Market & Economic Outlook
Market Commentary Q2 2019 - Economic Outlook
Second Quarter 2019
A new year ushered in a new tone for U.S. monetary policy, translating to a much needed pivot point for investor sentiment following the worst quarterly decline for the S&P 500 Index since the fourth quarter of 2011 during the height of the European Sovereign Debt Crisis. In the span of a few hours on January 4, the equity market’s boogey man, a hawkish leaning Federal Reserve (“Fed”), seemingly vanished almost as quickly as it emerged as an underappreciated risk exactly three months earlier. Fed Chairman Jay Powell cast aside past comments indicating that monetary policy was on a predetermined tightening track, opting for more dovish terms that pleased equity market investors, like “patience” and “data dependence”.
In the minds of many investors before Powell’s about-face, the Fed was ignoring softening economic data not only at home but especially abroad. Perhaps the most concerning datapoint was a downshift in forward looking measures of economic activity in Europe and China. It seemed improbable that the U.S. could remain on an isolated economic island of prosperity as the rest of the world flirted with recession. Since then, the data has confirmed fears of a global economic deceleration with growth in the U.S. slowing in the fourth quarter of last year to 2.2% after having peaked in the second quarter at 4.2%.
Company fundamentals have not been immune to the economic malaise emanating from overseas. Adverse management guidance and analyst earnings estimate downgrades for 2019 have reflected the moderation of global growth. Yet investors piled back into global equities under the assumption that the Fed is on hold and may even retreat (i.e., cut rates).
Facing the threat of a global economic slowdown, the removal of a potential accelerant by way of tighter monetary policy substantially reduced investors’ fear factor and resulted in a “V” shaped recovery for riskier assets across the board. At the end of the first quarter, as shown in the chart on the next page, the S&P 500 Index stood at just 3% below its all-time high set in late September 2018.
Stock/ Bond Divergency
The renewed optimism coursing through global equity markets did not carry over into the bond market, however, where yields on longer-term issues continued to decline reflecting a lower growth and inflation outlook. Since peaking in early November 2018 at 3.22%, the yield on the bellwether 10-year Treasury Note fell 81 basis points (0.81%) to end the first quarter at 2.41% as shown in the chart above.
In a potentially prescient signal for the economy and equity market, longer-term yields fell so far that the Treasury yield curve inverted briefly at the end of the quarter for the first time since 2007. Sustained yield curve inversions have preceded each of the past six recessions.
Dismissing the bond market’s skeptical outlook, the equity market’s more sanguine view also implied that lingering and unresolved geopolitical issues are likely to see a positive outcome in the near future. Not surprisingly, escalation of U.S./China trade tensions was avoided and expectations of a forthcoming resolution have increased. Meanwhile, Brexit has seen little progress save for buying a little more time for the UK Parliament to agree on a deal to leave the European Union. Given the current status of the stalemate, a disorderly ‘no deal’ Brexit cannot be ruled out.
Event risk aside, there is no doubt that global growth is slowing. What is debatable is the effectiveness of the varying policy responses from both a fiscal and monetary perspective. The European Central Bank and Peoples Bank of China have joined the dovish central bank chorus. China has also deployed fiscal stimulus measures, including tax cuts, in an effort to reaccelerate growth. The early read from March data is showing signs of green shoots, but more time will be needed to determine if the current expansionary cycle will get a second wind. Until then, the divergent views between stock and bond investors are likely to go unreconciled.
Bond Market Review
Bond markets were unusually volatile towards the end of the first quarter as the Fed signaled a dovish pause in both tightening and balance sheet tapering. It also suggested that it might even return to cutting rates for the first time since the depths of the great recession if first quarter economic growth repeats the lackluster results of the fourth quarter of 2018.
Meanwhile, investors digested the news that the U.S. Treasury yield curve had inverted for the first time in a decade with reactions ranging from a shrug to a shudder depending on their view as to whether or not inversion invariably leads to recession. While inversion is a strong signal that has often, but not always, led to recession, the key question is when: on average, inversion is followed by recession around 14 months later.
