First Quarter Recap
In our 2019 outlook, we noted that the fourth quarter of last year was difficult for nearly all asset classes, with stocks, bonds, commodities, and non-U.S. currencies falling precipitously. The U.S. stock market experienced its worst December since 1930. Almost as if depression-era market volatility was an aberration, the first quarter of 2019 saw nearly all asset classes rebound just as quickly, with many areas of the stock market regaining the ground they lost in the prior quarter.
Nobody enjoys a whipsaw experience in their portfolio, no matter how strong their focus on the long-term. The Fed’s hawkish stance was a primary contributor to market volatility, as investors worried that they were being overly aggressive in tightening policy despite a slowdown in economic growth. As the Fed backed off its policy projections and indicated they would not be so quick to raise rates during the first quarter, the market rallied in response.
Also contributing to volatility was the fact that earnings estimates for 2019 were much too high and needed to be adjusted lower. Throughout most of 2018, consensus estimates were that companies in the S&P 500 would experience pretty consistent earnings growth of around 10% throughout 2019. In any given year, this might be a bit rosy, but it was especially so considering that earnings grew at a 20% rate in 2018 due to tax reform and above average economic growth. You can see in the following chart, which shows the trend in earnings projections for 2019, that earnings estimates have been consistently lowered to more realistic levels.
First quarter earnings are expected to fall from their 2018 levels, partly as a result of tariff wars, as well as difficult hurdles due to tax changes kicking in during the first quarter of 2018. The second and third quarter are expected to see earnings growth between 1-3%. Now that earnings estimates have been recalibrated, and companies have issued guidance indicating slower growth than last year (but not an outright recession in earnings growth), the market has stabilized.
In summary, the two major question marks at year end – (1) Where is the Fed going to go from here and (2) just how bad will earnings be – have been answered. The Fed is notably more dovish and earnings growth is slower than before, but still positive for this year. Where does that leave us for the rest of the year and beyond? We will address some of the opportunities and risks in our outlook ahead.
The U.S. Economy – Moderating, positive growth
After experiencing strong growth in 2018, the U.S. economy will see more modest growth in the first half of 2019, with estimates suggesting that the economy is growing at an annualized rate of 1.0% - 2.0%. By comparison, the economy grew at a 3.0% rate last year. Looking forward through the rest of 2019, there will be a tug and pull between two mitigating factors: on the positive side a healthy consumer and on the negative side an economic cycle which moves closer to its maturity as interest costs rise.
On the consumer, one of the primary reasons why we believe that economic growth will be supported, rather than slow further, is because the U.S. consumer is in healthy shape and has the ability to increase their spending. Since the financial crisis, net worth for people in the U.S. has steadily increased as a result of, primarily, gains in the stock and housing markets.
At the same time, the ability for folks to stay current on their debt payments remains on solid footing. The percentage of debt payments relative to disposable income currently stands at 9.9%, down from 13.2% prior to the financial crisis. After 2008, debt levels were either paid down or held steady, rather than getting ramped back up again. Improving wage growth, combined with a strong jobs market should help consumer finances continue to improve through the rest of the year.
Also helping consumers out is the fact that interest rates have held been held relatively low, thanks to years of easy interest rate policy from the Federal Reserve. Though mortgage rates spiked last year to nearly 5.0%, they have settled back down to around 4.0% as interest rate policy has been put on hold and future rate hikes become less certain.
Mortgage rates have dropped significantly in the last six months
The spike in rates, which sped up in the second half of 2018, followed by the decline to start 2019, closely aligns with the downturn and rebound in the stock market and helps explain the fear of a cyclical slowdown that is entrenched in investor’s minds. With the Fed moving more aggressively in 2018 and debt costs increasing, sectors of the market that would fare worse during a recession – homebuilders, financials, industrial stocks, etc – all saw increased volatility, which then subsided as rates fell back lower. The fact that rates are near their lowest levels for the last year should help improve house sales and refinance activity, which should in turn help support economic growth.
Federal Reserve Policy – The perpetual 7th inning stretch
The recent trend in rates ties in closely with the potential risk that the economy is continually moving closer to the end of its growth cycle. Economic cycles don’t end because of age alone, but rather because certain events always tend to happen prior to a recession, the foremost of which is interest rates rising and restricting the supply of money. We continually take stock of where we are in the cycle and for the last few years, it has seemed as if we have constantly relayed to our clients that we are in the late innings, a perpetual 7th inning stretch if you will. What is keeping us in this late stage, but not end stage, portion of the cycle is the fact that the Fed seems ever intent to not end the party. Each time the Fed telegraphs a move to a next chapter of tighter monetary policy, they go two steps forward and one step backward.
Over the last ten years, each time the Fed has proposed making their monetary policy framework tighter, they have ended up not enacting the plan or implementing a more dovish version of the initial suggestion. The last year is a perfect case in point, where they initially forecasted 4 interest rate hikes in 2018 and 2019, and now only project maybe one rate hike this year after a bout of stock market volatility, moderating economic growth, and muted inflation.
