The name of the game – PiVot
Rewind to December 24, when the S&P 500 had bottomed, falling 17.64% for the fourth quarter. The Federal Reserve had informed investors they were not done raising rates, and were expecting to raise rates at least twice over the course of 2019, maybe three times. Many investors feared the Fed already overshot their target, and would cause a recession sooner than perhaps it would have unfolded on its own. Though the market rebounded admirably in 2018’s last trading week, it was the Fed Chairman’s “Powell Pivot” to a more patient monetary policy approach in January that really accelerated returns across global markets and most asset classes. With technology companies and US small cap equities dragging markets down in the fourth quarter of 2018, it was those same culprits that pivoted and lead the “V” shaped rebound over the first three months of 2019 with gains on technology-based NASDAQ of 16.49% and the small cap’s Russell 2000 of 14.58%. While not quite as strong, US large cap and mid cap equities still posted solid results of 13.07% and 14.49% for the S&P 500 and S&P MidCap 400 indices, respectively.
Concerns of slowing global growth, geopolitical tensions and ongoing trade pressures are still plaguing markets. However, driven by accommodative central banks around the globe and a relatively benign US dollar, foreign equity markets posted solid gains in 2019’s first quarter, with the MSCI EAFE Index adding 10.13% and the MSCI Emerging Markets Index gaining 9.97%. Traditionally, bonds and equities are inversely correlated, so as equities rally, investors typically sell their safe haven fixed income securities and pivot to risk assets (equities), causing the price on bonds to fall, and their respective yields to rise. However, this was not the case over the first three months of the year, as bond investors sent a clear message to the Fed that they believe the Fed may have overshot their target by one or two 0.25% rate increases, pushing yields lower in the belly of the curve (2-10 years) and causing the first 3-month to 10-year yield curve inversion since 2007. With yields falling, the Barclays Aggregate Bond Index was able to post a solid return of 2.94% over the first quarter. While some softening has taken place, too many indicators (i.e. labor market, LEI, PMI, etc…) are not flashing recession signs to give us fear of an imminent recession in 2019.
Hurry up and wait
On January 25, President Trump signed a decree to officially reopen the federal government, ending the longest government shutdown ever. Undoubtedly the shutdown will have some degree of negative impact on the economy’s first quarter growth. However, as paybacks are issued, the loss in growth should be recaptured over the coming quarters, producing minimal long-term repercussions on the economy. Unlike most government shutdowns, the president chose to hold the government’s closure hostage with his own major political agenda – immigration. Ultimately, facing mounting pressure from his own party, the president conceded, dealing the Democrats a perceived victory. It will be interesting to see what political impact this loss will have on the president’s ability to push initiatives through Congress for the remainder of his term. Some even speculate this may cause Mr. Trump to seek a quicker resolution on the trade war with China, rather than pushing for the best deal; perhaps explaining his softened rhetoric lately.
Both sides claim to want an agreement on trade, and why shouldn’t they? After all, both economies have already started to feel the impact of the year-long trade war between the US and China, which is also contributing to the global slowdown. Though significant progress has been made through the course of negotiations, the two parties are still fairly far apart on deal enforcement and oversight, the timing of the tariff removals, intellectual property and Chinese purchase agreements. As reported by Bloomberg, China would have until 2025 to meet commodity purchase requirements (i.e. soybeans, natural gas, etc.) and allow American-owned companies to wholly-own enterprises in China. The president’s administration is particularly focused on frontloading as much of the purchase commitments as possible through the second quarter of 2020. This would help narrow the trade balance ahead of President Trump’s re-election campaign.
Both presidents plan to formally meet for a signing ceremony, which Xi has requested it be held on neutral ground; leaving the G20 Summit in Osaka, Japan at the end of June as a heavily predicted culmination site. In the long-run, an agreement should bode well for the global economy, allowing accommodative monetary policy to spur economic growth with little supply chain disruption. In the short-term, the market has already priced in an amicable resolution, while the global capital markets may initially spike up with any sort of agreement between the world’s two largest economies – leaving the devil in the details to how markets will ultimately respond. Conversely, should no agreement be reached, the markets would probably unwind the baked-in gains, and continue to sell-off as further global slowdown concerns would cause further unrest.
Brexit remains a factor, as the March 29 deadline came and went, and yet no deal exists today. Prime Minister Theresa May continues to struggle to unite leadership and pass her “soft Brexit” deal, also referred to as the ‘Norway’ option. Such a deal would give the UK Common Market access, but also come with the cost of European Union (EU) membership, without any influence on regulation. Though most want Brexit resolved, many believe the worst case scenario for all parties is a hard Brexit, one in which the United Kingdom leaves the EU with no deal or concessions in place. With the EU granting the UK a six-month extension to reach an exit deal, set to expire on Halloween, the probability of the UK either leaving the EU with no deal, or casting a second referendum vote not to leave the bloc at all, continue to increase. Regardless of the outcome, the path from here to the final decision will be bumpy and will likely weigh on returns.