This does not imply that the U.S. will enter recession around a year from now—just as the 2020 presidential election heats up—and few pundits have been bold enough to read yield curve inversion as a date-certain for economic recession.
Our Canadian neighbors also witnessed yield curve inversion as concerns over global growth rates migrated from Europe to North America. Central Banks at home and abroad paused their cycle of rate hikes with several even hinting that rate cuts may be forthcoming.
Our view on yield curve inversion is similar to that of equity investors—more shrug than shudder—and we believe the Fed under Chairman Powell differs from prior FOMCs in its proactive response to available data on employment, income and inflation. While a pause in rate hikes leaves less ammunition for the next economic rough patch, Powell and his colleagues will do everything they can to prevent a recession. Bond markets seem to agree, with a rate cut now expected within the next year to two years.
We do, however, see warning signals in both domestic and international bond markets that appear to forecast a hard economic landing; notably developments in German government bond markets.
Back to the future?
Today’s global economic environment is, in many ways, similar to the 2015/2016 period and Germany’s debt markets are a good example of the disconnect between a risk-on equity market supported by Fed actions and fixed income markets signaling a risk-off, cautionary stance.
In the case of Germany, 10-year government bond (“bund”) yields slipped back into negative territory for the first time since October 2016 following manufacturing data falling to a six-year low and export sales and orders slipping back to pre-financial crisis levels. Germany is often seen as a harbinger of global macroeconomic trends, and recent trade uncertainty and softening export demand may point to global manufacturing doldrums.
German 10-year bunds are often seen as safe-haven investments for investors across Europe, particularly those concerned that Brexit and slowing growth may push the region into recession. With German GDP growth flatlined at 0.0% for the fourth quarter of 2018, and the European Central Bank cutting growth forecasts for 2019 to 1.1% from 1.7% in early March, the concerns are real. In conjunction, the bund’s yield collapse has pushed the supply of global government debt with negative yields back above the $10 trillion threshold for the first time since the summer of 2017.
Farther Out, Harder to See
With recessionary signals around the world turning yellow, or red in some cases, and the U.S. yield curve inverting, investors seeking macroeconomic clarity frequently turn to the domestic Treasury market. But the information content of the longer end of the curve, in particular, may be less than hoped for.
The Fed, as opposed to non-governmental entities, holds a significant portion of the yield curve, particularly in publicly-traded notes with longer maturities, as shown below:
While the Fed has begun to reduce its holdings in these longer-dated issues, at least until the recent taper-pause, it still retains roughly half of publicly-traded, longer-term debt. This makes changes in the longer end of the yield curve less likely to provide information that is useful in forecasting economic conditions, whether helpful or harmful to Treasury prices and yields. The situation is somewhat similar to trying to determine valuations of a publicly-traded company where most of the equity is closely held by the founders.
The Fed’s decision to pause its planned tapering of the balance sheet through asset sales further complicates using market activity in longer maturity bonds as a source of information: the greater the concentration of debt held at the Fed, the higher the probability that the Treasury curve fails to accurately reflect a normal market view. While equity market participants welcomed the pause in tapering, bond managers rued the loss of a helpful metric.
The combination of warning signals from debt markets, and the muddled picture the Fed ownership presents, has led our bond strategy to avoid Treasuries with maturities greater than two years. Caution in both equity issue selection and U.S. Treasury holdings is certainly warranted until market forces lead us to a soft or hard landing.
Equity Market Review
In the first quarter of 2019, U.S. stocks mostly recovered from 2018’s end-of-year downdraft despite meaningful downgrades to corporate earnings growth and a growing disconnect between equity market prices and fundamentals. The first quarter rally seems to indicate that market returns continue to be driven by sentiment and the Fed’s intervention (in the form of monetary stimulus) rather than fundamentals. In the current environment, equity markets are seemingly anticipating an economic soft landing versus the hard landing anticipated by bond and currency markets.
