February 2019 Market Commentary

The rally in global equities that began December 26 continued through February, supported by positive signs of progress on the U.S. – China trade dispute as well as growing expectations that Fed and global central bank policies would remain accommodative, reducing investor concerns about the possibility of a recession in 2019.  Bond markets were mixed; Treasury yields climbed and credit spreads fell in response to improving expectations for growth to continue. In driving asset values higher in February, investors appeared to overlook growing signs that U.S. and global growth has peaked.

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

Index February YTD Index January YTD
S&P 500 (Total Return) +3.21%  11.48% MSCI All Country World (Net) +2.67% +10.78%
MSCI EAFE (Net) +2.55% +9.29% Bloomberg Barclays U.S. Agg -1.06% +1.00%
MSCI Emerging Markets (Net) +0.22% +9.00% 60/40 Blend* +1.58% +6.78%

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

Since falling to 2350 on Christmas Eve, the S&P 500 index has gained over 18% and begins March near 2800.  Much of February’s rally can be attributed to a series of statements regarding progress in the  U.S. – China trade negotiations that culminated in an announcement that the U.S. would hold off on imposing higher tariffs set to go into effect on March 2.   It was reported that China has agreed to not only buy  $1.2 trillion more of U.S. goods, but to new agreements on forced technology transfers, protecting U.S. intellectual property and currency intervention rules.  Observers increasingly believed that a “preliminary” agreement could be signed at a summit between Trump and Chinese President Xi later this spring and would be the basis for further negotiations on the details of a final agreement.

Though its effect on economies and markets is not as immediate, recent statements by central banks have been encouraging to investors who question the sustainability of the current economic cycle.  Fed Chair Powell reiterated that the Fed would take a patient, data-dependent  approach to policy changes.  He also said that the Fed would continue to shrink its balance sheet, but that it would likely end that process in 2019, earlier than anticipated and with a larger balance sheet than originally believed.  In separate comments, the Fed  stated that higher wage growth was not necessarily a reason to raise its policy rate, and that  that they were prepared to let inflation rise above 2% without raising rates.   The ECB, recognizing economic weakness in the EU, appears likely to postpone its planned rate hikes and the shrinking of its balance sheet, which were anticipated to begin this summer, until 2020.  That decision appears based on the conclusion that  while data shows the current EU slowdown is more protracted than initially expected, key factors underpinning the economy remain intact.

The rally in global equity markets over the last two months has taken place even as economic data suggests slowing growth across countries. In the U.S.,  GDP growth reached a 4.2% annualized rate in the second quarter of 2018, but  slowed to 2.6% in the fourth quarter, leaving growth for all of 2018 at 2.9%.  Despite softening growth, consumers appear to remain confident.  A measure of consumer confidence rose in February, driven higher by rising wages,  and  job openings reaching 7.3 million, a record high.   That confidence has seen its way into pending home sales, which grew 4.6% month-over-month in January.

But while consumer sentiment and job openings are supportive, the U.S. – China trade dispute continues to be a drag on forward-looking measures of growth. The ISM manufacturing index fell 2.4 points to 54.2 in February while a measure of new orders was down 3.2 points to 52.3.  Another component of the ISM survey measuring expected hiring fell 3.2 points to 52.3. Small Business Confidence fell to a two-year low as a measure of business uncertainty hit its fifth-highest reading in 45 years. That led many small businesses to become more cautious about investment and hiring plans.  A survey of expected first quarter U.S. GDP growth fell to 1.8% over concerns about softness in business development.

Outside of the U.S., the EU Commission cut its forecast for 2019 growth to 1.3% from 1.9%, noting that the impact of the slowdown in China and uncertainty about U.S.-China trade negotiations are weighing on business sentiment.  The result has been falling Eurozone lending to non-financial businesses.  An index that reflects the mood of EU households and businesses dropped for the eighth consecutive month.

Concerns about economic growth are seeing their way into analyst estimates of 2019 S&P 500 corporate earnings.  Over the first two months of 2019, analysts’ estimates of first-quarter earnings have fallen 6.5% from $40.21 to $37.60.  If first-quarter earnings  reach $37.60, they will be 3.2% lower than first-quarter earnings in 2018, despite estimated revenue growth of 5.2%.    The decline reflects falling profit margins as companies face higher labor and other input costs, some of them driven higher by tariffs.  Looking further out, analysts estimate than earnings for all of 2019 will be 4.1% higher in 2019 on 5.1% revenue growth.

Given expected growth and current interest rates and inflation, Caprock believes the S&P 500 is fairly valued.  Caprock also continues to believe the U.S. and Chinese policy makers will reach an agreement that reduces the risk of a global slowdown. We acknowledge that  a successful resolution to policy risks combined with renewed economic momentum could propel equity markets higher from current levels.  A failure of U.S. and Chinese policy makers to achieve an agreement  would likely raise business uncertainty and reduce investment spending, hurting growth and corporate earnings.

Regardless of the outcome, the upside opportunity relative to the downside risk is becoming increasingly less attractive and markets are becoming more volatile.   Historically in this kind of environment, regularly rebalancing to target weights has proved to be a capital-preserving strategy.  As a result, Caprock continues to believe rebalancing to target allocations is a smart discipline at this stage of the market cycle.