April 2019 Market Commentary

Global equity markets continued their four-month long rally, supported by improving investor sentiment over better than anticipated headline GDP and earnings growth, dovish central bank policy intentions, and growing confidence that a trade agreement is almost in hand, leading the S&P 500 index to end April at an all-time high. The yield curve, which had inverted in March, raising investor concerns over the possibility of a recession, regained its positive slope, but overall bond yields remained range bound, leaving the performance of core bonds effectively unchanged in April.

The following table contains a summary of April and year-to-date market performance:

Index April YTD Index  April YTD
S&P 500 (Total Return) +4.05%  +18.25% MSCI All Country World (Net) +3.38% +15.96%
MSCI EAFE (Net) +2.81% +13.07% Bloomberg Barclays U.S. Agg +0.03% +2.97%
MSCI Emerging Markets (Net) +2.11% +12.23% 60/40 Blend* +2.04% +10.77%

*60% All Country World Index / 40% Bloomberg Barclays US Aggregate Bond Index

U.S. equities climbed steadily over the month as a variety of risks that had weighed on markets were not realized, encouraging investors to take on additional equity market risk and driving prices higher.  Investors began April concerned about the possibility of an earnings recession, disappointing first quarter U.S. GDP growth, slowing global growth, trade negotiations dragging on beyond earlier expectations, and the implications of an inverted yield curve.  Instead, each of those factors surprised to the upside.

Estimates of first quarter 2019 S&P 500 earnings growth fell from nearly +7% last fall to -4.2% by the start of earnings season, revised down sharply in the fourth quarter over concerns that the Fed would raise its policy rate another three-to-five times in 2019-2020, hurting corporate revenue growth.  With the Fed taking a dovish stance to end 2018, earlier estimates of earnings appear to have been too pessimistic. To date, with a third of companies reporting, 77% have beaten analyst expectations by an average of almost 6%.  Earnings are now forecast to likely to grow by about 1% from a year earlier.

Following weaker than expected fourth quarter U.S. growth (2.2%) and the partial government shutdown, many expected first quarter U.S. GDP growth to be near 2%.  Instead, real U.S. GDP growth accelerated to 3.2%.  Investors celebrated the top-line result, but appear to have ignored a number of transitory factors suggesting core growth is not that strong.   Over 2% of the 3.2% real increase in GDP was accounted for by rising inventories and falling imports.  Consumption spending only rose 1.2% in real terms and investment in residential housing fell 2.8%, the third straight quarter of decline. Capital investment was up 2.7% but down from 5.4% annualized growth a quarter earlier.

Some economists expect many of these one-time “contributors” to growth (rising inventories and falling imports)  to reverse in the second quarter, leaving growth closer to the 2%.  Others point to the fact that the partial government shutdown was accompanied by large quarter-over-quarter declines in federal spending, consumption expenditures and investment spending that could recover in the second quarter.   Supportive of this view regarding GDP growth closer to 3% is continued strong job growth, rising home sales and improving consumer confidence.  The latter increased from 124.4 in March to 129.2 in April.  Another factor raising investor confidence over future growth was the yield curve, which had inverted in late March, regaining a positive slope.  The yield curve steepened due to the 10-year Treasury bond yield, which had fallen from 2.7% to 2.4% in March, recovering and rising to nearly 2.6% to end April.

In the European Union (EU), new data suggests concerns that  EU growth might slow to recessionary levels appear a bit premature.  Initial data reveals the EU grew 1.5% (annualized) in the first quarter, up from 0.4% and 0.8% the previous two quarters.  The “rebound” can be attributed to an acceleration of Spanish growth, stabilization of French growth and Italy moving out of recession.  The improvement is also supported by greater optimism from companies that sell to EU consumers (and that are less dependent on exports) as unemployment continues to fall and wages rise faster than inflation.  Supporting a turnaround in the EU is the announcement of a new ECB program designed to support bank balance sheets and additional lending.

China announced that its economy grew by 6.4% year-over-year in the first quarter, more than expected, and surprising investors who had been paying attention to weakening output data. The Chinese manufacturing PMI had fallen from 50.8 to 50.2 and the country’s services PMI from 54.8 to 54.3 in April.  A pearl of conventional wisdom is building, however, that Chinese efforts to stimulate their economy will bear fruit later in 2019 and 2020, assisted by a likely U.S. – China trade agreement in the next couple of months.  U.S. Treasury Secretary Steven Mnuchin stated “we’re getting into the final laps” and that “both sides have a desire to reach an agreement.”    Recent reports suggest the U.S. and China are even making progress on a plan to roll back tariffs each nation earlier put in place.  According to the report, the U.S. will immediately remove a 10% tariff on a portion of $200B worth of imports, and then phase in lifting duties on the rest of these items “quickly.”

Investors reacted positively to the apparent weakening of particular risks in April, but at the same time, a number of other risks to asset values were largely overlooked. These risks lead Caprock to see a rising risk-to-reward ratio in today’s equity markets.  Besides questions about the level of growth the rest of the year (only 53% of surveyed economists believe the U.S will grow by more than 2% in 2019), there is a growing view that that the factors supporting robust earnings growth over the last two years and thus asset prices are coming to an end.  While corporate earnings surprised to the upside, revenue growth did not.  Evidence that wages across much of the world are now rising faster than inflation was met by a  Factset report that corporate profit margins actually fell year-over-year and face continued headwinds.  Slowing top-line revenue growth and falling margins are not supportive of rising equity prices, particularly for assets whose prices have climbed from 14X to nearly 17X 12-month forward earnings over the last four months.

In the absence of a reacceleration of global and U.S. economic growth, The Caprock Group sees limited upside opportunity in equities given current valuations. As a result, Caprock is recommending that clients begin modestly underweighting equities on any continued rally in equity prices.