Top Headline for Q1: The Big Bounce
After a brutal fourth quarter that culminated in double digit losses for the major indices, the U.S. equity markets have generally been on a steady upward trajectory. Although the indices have not regained their 2018 “highs” they have recovered much of the loss from the fourth quarter decline. For the quarter, the S&P 500 Index finished up 13.1%, the Nasdaq Composite grew 16.5% and the Russell 2000 Index was up 14.2%.
General Market Update
US Equities: As mentioned above, the indices “bounced” off their December lows en route to an excellent quarter. However, not all segments of the market performed equally well. There appears to be an underlying shift toward segments of the market with stronger balance sheets and more stable earnings. For example, Utilities, Real-Estate (including Real-Estate stocks and REITs) and Consumer Staples all had particularly good quarters. Moreover, it’s noteworthy that the Russell 2000 Index, comprised of smaller companies with less stable earnings and higher average debt levels, did not see the same amount of recovery during Q1. As of March 31, the Russell 2000 Index remains 11.2% off its 2018 peak versus the S&P 500 Index which closed the gap to 3.3%.
International and Emerging Market Equities: Like the U.S. market, the international markets enjoyed a strong first quarter. For example, the Schwab International Equity ETF, which holds stocks of developed markets excluding the United States, was up 10.4% in Q1. Moreover, the Schwab Emerging Markets ETF was up 10.5% in Q1. The emerging market performance was driven primarily by China which experienced double-digit equity market appreciation during the period.
US Bonds: The bond market, including Corporate bonds and Treasuries, saw a sharp rise in prices during the first quarter and a corresponding drop in yields. All maturities appreciated with the greatest growth being seen in the longer-dated segments and, in particular, the corporate bond segments. The bond market price action was interesting as it seemed to anticipate the outcome of the March meeting of the Federal Reserve. The Federal Reserve had been expected to increase rates two additional times in 2019 but took a much more “dovish” stance in words and action – revising it’s forecast to zero rate-changes for 2019. The announcement added more fuel to the existing upward trend in bond prices.
A Look Ahead
As we look to the future, we see conflicting signals. That is, economic fundamentals continue to deteriorate and yet equity markets are climbing with expanding price-earnings multiples. In the equity markets, there appears to be a tug-of-war between the short-sighted stock-market “bulls” and the underlying economic trends. Our expectation for equity markets is that the road ahead includes greater volatility and downside risk. In general, it’s hard to justify any expansion of price-earnings multiples in the current economic environment.
Regarding the current economic conditions, the International Monetary Fund reports a downward trajectory for GDP in Europe, Asia and North America (i.e., most of the world). Moreover, the Federal Reserve and surveys of leading economists also forecast positive, but declining, GDP in 2019. As one would expect, this macro-trend is reflected in corporate earnings as U.S. companies continue to slow down from 2018 peak levels. As of the last update, Factset reports that analysts are only expecting U.S. corporate earnings to see mid-single-digit growth in 2019. Another ominous sign reported by Factset is that the number of downward adjustments in earnings projections by analysts during the quarter was the second largest in the last eight years.
By now, you’ve also heard the buzz regarding the “inverted yield curve.” An inverted yield curve, where shorter-dated bonds have higher yields than longer-dated bonds, has proven a reliable predictor of recessions. During the quarter we saw 1-year Treasury bonds exceed the yield of 10-year Treasury bonds for the first time in more than a decade. The yield curve action seems consistent with other “late-cycle” indicators including high corporate debt levels, low unemployment and some early signs of wage inflation. What is surprising to us is that no one seems to be concerned with, or is planning for, the possible “rainy days” ahead. For example, consumer and business sentiment are at 10-year highs, consumer spending remains relatively strong (including a recent up-tick in real-estate activity) and corporate debt continues to climb.
On the bond side, Federal Reserve actions – real or predicted – will drive the markets in the short-term. The Federal Reserve’s willingness to abruptly shift trajectory on rates makes their forecasts less reliable and will likely lead to more volatility in 2019. The market, in fact, no longer seems to believe the Federal Reserve forecasts as the “futures” market is predicting two rate decreases in 2019 as compared to the flat “dot-plot” projections offered by the Fed. Lastly, we can’t ignore the potential impact of the upcoming 2020 elections. As evidenced by Larry Kudlow’s call for a 50 basis point reduction, it’s clear that the current presidential administration is putting pressure on the Federal Reserve to lower rates in 2019. The Federal Reserve is supposed to ignore such pressures but some suggest that the abrupt change of course in Q1 was impacted by political influence.
In summary, underlying economic trends call for greater caution in the equity markets. We will continue to monitor exposure and shift toward lower-risk segments of the market including higher market capitalizations and lower volatility ETFs. One the bond side, we continue to weight the short and medium duration segments of the yield curve more heavily. While the longer-date bonds enjoyed a nice increase during the quarter, the futures markets indicate that bond buyers may have already “priced in” a rate decrease. As such, any sideways or upward movement in rates by the Federal Reserve may cause a reversal in bond price trends with the longer-dated segment being the most adversely affected.