Economic Strength with a Dose of Uncertainty
During the first four months of 2019, the S&P 500 advanced almost 18% 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. However, investor focus quickly shifted recently to the escalating and widening trade war and its potentially negative impact on the global economy. Stock prices declined every week in May and dropped more than 6% during the month.
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, 2018 saw GDP growth spike to over 4% in the second quarter. Growth moderated to 2% in the second half of the year 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. Helped somewhat by one-time factors, the first quarter of this year reversed that trend and our economy enjoyed an unexpected bounce to 3.1% growth.
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. This positive environment for stocks, however, has recently been overshadowed by the fear and uncertainty regarding the length and depth of tariffs that have been both implemented and proposed. Rising risks to global growth from trade wars have caused a decline in long-term interest rates around the world and an expectation that the Fed may need to cut rates. In fact, bond futures prices already have rate cuts priced in for later this year.
Currently, however, our economy remains healthy. The foundation of strength has been the robust job market, which is attracting sidelined Americans back into the workforce. Unemployment claims in May were in record low territory and the 3.6% unemployment rate is at a 49-year low! The service sector of the economy has been stable, while manufacturing slowed due to global conditions. Importantly, the strong labor market has translated to continued high levels of consumer sentiment with recent index readings at multi-year highs. Jobs and the consumer remain the backbone of our economic expansion.
Despite the historically long government shutdown during January and the abundance of inclement weather during the first quarter, GDP growth surprised to the upside at 3.1%, boosted in part by temporary factors. We expect that domestic economic growth in the second quarter will be somewhat slower and the year as a whole should come in around 2%. 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 unusually 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 was likely the first quarter. However, consensus expectations of a small decrease in earnings versus last year were overly pessimistic and reported earnings growth was slightly positive for the quarter. As headwinds abate over the course of the 2019 and year-over-year comparisons become easier, quarterly earnings growth should increase sequentially. For 2019 as a whole, we continue to foresee high-single-digit earnings growth, a very respectable result.
Recently, the yield curve inverted and grabbed the headlines 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. Federal reserve policy remains accommodative with a strong possibility that the Fed will lower short-term rates later this year.
Despite the market’s rapid 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 global economic conditions improve. In conclusion, we remain constructive on U.S. equity markets. While market volatility may increase and return to more normal levels, we expect the indices to make additional highs in the coming quarters.
Holger Berndt, CFA Director of Research