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Quarterly Investment Commentary – Q1 2019

 

Market Returns:

  • Global markets rebounded nicely in 2019’s first quarter from last year’s poor performance as investors bid up risk assets on better news.
  • Global stocks surged, led by the U.S. equity markets which were helped by the Fed’s announcement in January of taking a more “patient” approach to changes in interest rates. With the current Fed funds rate now much closer to its forecasted neutral rate – a rate which theoretically balances full employment and price stability (the Fed’s main mandates) – the Fed is seemingly more comfortable taking a pause on any rate action for the time being.
  • Another investor concern showing signs of potential resolution has been negotiations between the U.S and China on trade, as avoiding a trade war between the world’s top two economies would obviously be a positive for global investors.
  • Global bonds also appreciated, sending yields lower (bond yields move opposite to prices). While U.S. GDP growth is positive, concerns around a global slowdown has sent investors looking for safety in bonds, thereby pushing yields lower, and in some cases into negative territory in Japan and certain European markets.

 

LOOKING FORWARD:

U.S. Economy: The economy is still growing, albeit at a slower pace than the high growth rate from last year. The tax cuts enacted at the end of 2017 had the effect of raising consumer spending, but the impact from the cuts did not lead to permanently higher growth rates in spending. While growth is likely to not match the almost 3% experienced last year, it is still likely that we can see at least 2% growth for 2019 GDP. The following are likely inputs that have led the Fed to take a patient stance on interest rate increases, a stance which likely helped spur the rally in markets this year:

  • Unemployment (at 3.8%) is still at very low levels and inflation has been in check at around 2%.
  • Wage growth has also been rising slowly which supports consumer spending.
  • While corporate profit growth has come down, 2018’s growth was boosted one-time by the tax cuts, making comparisons difficult. Expectations are for continued positive but slower growth.
  • Global growth is also positive, although there are expectations that it will slow.

Trade is still the outstanding question. While progress has been made between the U.S. and China, the concern for global investors is the U.S.’s resolve in coming to a resolution on trade. The U.S.’s low relative share of exports to GDP compared to other countries increases the risk that trade resolution is more tied to politics than economics, which could stall or delay progress. Overall, while risks are clearly present, the U.S. economy is still growing which can provide a backdrop for continued stock gains.

Yield Curve:
The upward move during 2019’s 1st quarter in both stock and bond prices offered a mixed signal as far as recession risks and future economic growth expectations. In fact, towards the end of March, longer-term U.S. bond yields fell more quickly than shorter-term yields, causing an inversion in the U.S. yield curve with 3-month yields exceeding 10-year yields. Normally, longer maturity yields should exceed shorter maturity yields as investors usually seek greater compensation for an investment with a longer time horizon.

When the yield curve has inverted in the past it has been reasonably predictive of an oncoming recession. Specifically, when the spread between long-term and short-term yields has gone negative, (or when short-term yields exceed long-term yields), it has preceded a recession by about one to two years.  While not a welcomed signal, it is not entirely unexpected given the record length of the current economic expansion which began in 2009. However, while recessions tend to be preceded by yield curve inversions, not all yield curve inversions lead to recessions, or even poor stock returns after the inversion.

 

Research by Professor Campbell Harvey of Duke University suggests that an inversion should be sustained for at least a full quarter for it to offer predictive power, and not just for a few days as was the case for this last inversion[1]. The last time the curve inverted in 2006, the housing bubble was the lead cause for what led to the subsequent recession; today we do not see similar asset bubbles. In fact, what is different about conditions today than in past inversions is the combination of low interest rates and low inflation (which are good conditions for the economy), along with relatively benign stock valuations as compared to the recent past. While we can not say that a recession is not likely at some point, one as severe as the one experienced in 2008 may be far less likely given current conditions.


Conclusion:
Consistent with our message from our January client letter, while the global economy is likely to continue to slow this year, conditions exist for stocks to offer the opportunity for positive returns. U.S. GDP growth and earnings growth have been slowing but they both look to continue to remain positive, and stock valuations are not stretched. While performance and relatively calm volatility this last quarter were certainly well-received by investors given the tumult from last year, volatility may tick up as we move through the year as unresolved issues such as trade and Brexit are still to be worked out. We will maintain vigilance in keeping an eye on the markets and will continue to provide updates. We appreciate your confidence in allowing us to serve your wealth planning needs, and wish you a Happy Spring!

 

[1] “What the Yield Curve Inversion Really Means, According to the Professor Who Discovered It”; Campbell Harvey; Barron’s; March 22, 2019.