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First Quarter 2019 Capital Market Summary & Outlook
Capital Market Action Summary
After a volatile fourth quarter marked by significant declines in virtually every asset class and a year when cash was one of the best assets to hold, the global stock markets rallied from their lows in late December to almost erase the 2018 losses by the end of the quarter. Despite a slight downturn around the yield curve inversion in early March, the equity markets reacted very favorably to the anticipated changes in central bank policy from The Federal Reserve whose December rate hike was very negative for asset prices. The new, more dovish stance spurned investors to take more risk as they felt the markets were being backstopped by the central bank.
Domestic equities were generally up double digits during the quarter with growth and technology stocks outpacing value and small-cap stocks performing better than large-cap. The declines late last year established the environment for the recent rally with a change in Federal Reserve policy stemming in many ways from the market action at the end of 2018 and the slowing of anticipated tariffs on China which was also the result of the late 2018 trends and the Trump administration not wanting to further shock the markets. In a way, the market decline directly led to the mitigation of two of the biggest risks.
Otherwise, the macroeconomic data during the first quarter was generally mixed and suggestive of late stages of the business cycle with manufacturing reports softening, earnings expected to decline year-over-year, and a slowdown in Chinese demand. The US/Chinese trade negotiations have also continued through a series of fits and starts, but largely trended in a positive direction. However, weaker monetary policy and a trade deal could already be priced into the market and the upside market catalysts will need to come from earnings improvement or an uptick in global growth. Given the historically low unemployment rates, there is still potential to do so as the lack of labor supply has yet to meaningfully drive inflation.
Abroad, stocks also lifted off the lows of December and recovered much of their losses, but trailed their US counterparts. Brexit continues to weigh on European stocks through weak consumer sentiment and lessened business investment due to the uncertainty of the final agreement. Most companies have long since designed their strategies around the Brexit, but they still anticipate some pain upon execution. The graphic below from Charles Schwab summarizes the potential outcomes:
Emerging markets stocks also saw a recovery due in large part to softer monetary policy and increased fiscal stimulus in China. A rebound in energy prices also contributed to the reversal. Even still, emerging market stocks remain well below the highs they set early in 2018.
In an uncharacteristic fashion, bonds also rallied during the quarter which is a bit of an anomaly as bonds tend to sell off and rates tend to rise in times of strong stock market performance as bond investors anticipate a stronger economy. The trends over the first quarter were just the opposite with bond prices improving and yields falling with bonds posting modest gains over the quarter. The moves were predicated on several factors: mixed economic data, a switch to dovish stances from the global central banks and the Federal Reserve stopping bond sales later in 2018. There was also a slight inversion in the yield curve (this happens when short-term rates are higher than long-term rates) which is usually a harbinger of recession, but this time around may be more a factor of central bank policies leading to a low interest rate environment. In another significant policy shift, the Federal Reserve also signaled that they may let inflation overshoot their target (2%) and run a little hot before raising rates.
Major Index Returns for the First Quarter of 2019
- S&P 500 Index (Large Cap Stocks): 13.65%
- Russell 2000 Index (Small Cap Stocks): 14.58%
- MSCI EFAE Index (International Stocks): 9.98%
- MSCI All Country World Index (Global Equities): 11.61%
- Barclay’s Aggregate Bond Index (Fixed Income): 2.94%
Both equities and bonds have performed well in the rebound out of the late 2018 sell-off. Stocks are fairly valued and bond yields may be slightly below their equilibrium point. While stock prices climbed over the past month, we saw an inversion in the yield curve and a drop in mid and long term rates. Normally, when stock prices climb, bond yields climb as well. The recent market action has created a large spread between the two that developed over the first quarter as demonstrated in the chart below from Charles Schwab with the S&P 500 in blue and the 10 Year Treasury Rate in orange:
History suggests that the trend lines should act in closer unison as opposed to the spread seen in the red circle above.
