1st Quarter Commentary
A relatively strong, albeit slowing, US economy in the first quarter mingled uneasily with the specter of an inverted yield curve – historically a herald of recession – and talk of lower interest rates. Markets moved higher though earnings trended lower, consistent with late- cycle trading. Industrial activity continued to slump but was offset by an improving housing sector. The key to continued growth – consumer spending – ended the quarter in a holding pattern after a strong holiday season, bad weather, a government shutdown and a $4 trillion decline in household net worth during the fourth quarter. However, continued improvement in real income should, in our view, help deliver a brighter second quarter.
“Nothing is written in stone,” Bloomberg’s Richard Breslow wrote on March 25 after the yield curve inverted. “Whether [recession] comes to pass or not doesn’t validate nor negate the signal one way or the other.” Nevertheless, on a day when markets were pricing an easier Fed in 2019 than the European Bank, Breslow allowed that “it just isn’t possible to escape the fact that how the rest of the world is faring directly affects the US economy and asset prices.”
JP Morgan weighed in, pointing out that US equity markets were pricing in a mere 15% chance of recession – a far cry from the 66% chance at the start of the year – and discounting only a 3% decline in earnings. On the subject of earnings, FactSet Research reported that estimated earnings declined for the S&P 500 in the first quarter of the year is 3.9%, which if borne out would mark the first year-over-year decline in earnings for the index since the second quarter of 2016. However, it should also be noted that as corporations reduce expectations, outperformance becomes easier as the year progresses.
The Fed in March launched a hawk-to-dove reversal so compelling that the market-based probability of a rate cut in 2019 soared to over 75%, according to the WSJ’s Daily Shot blog. Moody’s noted that since the federal funds rate was raised last December, the 10- year Treasury yield has subsequently declined. This, in addition to an even deeper slide by Treasury bond yields, may increase the likelihood of a Fed rate cut.
The Kirk Report reported that the FAANG basket of stocks – Facebook, Amazon, Apple, Netflix and Alphabet (Google) returned to outperformance status on the broader S&P 500, having lagged the market since the equity market peak in the third quarter of 2018. If the FAANG stocks can sustain their position as market leader, according to the report, it could provide some tailwind to the overall S&P 500 Index returns, as all but Netflix are top ten market capitalization weightings in the S&P 500 Index.
Heartland Advisors chief executive, Will Nasgovitz, in January expressed concerns over the torrent of corporate debt coming due in the next few years – $3.3 trillion to be exact, roughly half of all current outstanding commercial debt. “With interest rates low, the economy strong and relatively easy lending standards, the thinking went that borrowing to buy-back shares or finance acquisitions was a low-risk strategy,” Nasgovitz explained in a post. “But the next five years could severely test that Pollyanna view.”
The Fed, along with JPMorgan and the International Monetary Fund, in January proactively identified the $1.3 trillion global leveraged loans market “excessively speculative”. Nevertheless, these and other comments didn’t prevent the asset class from having a very solid quarter—US leveraged loans had their best quarter performance in some time, returning 5.13%.
Ever docile, CPI rose 0.2% month-over-month in February while the core rate, which excludes food and energy, rose 0.1% month-over-month. On a year-over-year basis, CPI was up 1.5% while the core rate climbed 2.1%. “This report shows no reason for concern on the inflation front,” reported Seeking Alpha, “as the Fed assumed a more dovish posture with regards to monetary policy to combat falling financial asset prices.” Meanwhile, real average weekly earnings grew 1.6% on an annual basis in February, a decline from the January growth rate of 1.9%, but up from the rate of 0.9% one year ago.
The subsequent March unemployment report reassured economists and investors that February’s extremely weak print of 33,000 jobs added was an anomaly, as 196,000 jobs were added in March, exceeding the 175,000 expected by economists surveyed by the WSJ. The unemployment rate stayed put at 3.8% while average hourly earnings increased 3.2% year-over-year, another consecutive print with wage gains above 3%.
Existing-home sales rebounded strongly in February, according to the National Association of Realtors, as turnover rose 11.8 % from January to an annual rate of 5.51 million units in February. At the same time, sales of new single-family homes increased to an 11-month high in February – by 4.9% to an annual rate of 667,000 units – and sales for January were revised higher. The recovery in sales for both sectors was attributed to lower mortgage rates. Meanwhile, construction spending increased in February for a third straight month, due to gains in both private and public demand, as spending rose 1.0 % to a nine-month high after an upwardly revised 2.5% surge in January.
