As the longest and one of the strongest bull markets in history has officially turned 10 years old, it appears that reports of the economic expansion’s death appear to have been greatly exaggerated. The sort of volatility and uncertainty that investors experienced over the past few months is, unfortunately, pretty typical in the late stages of economic and market cycles. It is also a reminder of why we encourage our clients to remain disciplined through times of volatility. Those that have remained true to their long-term investment playbook have been rewarded. Last quarter, we anticipated a high probability of mean reversion after the primarily sentiment driven December sell-off, and thus far in 2019 the markets have delivered it with confidence and momentum.
Just a few months ago markets faltered due to worries over rising tariffs, a belief that the Fed would raise rates too far and expectations of an imminent recession. Today, markets have been rising on widespread trade optimism, a view that the Fed’s rate-hiking cycle may be over and stronger growth forecasts. The truth probably lies somewhere in the middle, meaning that stock markets may soon need to pause and digest their recent gains. The astonishing year-to-date rally is solely due to multiple expansion in the price-to-earnings (P/E) ratio, or the multiple that investors are willing to pay for one dollar of corporate profit. Since late 2018, the trailing P/E multiple on the S&P 500 Index has expanded from 15.5x to 18.7x. Displaying this dramatic shift, the Ned Davis Research Crowd Sentiment Poll, covering both attitudinal and behavioral measures of sentiment, has recently moved from the extreme pessimism zone to the extreme optimism zone in a very rapid fashion – barely pausing in the neutral zone.
Contributing to the risk-on sentiment is the perception that global monetary policy has taken on a more dovish tilt. Markets now see the Federal Reserve on pause for the entirety of 2019 and have further pushed back expectations for an interest rate rise in the eurozone after the European Central Bank (ECB) said rates were unlikely to rise until at least 2020. In just a few short weeks the US Federal Reserve completely reversed its positions: no more interest rate increases, flexible on balance sheet reduction (and consideration for even stopping balance sheet reduction altogether) while simultaneously discussing bond purchases as a regular policy tool rather than just for emergency measures. Against this backdrop, Fed Chair Powell stated that “especially in an environment of muted inflated pressures, the Committee could afford to be patient about further policy firming.” It appears that Powell is worried about recession on his watch and wants to prevent it if he can, or at least make the Fed look less responsible for it by taking a more accommodative stance. In his favor is the recent economic data, including that of initial claims for unemployment insurance dropping near its lowest level since December 1969. This dynamic is a strong argument against recession, as you cannot have a contraction without more layoffs. Moreover, while assisted by a surge in inventories and a drop in imports, real GDP increased at an above consensus 3.2% annual rate in Q1, the best first-quarter growth in four years. Meanwhile, retail sales jumped 1.6% in March, the most since September 2017. This offset the weakness from late-2018/early-2019, as consumers remained the driving force of the economy despite a soft holiday shopping season, a volatile stock market, a partial government shutdown, and delayed or reduced tax refunds.
With regards to the global economy, we look for another step forward on trade over the coming weeks and the final steps on economic stabilization in China and Europe over the coming three to six months. Efforts by Chinese authorities to stabilize their slumping economy seem to be working, dampening fears of a global economic slowdown. We’ve been hearing about an imminent US-China trade deal for a couple months now, but nothing has come to fruition yet. The anticipated result of the deal is likely to be a transactional agreement for China to buy more US natural gas, soybeans and other products, perhaps with a cosmetic agreement around the bilateral trade balance and currency and some modest progress on intellectual property protections, but little or no progress on structural change to China’s economic model. Both sides will inevitably claim victory. In Europe, financial conditions have eased significantly since the start of the year, and China’s stimulus efforts could boost capital spending – a potential boon for Europe’s manufacturers. We expect the European economy to pick up pace in the second half of 2019.
We remain generally positive about the economic backdrop and are not expecting abrupt negative shifts in fundamentals, but several possible risks could renew volatility, including rising bond yields, a more complicated geopolitical environment, rising oil prices, corporate earnings disappointments and a return to more combative trade rhetoric. Even just waiting for a US-China agreement can create some paralysis among corporate decision makers and negatively impact capital expenditures. And, even still, investors should not mistake a US-China trade deal for a resolution of global trade tensions as the US is turning its focus to Europe with the threat of new auto tariffs. Other political concerns include the increasing possibility that the USMCA (former NAFTA) doesn’t get ratified by Congress and a lack of Brexit resolution.
We expect downside risk to be limited to single-digit percentage pullbacks, given the improved technical health of the market in the wake of the 2018 correction which placed shares into stronger hands as the weak holders fled the market.
Our main investment theme across portfolios is to maintain exposure in quality stocks to meet our clients’ long-term objectives, while also continuing use of opportunities for balance. It is our belief that the odds of an economic acceleration this year are better the than odds of a recession, especially with the more growth-friendly positions of global monetary and fiscal policies. Nevertheless, we are mindful that financial asset valuations are now less compelling than the prior quarter and think 2019 will continue to be an environment where selectivity remains critical. Expectations for Q2 2019 and the following quarters will evolve as companies report Q1 results and provide commentary about ground-level business conditions. We will be keeping a close eye on this revisions trend. In all of our investment approaches, we think research, risk management, nimbleness, and defensive hedging will be the difference-maker this year.