After a tumultuous December sell-off, both the stock and bond markets rebounded sharply in Q1 and generated a near reversal of the losses from 2018’s fourth quarter. As we reported in January, the sell-off was not based on economic conditions but upon fear and uncertainty. Perhaps due to the sell-off, the Federal Reserve Bank toned down the pace of rate increases, and investors have responded.
Let’s review current key indicators and the first quarter’s performance while we look forward into the rest of 2019.
BONDS & INTEREST RATES
Following December’s correction and falling bond prices, the Fed shifted its messaging from increase rates (driven by concerns of economic growth fueling inflation) to patience and restraint.1 The next rate move is questionable, and for the first time in 10 years, the Fed committee is not projecting a near-term rate increase and is instead considering lowering rates.
With the likely pause on future rate hikes, the bond markets rallied last quarter. This pause is very important for future bond values and it led to massive buying that pushed prices higher and yields lower. Money flew out of stocks and into bonds.2 Stock-fund outflows were -$2.8 billion, while $6.4 billion went into taxable bond funds, $2.5 billion into municipal bonds, and a net $5.6 billion into money markets—all big numbers backed by hopes that current rates are near a peak and bond prices will remain stable for the next few years.
The Yield Curve-Recession Connection
Now it is all about stable rates and increasing bond prices. Money flowing into the bond market is pushing prices up and lowering rates.
Rates for the 10-year T-note are now close to those of 2-year T-bills. When short-term rates are greater than long-term rates, we call this an inverted yield curve. The significance? Historically, inverted yield curves have signaled a recession.
Since 1962, when the yield curve is inverted and that inversion is sustained, a recession has followed seven to 19 months later—on all but one occasion.
The curve is not inverted now, but it is significantly flatter than in recent past (see Yield Curve graph above for comparison versus 2013) and this could be an early warning signal. The lengthy time span over which an inversion historically foreshadows a recession makes it difficult to predict a downturn’s start. However, we are watching this indicator, along with a myriad of others, and we’ll focus on all these in a future edition of our Economic, Market & Allocation Outlook to broaden the perspective for a better guide.
For now, flat rates can actually create a better environment to achieve target returns, and the recent changes in the bond market will provide a more stable backdrop and better risk/return conditions for the overall bond market.
THE ECONOMY & THE NEXT RECESSION
After looking at the yield curve, let’s turn to the economy for any recessionary signals.
The U.S. economy continues to grow but at a slower pace than in the past two years, and it may be facing some headwinds. Corporate earnings, which have been the backbone to stock-price valuations and are an economic indicator, are beginning to slow and to settle into a normal range. The 2018 tax-cut benefits, which jet-fueled earnings growth, have begun to taper, while increasing wage pressure and the challenges of hiring workers in a tight labor market will subdue profit. We expect corporate earnings to continue to grow, just at a slower clip than the last few years.
Economic focus now shifts to the timing of the next recession. Most economists peg it beyond 2020, but actual economic results, to be published in the coming months, will give us a better clue. We estimate it will be at least 18-24 months before our economy sees a severe downturn, as many key indicators of the next correction/recession have yet to appear.
EQUITIES IN 2019
The recent V-shaped recovery in stocks is a good indicator that we are not yet at the end of the long bull market.
First, when investors realized that December’s sell-off had no economic justification, a buying snap ensued. Stock prices rebounded sharply last quarter, and the increase was global2: The S&P 500 rose 13.1%, Latin America 7.8%, Europe 10.4%, and the Pacific Rim 8.6%.
Second, investors also realize most of the factors that drove the panic have been muted: The trickle-down fears of trade wars have lessened with resumed negotiations. U.S. political turmoil, fears of Russian meddling, and Brexit have had far less impact on our economy than touted. And the Fed and the markets appear to be more in line regarding U.S. economic projections, calming investor fears of rising rates in a slowing economy.
Now stocks trade near their 25-year average P/E ratio, while internationals look even more attractive at a current P/E of 13.0x. Focus on future earnings growth rates and the international recovery is key to assessing valuations from here. The lack of a U.S. recession will support a bias of U.S. over foreign stocks in the short term, while longer term, lower foreign valuations may be attractive for potential price appreciation.
It is normal to see more volatile stock prices and lower average-price increases near the top of a market. In the absence of a near-term recession, we should see at least average market returns for 2019 and 2020.
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Categories: Market Commentary, Market Forecast
1 Source: https://www.cnbc.com/2019/03/20/fed-leaves-rates-unchanged.html
2 Data Sources: Barron’s, published April 1, 2019, and JP Morgan Guide to Markets, published April 1, 2019.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual. All performance referenced is historical and is no guarantee of future results. All indices are unmanaged and may not be invested into directly.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.
Investing in Real Estate Investment Trusts (REITs) involves special risks such as potential illiquidity and may not be suitable for all investors. There is no assurance that the investment objectives of this program will be attained. Bonds are subject to market and interest rate risk if sold prior to maturity.
Bond values will decline as interest rates rise and bonds are subject to availability and change in price. An increase in interest rates may cause the price of bonds and bond mutual funds to decline.
Stock investing involves risk including loss of principal.