The US Census Bureau reported that new orders for manufactured durable goods fell 1.6% in February, which follows a 0.1% increase in January and marks the first monthly decline in three months. Shipments of manufactured durable goods, which have been up three of the last four months, increased by 0.2%in February from the prior month.
The University of Michigan’s sentiment index climbed to 98.4 in March from the prior month’s 93.8 thanks to low unemployment, rising wages and the Fed’s apparent reversal on interest rates. In contrast, the Conference Board survey slid to 124.1, down from 131.4 in February. Meanwhile, optimism about personal finances soared to its heights in 16 years, according to a February Gallup study, as 69% of Americans expect to be better off this time next year. Confidence increased in February to 131.4 from 121.7 in January, the Conference Board said, as expectations rebounded following recent months of market volatility and the government shutdown.
Overseas, threat of an economic slowdown looms large—indeed, some fears are already being realized. Italy’s recession dragged on through the quarter and the economy is expected to remain stagnate this year, economists now forecast. First quarter GDP is forecasted to fall 0.1% according to a Bloomberg survey, compared with the previous survey’s forecast of +0.1%. The OECD projects a 0.2% contraction in 2019, down from a 0.9% expansion previously estimated.
The Swiss government lowered its growth forecast for 2019 to 1.1% from 1.5% last forecast in December, itself a downgrade from 2%. “In particular, the outlook in other European countries has recently become much gloomier,” according to CNBC, “as a result, international demand for Swiss products is weaker and the export economy is losing momentum”.
The February German factory orders report was nothing short of a “disaster”, as aptly labeled by the Daily Shot, as manufacturing orders fell 4.2% month-over-month vs. economists’ expectations of a 0.3% increase. On a year-over-year basis, orders fell 8.4%, a rate not seen since 2009.
In China, investors and economists had concerns confirmed as industrial production in the first two months of the year rose only 5.3% year on year, the slowest since 2009 and below expectations, while factory gate inflation hovered at multi-year lows. Fixed asset investment growth quickened to 6.1% led by infrastructure spending. However, the most recent Caixin China General Manufacturing PMI provided some good news, as the Index “posted 50.8 in March, up from 49.9 in February, to signal the first improvement in the health of China’s manufacturing sector for four months.”
On the fiscal side, Beijing reported that the unemployment rate in urban areas nationwide jumped to 5.3% from 4.9%, while retail sales year to date rose 8.2%, the slowest pace since June 2003 when it bottomed at 8%. In an effort to help stimulate stronger growth, Premier Li Keqiang’s annual report to the National People’s Congress included a 2 trillion yuan tax cut along with the 3% VAT cut. Li also signaled additional cuts in the bank required reserve ratio for smaller banks.
In Japan, the Reuters Tankan March survey of manufacturers fell to +10 from +13, the lowest in 2.5 years. Beyond the usual concerns about world trade, Europe’s stagnation, Brexit and political jitters in emerging markets, managers complained that costs of raw materials were squeezing profits as higher prices could not be passed on to the consumer.
Commenting on US-China trade negotiations in January, Forbes wrote that “Evidence to date suggests that, after months of haggling, China hasn’t budged an inch on U.S. calls for structural reforms that would eliminate subsidies to China’s state-owned enterprises. Nor has Being agreed to concrete actions to curb rampant theft of American technologies.”
Despite a mixture of both good and bad data points locally and around the globe, US equity markets charged higher with one of their strongest quarters ever, and global equities were not far behind. Nevertheless, with declining earnings expectations—which may be confirmed in short order as earnings announcements are just around the corner— markets may have trouble ascending further. Global economies are generally slowing, in line with what we labeled earlier in our 2019 Annual Outlook as the “Great Moderation”; however, they have not stopped, and we do not see a recession coming in 2020. We believe there are still investment opportunities out there to take advantage of, and as always, our investment team is working diligently each day to maintain your trust and support and deploy capital in a responsible manner.
David Young, CFA®
Chief Investment Officer, IWM, LLC
Brent Pine, CFP®, CPA
President & CEO, IWM, LLC
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*David Young is not affiliated with Geneos Wealth Management, Inc.
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