Where Have All the Earnings Gone
The S&P 500 Index delivered a total return of 13.7% in the first quarter, making it the best performing quarter since the third quarter of 2009.
Despite this result, analysts dialed back corporate earnings estimates during the quarter largely due to fears of a synchronized global economic slowdown and continued uncertainty regarding ongoing trade negotiations between the U.S. and China. Estimated earnings of S&P 500 companies fell by 7.2% for the first quarter from year-end 2018, representing larger declines than averages from the prior 5-, 10-, and 15-year periods.
As shown in the chart below, seven of the 11 S&P 500 sectors are forecast to report negative year-over-year earnings for the period ending the first quarter of 2019, with three sectors—energy, materials and information technology—declining at double digit rates. The weakening in earnings growth has been rapid and pronounced. For the same time period, but ending at year-end 2018, 10 of the 11 S&P 500 sectors recorded positive earnings growth rates led by energy, health care and industrials.
Additionally, broader consensus estimates for calendar year 2019 earnings have also been reduced significantly—from 11% to 5%, a decrease of over 50%. What does this mean for investors? Strong corporate earnings form the backbone of durable, healthy market advances. Without the support of earnings, stock market rallies can fade over time. As such, weakening corporate earnings could be a harbinger of future trouble for equity markets.
Deteriorating corporate earnings and their potential negative impact on financial markets become particularly important given that financial assets now represent a much larger share of American household net worth than they have historically. As shown in the chart on the next page, between 2007 and 2016, financial assets as a percentage of total household assets grew from 34% to 43%, an increase of over 25%. If market returns begin to track declining earnings reports, the decline would have a magnified impact on household net worth, which has become increasingly tied to gains in the stock market over the most recent bull market run.
Although earnings estimates for the first quarter were dismal, equity markets rallied nonetheless due to valuation expansion and lower market volatility. The Price to Earnings (P/E) ratio for the S&P 500 Index grew from 13.5 in late December 2018 to over 16.5 by the end of the first quarter. While this most recent P/E level is not necessarily high by historical measures, the increase of three points is notable in that this type of rise is typically reserved for markets that are recovering from recessions, not from a growth scare in an overvalued market.
We believe that equity markets were due for a bounce-back after the tumultuous end of 2018 market selloff. While this recent market rally has largely pushed aside fears of an impending recession, the market backdrop remains complex and fraught with risks. In the near term, our focus will be on the outlook for corporate earnings, particularly given the numerous headwinds pressuring growth and margins.
Our view is that mean reversion is a potent force and that we are likely transitioning to a slower corporate growth environment. Divergent signals from stock and bond markets are continuing into the second quarter this year, providing little resolution to the question of whether we are headed for a hard or soft economic landing.
Going forward, we believe that the market landscape will look markedly different from the outsized returns that characterized the last cycle. As the first quarter of 2019 marks the 10th anniversary of the U.S. equity bull market, investors should recalibrate their expectations to include more moderate stock prices and lower (but not necessarily negative) returns. Caution with regard to embracing risk in an environment of slowing global growth is warranted going forward, we believe, and investors may benefit in the long run from a combination of judicious asset allocation and actively managed stock and bond portfolios.
David Wines, President and Chief Executive Officer
James St. Aubin, Managing Director and Head of Investment Strategy
Todd Lowenstein, Managing Director and Chief Equity Strategist
Economic and Market Perspectives is a publication of HighMark Capital Management, Inc. (HighMark). This publication is for general information only and is not intended to provide specific advice to any individual or institution. Some information provided herein was obtained from third-party sources deemed to be reliable. HighMark and its affiliates make no representations or warranties with respect to the timeliness, accuracy, or completeness of this publication and bear no liability for any loss arising from its use. All forward-looking information and forecasts contained in this publication, unless otherwise noted, are the opinion of HighMark, and future market movements may differ significantly from our expectations.
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