As such, we believe that the gap will narrow and that the big question is “From what direction?”. From our perspective, the narrowing will likely come from both directions over time. Bond yields may have overshot to the low side after The Federal Reserve revised its dot plot and surprised in March about holding off on rate increases. The resulting dovish optimism pushed the 10 Year Treasury Rate a little too low and we expect the 10 Year Treasury Rate will likely climb into the 2.5-2.7% range in the near term.
Equities shrugged off a weak trend in recent manufacturing data and a fall in small business sentiment as the markets responded to the change in Federal Reserve policy and foreign central bank easing. Nevertheless, we see the biggest equity risks coming in the first quarter earnings season as it is likely that revenues were hampered due to the government shut down and some severe weather events. Additionally, recent manufacturing data suggests economic growth softening. Furthermore, we view the chances of a near-term recession to be low and the yield curve inversion is unnaturally effected by the foreign central bank policies that have driven foreign investors to the long end of the US bond market. Nevertheless, investors have become increasingly uncertain when the market has hit these levels recently as evidenced by the chart from Bloomberg on the following page of S&P performance with volume declining when performance hits the top of the range:
Geopolitical risks still remain, but they are largely confined to foreign nations. The Brexit overhang remains and although companies have had time to position for the exit, it is still likely to bring pain. Additionally, economic trends have not been positive and where the companies tend to be more on the value side of the ledger over growth, we are not sure where a large spark would come from to drive equity performance. Accordingly, while we would like to maintain some exposure to European stocks, we want to be on the lower side of historical allocations.
Whereas developed market European countries are less attractive than usual, Emerging Markets offer a much better investment thesis – especially if we see a meaningful China-US trade agreement. Even still, China’s recent stimulus and economic reforms should be able to counterbalance any trade setbacks or slowdown in the near term. Emerging market stocks remain below their recent highs a year ago and emerging market countries are poised to be the economies with the greatest growth over the next 3-5 years. Additionally, the chart below from Blackrock illustrates how Emerging Markets have historically been one of the best late stage performers:
We also do not see much immediate risk of a recession as almost all recent recessions were attributable to oil price shocks, inflation spikes leading to aggressive Federal Reserve action, and financial imbalances from too much leverage. We do not see significant risks of any at this point in time. Oil prices can be mitigated by the higher US production values. Inflation hasn’t trended above 2% despite unemployment at very low levels and companies are nowhere near as extended as they were in 2007 showing surplus rates closer to the mid cycle.
Lastly, we have begun to prefer municipal bonds as the first place to go for fixed income allocations. They are likely to gain further favor as individual investors adapt to the new tax laws. Additionally, there is a potential displacement in the high yield municipal market in the near future as Puerto Rico bonds return to the benchmark and managers sell issues to reallocate to the Puerto Rico bonds that have restructured. We do not favor a heavy allocation to foreign bonds and prefer shorter duration for core US bonds as there is not much of an upside to taking on more interest rate risk. Ferris Capital is also avoiding a lot of credit exposure at this time as spreads are too tight to take on equity-like risk.
We believe that US equities are at a bit of a crossroads with a growing underlying economy but slowing earnings growth and slightly stretched valuation. We anticipate some volatility in the first quarter earnings season, but US GDP growth will likely continue with an anticipated slowing in 2020. Bond yields could rise over the longer-term, but the recent Federal Reserve surprise should temper yields until we see signs of inflation. Even then, the Federal Reserve may allow inflation to go above 2% before tightening.
Abroad, the Brexit overhang, weak macroeconomic trends and a value tilt makes investing in European stocks less attractive and the ultra-low to negative yields of foreign fixed income market as a weak risk/return tradeoff without a significant dollar decline. However, emerging markets stocks are likely to outperform their developed world counterparts.
Preferred Portfolio Positioning
We believe that the preferred portfolio positioning is having a sound allocation to quality US stocks, less exposure to International developed market stocks and building a portfolio of Emerging Markets equities. We slightly favor stocks over bonds until rates climb or we start seeing the signs of an upcoming recession. Ferris Capital also views an allocation to Master Limited Partnerships as a good use of your risk budget and to maintain some exposure to technology stocks as there is a coming digital divide.