steadying economic data and a shift from the Federal Reserve to a more patient and accommodative stance. This redeployment included a return to a mid-point equity allocation and an increase to core fixed income positions as a buffer against future volatility.
With the backdrop of a sharp equity market rebound and a solid contribution from fixed income allocations, portfolios performed well in the quarter with results in-line with our level of risk exposure.
In stark contrast to last quarter, every sector of the S&P 500 Index produced positive and impressive returns. And more aggressive segments of the fixed income market outpaced more conservative bond strategies.
Below is a high-level summary of both contributors and detractors to quarterly performance results.
Contributors to Performance:
- In the fourth quarter of 2018, we completed our final step to eliminate dedicated foreign equity exposure and further consolidated to domestic stocks. That shift was beneficial in the first quarter as U.S. markets outperformed developed international and global equity markets.
- The technology sector was the top performer in the first quarter and an area where we maintain significant exposure across all investment policies.
- Preferred stocks rebounded nicely, posting returns in the 5%-7% range, outpacing the broad bond market by a wide margin.
Detractors from Performance:
- Healthcare and financial stocks turned in respectable performance results but lagged the S&P 500 Index’s return.
- After strong relative performance during the fourth quarter decline, defensive sectors such as telecommunications, consumer staples, and utilities were slight detractors in the quarter.
MarketView Closing Thoughts
The stock market experienced a 20% peak-to-trough decline in the fourth quarter of 2018. Investors were pricing in dire outcomes on numerous fronts, including trade issues, interest rate policy, corporate earnings, and economic growth. In hindsight, those assumptions appear to have been too pessimistic. Fast forward to the end of the first quarter and the S&P 500 Index has rebounded a massive 21% from the Christmas Eve lows, closing roughly 3% below all-time highs and suggestive of investors now assuming very positive outcomes for the plethora of uncertainties we are still facing. Which one is it?
It may be boring, but we think the reality is somewhere in the middle. Recession fears and calls for negative corporate earnings growth appear too pessimistic in our view. We expect both economic growth and corporate earnings growth to slow from the brisk levels of last year but to remain positive in 2019. However, weakness in foreign economies, the potential for trade tensions to escalate or broaden to other countries and negative signals from the fixed income markets are reasons for a neutral or mid-point equity allocation at present.
We discuss several relevant and important topics below. We plan on covering each in more detail on our upcoming MarketView webcast which will be distributed shortly.
Weak First Quarters
The chart below shows quarterly GDP growth rates for the last five years. As previously discussed, there has been a noticeable trend of weakness in the first quarter followed by a pickup in growth later in the year. We’re watching to see if this trend continues in 2019.
Q1s Historically Weak
Sources: “Schwab Market Perspective: Sliding into Recession…or Another Q1 Quirk” March 15, 2019. Charles Schwab, Macrobond, U.S. Bureau of Economic Analysis (BEA) as of 3/12/19.
Yield Curve Inversion – Kinda
The chart below shows the slope of the U.S. Treasury yield curve as of the end of the first quarter. While there are multiple examples on the chart, the inversion that received the most attention recently can be observed by comparing the yield on a 3-month maturity Treasury (2.46%) to the yield on a 10-year Treasury (2.41%). While this may not meet everyone’s technical definition of a yield curve inversion, it’s not reflective of a normal environment in fixed income markets and in our view is an indicator for caution going forward.
As mentioned above, yield curve inversions have historically been viewed as a warning sign of a looming recession. While we do not discount the historical relevance of this indicator and are always cautious to think that “this time is different,” – below are some important factors to consider before making the conclusion that a recession is on the near-term time horizon.
- The partial yield curve inversion that received the most attention in late March was only inverted for a few days and has since moved out of inversion territory.
- Other significant parts of the yield curve have not inverted.
- Other economic indicators do not confirm near-term recession fears.
- Low and/or negative bond yields outside of the U.S. are creating downward pressure on our bond yields (outlined in more detail below).
- During the past five economic cycles, the U.S. economy entered a recession, two years, on average, after a yield curve inversion. This significant lag times makes it difficult to utilize even an undisputed yield curve inversion as a reliable tool for near-term economic conclusions or investment strategy decisions.
U.S. Treasury Yields
As of March 26, 2019
Sources: U.S. Department Of The Treasury.
Did the Fed Go Too Far?
Many market participants feel that the Federal Reserve may have been too aggressive with their programmatic interest rate hikes that began in late 2015. The illustration below helps to compare the current rate hiking cycle to ones in the past.
The data points at the top of the table (labeled nominal federal funds rate) reflect where short-term interest rates peaked at the height of each previous interest rate hiking cycle. The average of these previous five cycle peaks has been 7.55%. The current federal funds rate is hovering around 2.4% or less than one-third of the average peak levels. It seems hard to conclude that the Fed has been too aggressive compared to history. But there are other factors to consider. We outline one of these meaningful factors below.
Nominal and Real Effective Federal Funds Rates and U.S. 10-Year Treasury
Sources: Bureau of Labor Statistics, FactSet, Federal Reserve, J.P. Morgan Asset Management. The real effective federal funds rate and the real 10-year Treasury are calculated as the nominal yields less core CPI. Between 1979 and 1982, the FOMC changed its approach to monetary policy, focusing on the money supply, rather than the federal funds rate. In the fall of 1982, however, the Federal Reserve shifted back to its approach of targeting the “price” rather than the “quantity” of money. Thus, because the federal funds rate was not the FOMC’s key policy tool, we exclude increases in the federal funds rate between 1979 to 1982 in our analysis of rate hike cycles. Rates as of end of month cycle based on monthly averages. *Latest core CPI reading as of February 2019. Guide to the Markets – U.S. Data are as of March 31, 2019.
Interest Rates – the U.S. vs. International Bonds
The chart below compares the yield on 10-year maturity U.S. Treasury bonds with 10-year maturity government bonds in other developed foreign markets. While we are not investing in foreign bonds, nor do we see much value in U.S. Treasury bonds, this illustration helps to provide an overview of the global interest rate environment.
It’s difficult to comprehend the willingness of investors in Germany, Japan or Switzerland to make 10-year investments that assure a negative return. Regardless of the Federal Reserve’s decisions, these low or negative international interest rates result in strong demand for higher-yielding U.S. bonds. This strong demand has, and will likely continue to, put downward pressure on U.S. bond yields.
10-Year Global Treasury Rates
As of March 29, 2019
Sources: WSJ Market Data Center. Global Government Bonds.
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