Fear Recedes as Quickly as it Arrived
During the first quarter of 2019, the S&P 500 advanced 13% as stocks quickly snapped back from the dive they took in the final quarter of last year. A shift in policy by the Federal Reserve, in which they no longer anticipate additional interest rate increases this year, ignited the V-shaped recovery for stocks. This led equity markets to their strongest start to a year since 1998. Although global economic growth has recently slowed, the new Fed policy stance diminished investors’ concerns of an imminent recession. While there are always issues for concern, the market looks to be on solid footing for generating additional gains and surpassing the highs from last year.
Over the long run, real inflation adjusted economic growth in the U.S. has averaged roughly 3% annually. In the ten years since the last recession, GDP has only expanded 2% per year on average with some quarters a little stronger and some a bit weaker. Thanks in large part to the recent tax cuts, last year saw GDP growth spike to 4% in the second quarter after climbing steadily from almost zero at the end of 2015. The pace of growth moderated to 2% in the next two quarters as the boost from tax cuts waned and tariffs/trade wars, weakness in China and Europe, Brexit uncertainty and the government shutdown all weighed on our economy.
With the initially elevated rate of economic expansion last year, the Fed jumped on the opportunity to begin to “normalize” interest rates from historically low, near zero, levels. They did so in a robotic manner, making four quarterly increases of 0.25% each to move closer to their target, a level considered to be neutral to both economic growth and inflation. This strategy worked well until growth tailed-off at year end. At which point the Fed continued to indicate they planned additional rate increases in 2019, even as the stock market was plummeting. Early this year in the face of a slowing domestic economy, the Fed “saw the light” and changed its tone, stating that rates were near their neutral target level and that no additional increases for 2019 were being considered.
The Fed and interest rates, one of the biggest headwinds for stocks last year, suddenly became one of the market’s strongest support mechanisms. With subdued inflation and tame wage growth, the Fed has no current reason to raise rates. Given the lesson they learned last year, we believe that even if economic growth exceeds expectations, the Fed will err on the side of growth and allow inflation to run a bit above their 2% target before raising rates again. Conversely, if growth slows from here, it’s highly possible the Fed may revert to cutting rates to boost the economy. For this year, that provides investors with a rare win-win situation when it comes to the interest rate outlook.
Currently our economy remains healthy, and there are signs of reacceleration both here and abroad. The foundation of strength for our economy has been the robust job market, which is attracting sidelined Americans back into the workforce. We just saw another solid report for March, in which jobs grew as quickly as in the fourth quarter while the unemployment rate held steady at 3.8%, just above the 49-year low of 3.7%. The service sector of the economy has been stable, while manufacturing slowed due to global conditions. Indications are that manufacturing may be on the cusp of improving. The March purchasing managers’ indices for both China and the U.S. increased after having fallen over the past three months and one month, respectively. Additionally, Germany’s industrial production saw a modest improvement in its latest reading. We believe we are starting to see green shoots of new growth in numerous areas globally.
Despite the historically long government shutdown during January and the abundance of inclement weather during the quarter, expectations for first quarter GDP growth have been rising recently and should come in around 2%. Our estimate for domestic GDP growth for all of 2019 has been in the neighborhood of 2%. We suspect we may need to revise that slightly higher as global economic conditions may be improving and could gain steam throughout the year. As for the ultimate duration of this impressive decade-long expansion, there is no reason to believe that it cannot continue for at least a few more years. Consider for example that Australia hasn’t had a recession in 28 years! Expansions don’t die of old age; the economy generally overheats and policy makers combat that with excessive restraint. We are a long way away from overheating, as this expansion has been mostly modest and very drawn out.
S&P 500 companies grew earnings by an astounding 20% in 2018, which makes for very difficult year-over-year comparisons in 2019. The most challenging period will be the first quarter. Current expectations are that earnings will decline by 4%, due in part to pressure on margins and a stronger dollar. It is worth noting that over the past five years, 72% of companies on average have exceeded expectations and boosted the overall growth rate by almost 4% versus estimates. Therefore, it is likely that the first quarter earnings decline, if any, will be slight. Ensuing quarters should return to earnings growth as headwinds abate over the course of the year. For 2019 as a whole, we continue to foresee high-single-digit earnings growth.
In March, the yield curve inverted briefly as the yield on the 10-year Treasury note fell below the rate on 3-month bills. This was the first yield curve inversion since 2007, and only the fourth time since 1980. Historically, this indicator has often preceded recessions by one to two years. However, there are enough unique conditions to believe the curve’s recessionary signals may not hold true this time. Distortions to the shape of the curve likely resulted from the accommodative Fed policies of aggressive quantitative easing/bond buying and a decade of exceptionally low interest rates, as well as investors fleeing negative yields in Europe for more attractive rates in the U.S.
Despite the market’s recovery since investors set aside their fears that Fed interest rate policy would overshoot and trigger a recession, current valuations remain below last year’s levels. Considering how low interest rates are today, valuations have room to move even higher without violating historical norms. While earnings growth will start out the year slowly, we expect it will gain momentum in subsequent quarters and return to more normal levels as comparisons become easier and economic growth increases. In conclusion, we remain constructive on U.S. equity markets. While we may see market volatility increase and return to more normal levels, we expect the indices to make new highs in the coming quarters.
Holger Berndt, CFA Director of Research