Positive investment returns were experienced across all asset classes as the weakness in the fourth quarter reversed quite nicely. Domestically this reflects reduced concerns that the trade war with China would escalate the move of the US economy into a recession. After the S&P 500 declined by 14.0% during the 4th quarter of 2018, stocks started 2019 with a vengeance, increasing by 13.6%. The advance was once again led by technology stocks (up 19.8%). Other top-performing sectors included industrials (which advanced by 17.2%), energy (16.4%), and consumer discretionary (15.7%). Laggards included health care which rose 6.6%, and financials which gained 8.6%. In the case of health care, political concerns have escalated around the need to contain health care costs and talk of “Medicare for All,” neither of which has positive implications for the group. In the case of financials, the persistence of the flat yield curve, in spite of continued economic growth (including a 3.2% Q1 2019 GDP number) has kept investors nervous about bank earnings. Domestic small and mid-cap stocks also participated nicely in the Q1 rally. International stocks did not match the strength displayed by US indices as economic conditions among many has continued to teeter with many only muddling through with little signs of meaningful growth. This included much of Europe as well as Japan. Both the MSCI EAFE Index and the MSCI Emerging Market Index underperformed the S&P 500 by some 350 basis points. Valuations (P/E Ratios) in most all key developed markets are below that of the S&P 500 (17.1x 2019 estimate) reflecting a more muted earnings outlook and a higher level of political instability across many.
The bond markets domestically continued to churn out steady returns and, like equities, above the fourth quarter of 2018. The wavering signs from the Federal Reserve have made for interesting reading but caused only modest volatility in interest rates in the first quarter. The market may want Fed rate cuts, but it may not get them if the leading cyclical data are starting to turn higher now in a durable fashion. Inflation also obviously matters. We have to believe we are in the neighborhood of full employment (3.6% unemployment rate in March) in the U.S., where slack is exhausted. Even the OECD global output gap has closed. Without some slack it is unlikely that the economy can sustain robust growth without eventually stoking some inflation. Given that the U.S. bond market is unwilling to price out the bet on a Fed rate cut, there remains risk if inflation picks up even a small amount in 2019. Holding on to “Goldilocks” indefinitely requires justifying a Fed rate cut that we find hard to justify now.
We remain fully invested in equities today (as we have been for quite some time) owing to the following factors:
- Inflation expectations are well-anchored and long-term interest rates are historically low
- Monetary policy remains accommodative; fiscal and regulatory policy remain stimulative
- The supply side impact of tax cuts are staling to come through (with the exception of capital expenditures)
- Economic growth is expected to stay in the 2-3% real range in 2019/2020
- We see few signs of speculative excesses including IPO activity and mutual fund flows
- Money growth and the velocity of money have started to increase, benefitting risk assets like stocks
- The Standard & Poor’s 500 sells at 17.1x our 2019 estimate – not necessarily cheap by historic standards, but not expensive either considering the current level of interest rates
Barring a policy error or an exogenous event, the U.S. economy appears far from recession. While some sort of trade deal with China has been priced into current equity prices, a “good” trade deal – one that actually opens up markets and expands commerce – has not. Global growth appears poised to accelerate in the second half as China’s stimulative measures start to take effect. This all means that the trade picture with China stands as the key event to watch as we continue into 2019.