May Investment Comments
After a strong start to 2019, markets have recovered from the significant declines experienced in last year’s fourth quarter. Much of the rebound can be attributed to the relatively abrupt pivot by the Federal Reserve at the start of the year to be patient with further rate increases, versus a prior indication of multiple expected rate hikes in 2019. At its most recent meeting in March, the Federal Reserve went a step further by indicating it no longer anticipates raising rates at all this year, while also pulling back on plans to shrink its balance sheet. These moves were well-received by the market, which was somewhat perplexed by the Fed’s prior bias toward raising rates in what looked to be an environment of slowing global growth and well-contained inflation.
The U.S. economy is expected to grow in 2019, but at a slower rate than the 2.9% growth posted a year ago. The Atlanta Fed’s GDPNow estimates Q1 growth of 2.3% and consensus expectations for full year GDP growth are closer to 2.0%. This slowdown isn’t necessarily cause for alarm, as the data point to an environment that remains positive.
The labor market continues to look healthy with the unemployment rate a subdued 3.8%. The economy added 196,000 jobs in March, easing concerns over February’s abnormally low addition of 33,000 jobs. For Q1, employment growth averaged 180,000 per month versus 223,000 per month in 2018, down slightly but still a good number. Average hourly earnings increased 3.2% in March, a touch lower than expected and down from the 3.4% reported in February, when wages achieved the highest rate of increase since 2009.
Despite the increase in wages, inflation continues to track below the Fed’s 2.0% target. The Fed’s preferred measure of inflation, the core PCE Index, has been running slightly below 2% with the most recent reading coming in at its weakest level in nearly a year, up 1.8% versus a year ago. The Treasury 10-year breakeven inflation rate has increased modestly since the end of 2018 but also remains sub-2.0%, showing concerns about inflation over the next several years are muted. As long as inflation remains in check the Federal Reserve is likely to maintain its “patient” posture.
Global central banks have also reaffirmed their accommodative stances and China has taken steps to boost its economy. The European Central Bank (ECB) recently kept its benchmark refinancing rate at zero and reiterated its expectation to keep borrowing costs on hold at least through the end of the year. It also highlighted plans to continue to reinvest bonds maturing under its quantitative easing program for as long as necessary to maintain favorable liquidity conditions.
Growth in developed markets outside of the U.S. has been slow, while the picture in developing markets varies. The International Monetary Fund (IMF) recently lowered its 2019 global growth forecast to 3.3% from its 3.5% estimate provided earlier this year and 3.7% estimate from last October. The IMF added the risk of further downward revisions is elevated given concerns around trade tensions, the potential for recent stimulus in China to disappoint, and political uncertainty in Europe. Growth in the Eurozone is struggling to recover from a slowdown that started in the second half of 2018, which has been evident particularly in the manufacturing data. Estimates for growth have been cut recently by both the IMF and the ECB, with the ECB cutting its forecast for growth to 1.1% from 1.7% last December, while also indicating risks to growth are skewed to the downside.
Slower growth is helping to pull down interest rates. The total of negative-yielding bonds globally has risen back above $10 trillion. Rates in the U.S. have felt the effect with the 10-year Treasury briefly touching 2.37%, down from 2.69% at the end of 2018, before settling in closer to 2.50% in mid-April. As longer-term rates declined on the back of growth concerns the Treasury yield curve inverted, with the three-month bill briefly yielding more than the 10-year note. This is typically viewed as a potential signal of an oncoming recession; however, this inversion has since reversed and the lack of persistence of the inversion has helped ease investor concerns. Still, the yield curve will be closely watched given the expected slowdown in growth.
The recent increase in stocks has for the most part been a grind higher with little relative volatility. The Cboe Volatility Index—also known as the “VIX,” or “fear gauge”—has been running well below levels seen at the end of last year. Such tranquility is unlikely to persist, but it is difficult to say when the next disruption may occur. Recently, the market has digested news reasonably well and very well may continue to do so. However, a turn for the worse in the trade discussions between the U.S. and China, or perhaps a disappointing Q1 earnings season could reintroduce volatility into the market. We are not calling for this to happen, only pointing out that risks, as always, exist.
The market enters the first quarter earnings season with modest expectations. Expectations are for Q1 earnings to decline just over 4% as we lap the benefit from tax reform and companies work to digest higher labor, transportation, and raw materials costs. If expectations prove correct, this would be the first quarterly earnings decline since 2016. Given full-year earnings are anticipated to grow in the mid-single digits for 2019, of particular focus will be companies’ outlook for the remainder of the year. Sales for 2019 are expected to grow nearly 5%, which should help with increased costs.
We’ve seen pockets of frothiness in the market. The recent parade of IPOs—like the highly anticipated upcoming offering from Uber—aren’t necessarily indicative of cautious markets. Yet the forward P/E for the S&P 500 is currently below 17x. This is reasonable in a low interest rate environment, which helps boost the relative attractiveness of stocks. If companies provide better-than-expected Q1 results coupled with an upbeat outlook for the remainder of the year, this could very well mean a continuation of the positive market trends we have seen so far this year.
James M. Skubik, CFA