Steady as she goes…
As it stands today, 2018 grew above trend at a rate of 2.9% Real GDP. While last year ended on relatively stable ground, the first quarter is shaping up to be one of low growth. According to FactSet, the first quarter is expected to come in at 1.6%. At first blush this appears to be a drastic slowdown, but when looking back over recent years, first quarter slowdowns are common, with Q1 GDP growth in 2016, 2017, and 2018, coming in at 1.5%, 1.8%, and 2.2%, respectively. Factor in the country’s longest government shutdown, China trade uncertainties, expiring tax cuts, and extreme weather conditions (arctic temperatures that plagued much of the country and severe flooding), and a quarter-over-quarter slowdown from 2.2% to 1.6% doesn’t seem that awful. We do expect GDP growth in 2019 to slow to approximately 2.0-2.5%, but the odds of a recession are slim. At the end of the day, the consumer drives our economy, making up roughly 70% of GDP and spending was up by 2.5% in 2018. With tight labor markets driven by a 3.8% unemployment rate, and solid wage growth of 3.2% year-over-year, the consumer remains in good shape. However, while still in healthy and expansionary territory, investor confidence, ISM Manufacturing Reports, and purchasing managers indices (PMIs) continue to trend downward. Concern around trade policy and the government’s budget/debt ceiling will likely continue to weigh on sentiment, but as uncertainty dissipates we expect a relatively healthy rebound in growth for the second and third quarters, especially as the Fed continues in failing to achieve their target inflation rate of 2%.
While the dovish Fed stance has been welcomed by risk assets, the rising US Dollar and the flattening and inverted yield curve pose ongoing risks. One indication of this sentiment is an inverted yield curve, which we’ve been warning about for almost a year. The yield curve plots the yield on Treasury bonds at each future maturity, and is considered a leading economic indicator. A flattening yield curve indicates that short-term rates are approaching similar levels on longer-term maturities, and typically means the longer-term macroeconomic outlook is not as positive as the shorter-term outlook. The real concern occurs, however, when a flattened yield curve turns into an inverted yield curve, where short-term rates are greater than long-term rates. Numerous studies have demonstrated a high correlation between the yield curve inverting and a recession occurring approximately 12-24 months later. The bond market sent a clear message to the Fed that it believes the Fed overshot their target and tightened too aggressively. As such, we experienced the first yield curve inversion on the 10-year-3-month treasury yield curve since 2007. Immediately the markets panicked, as investors clearly concluded that we’re headed for an imminent recession. While the yield curve inverted prior to each of the past seven recessions, it is possible for the yield curve to invert without a recession. According to Evercore ISI, the minimal inversion to signal a recession is about -15 basis points (bps) over 10 weeks. The most recent inversion averaged about -2 bps over six days. Even after a yield curve recession signal, as mentioned previously, the recession is typically more than a year out. Traditionally when the yield curve inverts, credit spreads on both investment grade corporate bonds and high yield bonds widen, but that did not occur with this most recent inversion, causing many to question if this was a false indicator. Time will tell if this inversion will lead to a recession, but many feel this time is different. We continue to monitor the slope of the yield curve very carefully and look for opportunities to adjust portfolios accordingly.
The US isn’t the only game in town
Much like the United States, foreign equities delivered strong first quarter results despite a relatively disappointing economic picture. The Eurozone, United Kingdom and Japan have continued to struggle to maintain momentum, and while growth is still above trend, the overall tone and direction of the data has fallen off. GDP Growth and consumer sentiment have appeared to peak and roll-over, and inflation has begun to soften despite expansive monetary policy. Although emerging markets and developed foreign equities have trailed US equities year-to-date, they went down less than US equities in the fourth quarter of 2018, and despite the headwinds with Brexit, German economy, and EU banks, the markets are still approaching all-time highs. Trade policy uncertainty and the slowdown in China are also a major headwind for developed foreign nations that are adding to slower growth rates. We look for these same headwinds to cause volatility and uncertainty for the next quarter or two. While not yet making the transition to restrictive monetary policy, like the US, Source: Bloomberg the tone of foreign monetary policy shifted from the intentions of tightening to accommodative. The European Central Bank (ECB) intends to leave rates unchanged through 2019, and has announced a third round of Targeted Longer-Term Refinancing Operations (TLTRO-III) that will not begin for another six months; the ECB’s program is similar to the Fed’s prior Quantitative Easing (QE) programs. The ECB is also exploring options such as tiered deposit rates to help banks which have suffered significantly from negative rates. Though developed markets (rightfully) continue to cool in 2019 and many hurdles remain, valuations are attractive relative to the US, as they are approaching 20-year lows yet maintaining modest earnings growth and attractive dividend yields.
