QUARTERLY MARKET UPDATE as of April 2019
Stocks surged in the first quarter, having the best quarterly performance since the third quarter of 2009, and the best first quarter since 1998. The S & P 500 was up 13.65% with broad participation, as all 11 sectors finished higher for the first time in five years. The Technology sector led the way gaining over 20%. International stocks also did well, moving up over 10% as measured by the MSCI EAFE index.
Longer term Treasury bond yields continued to decline. After dropping ½ point in the fourth quarter, the 10-year rate fell another ¼ of a point to 2.42%, the same yield as 6-month Treasury bills. For a few days near the end of March the yield curve inverted with the 10-year rate falling below T-bill rates, a harbinger to some of a pending recession. As a reflection of the slowing global economies, the German 10 year-bund yield dropped back below 0% into negative territory for the first time since October of 2016, joining Switzerland and Japan which also have negative 10-year government bond yields.
While growth rates in most of the world were slowing last year, the U.S. economy remained resilient until year end. GDP which had been growing by more than 3% slowed to a 2.2% rate in the fourth quarter, and 2.9% for 2018. The ongoing escalation of tariffs started to drag down growth, especially in manufacturing. Undeterred, at the December meeting the Fed raised rates anyways, and signaled it would continue to do so in a steady and measured manner this year. Along with the government shutdown, this combination of factors brought in a perfect storm of fear and negative sentiment, weighing heavily on the stock market. But even with that backdrop, the stock market correction was excessive. As we wrote in January, a rebound was expected. A slow and steady economy with low inflation and a more reasonable market valuation supported a bounce back.
In January a big shift in Fed policy also renewed optimism. The Fed changed its course for future rate increases, providing an additional tailwind. Previously, Fed Chair Jerome Powell had stressed the importance of staying ahead of inflation by applying steady increases to the Fed Funds rate, before inflation could ignite. With unemployment at historically low levels and wage growth inching up, the prior policy supported the December rate increase. But with a slowing economy and inflation under control, the Fed will now be patient and monitor economic activity before taking further action. This implies short term rates at the 2.25% to 2.50% range have reached a neutral level.
Additional future rate increases will require a more sustained period of inflation before the Fed takes action. If the economy continues to slow and unemployment starts to tick up we may even see a rate decrease. In an ever-evolving world where past economic theories may no longer be applicable, keeping the economy at full employment and inflation low will require the Fed to remain flexible. Over the last ten years a massive increase in the money supply and the unemployment rate at historical lows would have made any armchair economist predict the economy would have runaway inflation. But for several decades, the long movement away from manufacturing and towards services and an internet economy has put downward pressure on prices, making traditional inflation forecasts less predictable. In today’s global supply chain with ultra-low interest rates there is just as much concern about deflation as there is with inflation.
This has also impacted the predictive power of the yield curve. In decades past an inverted yield curve was associated with a pending recession. Typically, the Fed would raise rates to cool off an overheated economy and unintentionally overshoot their target. But we haven’t had an overheated economy this time, and inflation hasn’t been a problem. Our current economic expansion since the 2009 great recession has been slower than past recoveries. But there is ample liquidity in the financial system and banks are still making profitable loans at healthy spreads. With the recent decline in longer term rates we expect the housing market to receive a boost from lower mortgage rates.
The economy is expected to plod along at a slow and steady pace with GDP growth dropping to 1.5% in the first quarter per the Atlanta Fed’s forecast, then picking back up above 2% in the second quarter. Inflation remains under the Fed target of 2%. Historically, stocks have performed well during times of low growth and low inflation. The variability in the past between booms and busts in manufacturing and business cycles are much lower now. We can think of today’s economy and business cycle as a sine wave with lower amplitude. Recessions are always possible but not inevitable.
Since stocks have already achieved above average gains for the year, we may need another supporting element for continued gains. Progress with China on trade talks may fulfill that need. Recent discussions appear to be on a positive track, with proposals from China on a range of issues that go further than it has before. This would directly help both of our economies and assist growth in emerging markets. On the cautionary side, a setback in trade talks and an escalation in tariffs would be a big negative, and it is a wild card we hope to avoid. Valuation metrics for stocks still support more upside. The current value for the forward P/E is 16.8, lower than it was one year ago and well within a reasonable level. At past market peaks the forward P/E has been above 20.