The first quarter of 2019 was certainly easier to stomach than the one prior in which we experienced a dramatic sell-off to finish 2018. Refreshingly, the S&P 500 Index finished the first quarter up over 13%, recouping nearly all of its losses from the fourth quarter (although it hasn’t quite cut through its 2018 high of 2929.67). This was actually the market’s best start to a year since 1998—and every sector brought in positive returns. Market performance is just one piece of the puzzle, though, so we look to the economic backdrop and the behavior of monetary and political policy makers to get a true pulse on things.
US equity market multiples started the year fairly cheap but have crept up to be on the higher end of normal, based on historical averages. The market now trades at 16.8x forward earnings. While the valuation of the market is not at its peak, it’s no longer considered cheap outright—it is pretty in line with levels we saw in mid-2018 (before the nightmare that was the fourth quarter of 2018). The strong corporate earnings growth investors may have become accustomed to the past couple of years (boosted, too, by 2017 tax cuts under President Trump that should be seen as a one-time event already well-priced in) isn’t likely to be repeated in 2019. 2018’s sizable earnings beats set a very high bar, and one that will be difficult, if not impossible, to surpass again this year. Many recent earnings announcements are showing signs of material deterioration in corporate profitability. Essentially, current market multiples are likely not validated unless earnings growth turns out to be much better than what is currently expected. Therefore, we are prepared for negative growth or singledigits earnings growth for the remainder of 2019, but there is some hope we could be at the trough.
Domestically, our economy is holding up just fine, but it is slowing a bit. First quarter GDP estimates are expected to come in a little weak, which is not un-meaningful, but it also tends to be the case that first quarters stray from trends we see throughout the rest of the year. For instance, the first quarter could be skewed slightly by seasonal factors and the government shutdown we experienced during the first few weeks of the year. That being said, no one expects to grow like gangbusters in the remainder of 2019 either—we’ve already discussed the lack of contribution expected from corporate earnings. A bright light does continue to be labor markets, which are still quite positive overall, even despite small blips—the unemployment rate is sticking around its long-time low and wages are increasing. Inflation has receded, as have expectations for it, despite increasing wages and higher prices for some goods. It is also important to remember that in late March, we saw the inversion of the 10-year and 3-month Treasury yield curves, which is historically a dependable indicator of impending recession (and is certainly indicative of investor sentiment of the state of economic affairs). In a normal environment, longer-term investors are compensated with better interest rates than those who loan money for a much shorter time period. Its usual upward shape can change when investors think economic growth and inflationary pressure is likely to fall, which is what we saw just before the quarter ended. However, the inversion was a temporary and short-lived one, reducing its strength as a negative indicator.
Globally, several of the world’s largest economies are slowing, too, and some of them seem dangerously dependent on their central banks who are quick to step in and provide dovish support (not wholly unlike the US right now, mind you). China’s economy, arguably the largest driver of global GDP growth, is showing signs of bottoming in 2019, which would be positive for recovery. The euro zone will hopefully see stabilized growth soon, although it’s struggled with general weakness in manufacturing data in some of its larger economies, as well as just general sentiment. We know that the euro zone is no stranger to geopolitical concerns—namely the impending Brexit process (which was voted on nearly three years ago at this point!) that has now been delayed another six months to October. Kicking the can down the road certainly helps with short-term volatility, but we’re too old to believe that the issues don’t come back with a vengeance later on—a hard Brexit, or an exit from the Union without a solid deal in place, would be the default if agreement isn’t reached. This kind of haphazard exit is the exact sort of thing that economies and markets do not like.
Speaking of kicking the can down the road, trade relations have become a crucial part of the perception of global economic health. Ever since early last year when the planned levying of US tariffs on Chinese imports took the scene, ongoing negotiations about trade policy have been critical in investors’ assessment of prospects for global growth and, at the very least, have dictated market movements on countless occasions. Over the last few months we’ve seen the trade dispute between the US and China begin abating, but we’ve yet to see any real deal hammered out. This headwind, and global trade more broadly, isn’t going away anytime soon, especially when President Trump’s protectionist ideology isn’t unique to our relationship with China. As we have said before, the topic of trade wars is not one to be taken lightly, and we won’t underestimate its power to impact global growth and the onset of a global recession.
Just as everyone’s eyes were on the Fed last quarter, the central bank still holds investors’ attention. What’s changed is not only the Fed’s sentiment about its course of action going forward, but people’s perception of what that means for the economy. Last time we talked, investors feared that the Fed’s continued tightening could accidentally launch the economy into a recession. Developments over the past few months have quelled investors’ fears that monetary policy error could get us in recession-like trouble. This is because the Fed has softened its approach and has committed to a path of patience regarding raising short-term interest rates—and for now, the fed funds rate will remain unchanged at 2.25%-2.5%. Whereas two quarters ago, Federal Open Market Committee consensus was for four more rate hikes in 2019-2020, consensus now conveys expectations for just one hike in 2020. The markets seem to be forecasting an even more dovish path for the Fed, suggesting at least one cut before the end of 2019 with possible additional cuts in 2020. We fear this market optimism over the Fed might be overdone, especially since it’s been driving the market in a big way. Remember, 10 of the last 13 Fed hiking cycles have culminated in recessions and, interestingly, the other 3 involved the Fed actually cutting interest rates. Furthermore, historically, it is not uncommon for the Fed to forecast positive growth in the (unknown) face of a recession. These serve as important reminders that the Fed’s actions are very important and that by no means is it an all-knowing policy making body.
While we still do not believe a recession is imminent, it isn’t out of the realm of possibility, and it is a natural part of the economic cycle to some degree, especially this late in a historically long bull market. We do think an earnings recession or prolonged sluggish growth are much more palpable possibilities at this point. Therefore, we consider ourselves to be cautiously optimistic and always on watch for signs of a significant downturn. We are trying to focus our portfolios on quality companies with lower relative valuations, consistent earnings, and generally strong balance sheets (these are the companies that tend to hold up better in difficult times—even during recessions). We are also trying to minimize exposure to names with big growth stories and stretched valuations that tend to be much riskier, especially at these volatile times. While it may not be as exciting to stick to what’s safe when the market is still producing some big winners, it’s a much better position to be in in the event of a downturn or sudden spike in volatility. As has been the case for several months now, we think it is most prudent to capitalize on any volatility we see by getting into quality names we’ve been eyeing at more attractive price points.Our Perspective
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