March 2019 Market Commentary

U.S. and global equities markets rallied sharply during the first quarter, and in the case of the S&P 500 index produced its best one quarter returns in over a decade.  Equity prices were driven higher by investor optimism that monetary policy will remain accommodative, that trade tensions between the U.S. and  China are waning and  signs that Chinese stimulus may lead to improving growth.  Bonds also produced positive returns as sovereign bond yields fell and corporate credit spreads tightened over the quarter.

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

Index March YTD Index  March YTD
S&P 500 (Total Return) +1.94%  +13.65% MSCI All Country World (Net) +1.26% +12.18%
MSCI EAFE (Net) +0.63% +9.98% Bloomberg Barclays U.S. Agg +1.92% +2.94%
MSCI Emerging Markets (Net) +0.84% +9.92% 60/40 Blend* +1.52% +8.48%

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

While equity investors have every reason to celebrate strong returns during the first quarter, their optimism appears at odds with that of bond investors. Since peaking in November, sovereign bond yields have been driven lower over expectations of slowing global growth.  After reaching 3.2% in November, the yield on the 10-year U.S. Treasury bond fell to 2.7% to end 2018 and has since fallen to less than 2.5%.

Yields fell despite two policy announcements by the Fed supportive of growth that helped  push the S&P 500 index over 13% higher since the start of the year and over 20% higher since its Christmas lows.  The first Fed announcement followed their December 2018 rate hike and stated that its decisions would be data-dependent going forward.  That decision was a relief to equity investors who were concerned by the Fed’s earlier guidance of multiple rate hikes in 2019 and 2020.  In March, the Fed announced that growth was slower than expected and as a result it was unlikely to raise the federal funds rate twice in 2019 as previously expected.

As part of their announcement, the Fed lowered its view of expected U.S. GDP growth in 2019 to 2.1%, down from its estimates of 2.3% in December and 2.5% in September.  U.S. GDP growth for the first quarter  is forecast to grow by 1.5%.  This follows  U.S. GDP growth of 4.2% (annualized) in the second quarter of 2018 and 2.9% for the entire year.   The slowdown can be seen in a variety of economic indicators.   The Index of Leading Economic Indicators is 3.5% higher than a year earlier, supportive of growth in the year ahead, but since December the index has effectively stalled, producing monthly changes of -0.1, +0 and +0.1, suggesting slowing economic momentum in the year ahead.  Another leading measure of future output, the ISM Manufacturing New Orders index fell to 55.5 in March from 58.2 a month earlier.  And while investors are becoming more optimistic that a deal will be reached between the U.S and China over trade policy, the trade dispute has taken its toll on actual business decisions. Small Business Confidence fell to a two-year low as a measure of business uncertainty rose over concerns about trade policy, leading  many small businesses to become more cautious about investment and hiring plans.  In addition, global exports contracted in 2018, detrimental to U.S. exports of manufactured goods.

While equity prices have rallied over the past three months, estimates of 2019 corporate earnings have been revised downward.  First quarter S&P 500 earnings estimates have been revised down by over 7% over the quarter and are now expected to fall by 3.9% from a year earlier.  Earnings for all of 2019 are currently forecast to grow by 3.7%, down from an estimate of 7.4% made on December 31.   The revision downward reflects  analyst concerns over slowing revenue growth and declining profit margins due to rising input prices from wage increases and tariffs.  The impact on earnings from slowing trade and increased tariffs can be seen in the fact that S&P 500 companies  that generate more than half of their revenue in the U.S. expect to see earnings grow by 1% in the first quarter, while companies that generate more than half of the revenue outside the U.S. expect earnings to fall by over 11%.   Finally, with equity prices rallying and forecast earnings falling, P/E multiples for U.S. equities have climbed from 14.2X to end 2018 to 16.4X today, the latter in line with the  long-term historical average.

In pushing equity prices higher, equity investors are overlooking weakening earnings growth and instead believing that the Fed’s recent moves and a potential cut in rates will accelerate growth to previous levels.   The precipitous decline of the 10-year U.S. Treasury bond yield since last November (approximately 75 bps) on the other hand not only reflects bond investors’ perception of slowing growth, but their realization that the Fed also sees economic weakness ahead. Not only have long-dated U.S. Treasury bond yields fallen, but they have fallen so much that the yield curve between the 10-year treasury and 3-month T-bill  has  inverted (3-month T-bill yield is greater than the 10-year Treasury bond yield).  Historically, an inverted yield curve has signaled a  possible recession is on the horizon 12 months or more from now.

Ultimately, how bond and equity markets see future growth will  be reconciled.  Either growth and inflation will accelerate and cause interest rates to rise, confirming the rally in equity prices; or  growth will continue to slow and equity prices will fall, confirming the fall in interest rates.  The path the market eventually takes will depend in great part on how the U.S.- China trade dispute plays out, although other factors such as  effectiveness of Chinese economic stimulus  and Brexit  will have far reaching impact over the coming year.

In the absence of a reacceleration of global and US economic growth, The Caprock group sees little upside opportunity in equities given current valuations. As a result, Caprock is preparing to recommend that clients begin modestly underweighting equities on any continued rally in equity prices. Please see our upcoming quarterly investment perspectives piece for a more robust discussion about this recommendation.