This is not a bad thing as the Fed should be looking to tap the brakes on animal spirits, to keep the economy from growing too levered and ending up in a bubble of sorts. The fact that they are keen to float trial balloons on policy direction by suggesting future framework, letting the market adjust its expectations and reprice, and then delivering results that are more favorable than what is expected is a good thing. It allows for pauses that refresh and, frankly, has allowed for the current economic expansion to last 117 months, more than double the average expansion length of 48 months.
Some may argue that the Fed has been too easy with monetary policy over the last ten years and would argue that the stock market has been straight up in that time period. That line of reasoning however ignores the fact that seven of the last ten calendar years have seen market corrections of 10% or more. There have also been four instances of high yield spreads widening more than 200 bps, with significant repricing in high yield bonds occurring in 2011 and 2015. There have been multiple fits and starts in stock and bond markets over the last ten years to reset growth expectations and rein in euphoria, an essential part of a healthy market that keeps bubbles in check. If the Fed can continue to manage policy in a way that allows growth to continue while also preventing bubbles from forming, then it is possible we could stay in the 7th inning of this cycle for some time. Some may cynically observe that the Fed has not done a good job of managing soft landings in the past, to which we would respond, “with the exception of numerous soft landings in the current cycle.”
Global Equity Markets – Not too hot, not too cold
U.S. and global stock markets traded below their historical average valuations after the fourth quarter sell-off, only to rebound to trade in line with or slightly above average valuations. The S&P 500 trades at 16x forward earnings, above its 10 year average of 14x earnings. This makes it slightly expensive relative to recent history, though if you look at a 25 year history (which shows an average valuation of 16x), it is pretty fairly priced. In aggregate, valuations are not too hot (expensive) nor are they too cold (discounted) relative to average levels.
Some areas of the market – large cap growth stocks in particular – are trading at premiums to their average level. The one area slightly below recent averages is the MSCI Asian Pacific index, which includes Japan, China, and Australia.
Now that extreme selling pressure has subsided, markets have recouped much of their losses, the focus shifts to where we go through the rest of the year. Research from LPL Financial shows that when the market has been this strong over the first quarter – rising over 10% -- it has gone on to record positive returns for the rest of the year nine out of ten times.
The only year that didn’t experience positive returns through the rest of the year was 1987. On average, the S&P 500 has gained 5.8% over the final three quarters, after a 10% gain in the first quarter. Of course, volatility does not simply go away and there was an average pull back of 11% in each year.
For the remainder of 2019, what deserves close monitoring is earnings expectations and the effect that the slowdown in global trade – brought upon by tariffs and weaker growth in China – has on corporate earnings. Growth estimates for the S&P 500 have been lowered this year, with full year forecasts projecting 9% growth, down from 21% growth in 2018. Most importantly, the outlook for corporate earnings should stabilize, barring any unforeseen global economic issue.
Lingering in the background is the trade negotiations between the U.S. and China, which have been promised to be resolved yet are prolonged each month. President Trump has been seeking for Beijing to stem intellectual property theft while also easing regulations on agriculture imports. China in turn is seeking promises from the U.S. that export tariffs will stay low and that President Trump will not go back on his word after a deal is struck. While both sides continue to posture as talks drag on, the simple fact that the U.S. has continued to push out its “hard deadlines” on raising tariffs if a deal is not completed signals to us that they are now at the stage where it is more important to strike a deal rather than punish China regardless of what happens. That being said, the longer it takes a deal to be completed, the tariff uncertainty will continue to weigh on global trade and diminish the outlook for multinational corporations.
Though there will be periods of volatility through the rest of the year, we believe the investing environment is still positive for stocks as valuations remain reasonable. Growth is positive and underpinned by a strong consumer appetite and the Federal Reserve has shown they are unwilling to make a policy mistake by making monetary policy too restrictive.
The decline in interest rates has caused some concern as the yield curve between 2- and 10-year Treasury bonds came close to inverting, a long followed signpost that a recession is around the corner. However, growth remains positive in spite of prolonged government shutdown, wage growth is strong, and the labor market is in good shape. Perhaps yields in longer dated bonds are signaling that growth is about to weaken, but in the short-term it seems to provide a more favorable environment for housing market growth with mortgage rates back at twelve-month lows.
In our view, it is entirely possible that the 7th inning for markets last longer than some would expect and investing in both bonds and stocks is rewarded as growth and inflation grow modestly. Optimism in investing has been rewarded over the long-term, though we remain cognizant that owning assets with a margin of safety – whether it be through attractive valuations or defensive characteristics – can also help protect during periods of volatility. Our goal for our clients is to protect and participate as we navigate the years ahead. As always, we appreciate your trust in us and look forward to discussing our views and how it relates to your financial plan.
Investment advisory services offered through Independent Financial Partners, a Registered Investment Adviser
WhartonHill Investment Advisory is not owned or controlled by Independent Financial Partners
The opinions voiced in this material are for general information only and are not intended to provide specific investment advice or recommendations for any individual. To determine which investment(s) may be appropriate for you, consult your financial advisor prior to investing.
All data via St Louis Federal Reserve, Morningstar, Eaton Vance, Yardeni Research, LPL Financial, and JP Morgan