Like their developed counterparts, emerging international markets delivered strong first quarter results. While the slowdown in China continues to be a major headwind and drag on growth outside the US, especially in emerging markets, the Fed’s U-turn and a relatively stable US Dollar served as catalysts for the developing equity markets. A Fed tightening and raising rates combined with an appreciating US dollar paints one of the most challenging backdrops for developing countries. However, with the Fed on hold and the yield on US Treasuries retracing, the prospects of emerging market equities have improved. Historically speaking, valuations on emerging market equities are still attractive on a relative basis, but two major headwinds remain that could just as easily serve as catalysts for continued growth; the US-China Trade negotiations and the overall slowdown in China. Like nearly all other central banks, the People’s Bank of China (PBOC) and the Chinese government continue to add stimulus to try and kick start the economy, and indicators like last week’s manufacturing activity in China hitting a six-month high in March with the PMI breaking back the key expansionary level of 50. The US-China trade negotiations and tariffs continue to drag and are somewhat offsetting the stimulus efforts, which is why we are cautiously optimistic an amicable US-China trade deal will be met, further allowing the stimulus to push China’s growth higher in the second half of 2019; hence providing a favorable back drop for global equities to continue to grind higher.
As we assess the macro outlook and the opportunities across major asset classes, we see a balance of opportunities to both the upside and the downside. With synchronized central bank dovishness, central banks around the globe seem determined to keep this bull market and economic expansion alive. However, while US earnings growth has experienced five consecutive quarters of double-digit growth, projections are indicating a sharp deceleration in first quarter earnings. FactSet estimates the first quarter S&P 500 EPS fell 4%, or the biggest decline since the first quarter of 2016. While this slowdown may already be priced into the markets, we’ll be focusing on forward guidance to serve as good indication where business leaders feel our economy is headed. Furthermore, much like in 2016, earnings are expected to turn positive again in the coming quarters. Clearly the shape of the yield curve will continue to garner much analysis, discussion and attention, and we will continue to monitor the trends in its shape, as well as credit spreads for the bonds market to provide a clear indication. Until then we remain committed to allocating the fixed income portion of portfolios across various maturities along the capital structure, emphasizing quality by reducing overall risk to low quality credit. While we don’t see a real catalyst for rates to move too much higher, should the US economy continue to benefit from a strong labor market and a dovish Fed, and inflationary pressures begin to surface, we may look to modify duration. Ultimately, we believe the 9-month US-China trade war will eventually reach amicable terms and draw to a close, but in the mean-time expect any headlines pertaining to a deal to move the markets. Of course, still weighing on markets will be any outcome with Brexit, however with the can being kicked down the road for the foreseeable future, headlines should start to have diminishing effects on the markets. Ultimately while risks still plague the markets, we think recession fears are overblown and we are cautiously optimistic as we progress through 2019, but urge investors to temper expectations.
When markets shoot up like they have in the first quarter, it’s easy for investors to become complacent and let the good times roll. However, these are the moments that give us pause, as we reassess current portfolio positioning and look for opportunities to rebalance portfolios back to long-term strategic targets. As always, by maintaining a disciplined approach with a focus on diversification, we hope to provide you the confidence to keep a long-term perspective in line with your own personal risk tolerance and objectives. We appreciate your business and ongoing trust, and invite you to reach out to your advisor should you have any questions, or to schedule your next review.
The preceding commentaries are (1) the opinions of Chris Osmond and Eric Krause and not necessarily the opinions of PCIA, (2) are for informational purposes only, and (3) should not be construed or acted upon as individualized investment advice. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal. Past performance is no guarantee of future results. Advisory services offered through Prime Capital Investment Advisors, LLC. (“PCIA”), a Registered Investment Adviser. PCIA: 6201 College Blvd., 7th Floor, Overland Park, KS 66211. PCIA doing business as Qualified Plan Advisors (“QPA”) and Prime Capital Wealth Management (“PCWM”).
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Chris Osmond is the Chief Investment Officer at PCIA. Bringing 13 years of experience to his role, Chris has won numerous awards for his work in wealth management and financial services. Chris received his Bachelor of Science from the University of Arizona, and is a Certified Financial Planner, as well as a Chartered Financial Analyst.