“Confidence is a very fragile thing.”
Global markets continue to prove resilient as they strike a fragile balance between mixed economic data and late-year economic optimism. Consumer confidence remains upbeat with record low unemployment while business confidence and capex remain subdued due to elevated trade and geopolitical uncertainties. This fragile balance of confidence can change quickly. We remain cautiously optimistic, but as we approach midyear, anticipated improvement in global growth could be shifting forward to 2020 and is increasingly dependent on a resolution to the trade impasse.
Markets anxiously await the release of a second estimate of Q1 GDP on May 30. A surge in inventory investment and an unexpected trade surplus revealed a surprisingly high first estimate of 3.2% Q1 growth. The chart below shows the contributions to Q1 GDP growth (orange) in contrast to Q4 2018 (red) made by each key GDP component.
Personal consumption was cut in half while business investment, net exports and government consumption all had unexpectedly large contributions. This noisy GDP number will be revised twice more by the U.S. Bureau of Economic Analysis on May 30 and June 27. Markets gained confidence and support from the headline 3.2% estimate but subsequent quarters will come under closer scrutiny.
Trade: We defer to our recent Market Spotlight article released on May 10 when the new tariffs went into effect. The article is available here with high level updates below.
Update: Today we find ourselves at a trade impasse with frequent twists and tweets impacting the daily dialogue. Here are some of the recent developments through May 20:
- A trade deal remains 80% done, but the devil is in the details to get it across the finish line.
- Direct involvement with Presidents Trump and Xi will be required to complete a deal and neither wants to blink.
- Trump has delayed auto tariff discussions with Europe for six months.
- National security issues regarding the South China Sea, Iran and N. Korea are necessary complications in the negotiating process.
- Business decision-makers have hit the pause button restraining capex investment creating a larger drag on growth than the tariffs themselves.
- Calls for a Fed rate cut to counteract the negative tariff impact are misplaced as they may provide short-term confidence without generating lasting economic stimulus.
The Fed: The May Fed meeting offered no surprises. Recent speeches by Fed governors have shown unified support for a continued pause in the rate-hike cycle in effect since the December meeting. This supports our thoughts for the balance of the year where we expect no change to the Fed Funds rate. Bond markets, according the CME FedWatch Tool, continue to anticipate a 51% chance of a cut in October but we think that is unlikely.
The chart below tells the real story behind rate-cut cycles for each recession going back to 1957. The orange bars reflect the peak-to-trough Fed funds rate cuts when encountering past recessions. Note the smallest peak-to-trough cut, 3.37% was in 1957-1958. The red bar indicates today’s current Fed Funds effective rate at 2.45%. In other words, today’s Fed Funds rate is significantly below the amount of historic rate cuts going back over 60 years. This signifies that despite the rate hikes we’ve had since 2015, the Fed Funds rate remains at a level that would be challenged to move the economic needle at any future slowdown.
There has never been a cycle of Fed rate cuts that began with a starting point as low as today’s interest rates. In fact, history reveals only four Fed rate cut cycles since 1957 (1957, 1960, 2000 and 2007) when the Fed Funds rate was trimmed below today’s 2.45%. The chart below illustrates that only the 1960-1961 period generated meaningful subsequent economic growth.
Takeaway: Recent calls for the Fed to cut rates to combat trade wars are without merit. With their inflation target of “around 2%” in-tact, the Fed is increasingly aware that the risk of deflation in the event of a slowdown is equal to the risk of an inflation overshoot in the event of rapid economic growth. Cutting rates with today’s 2.45% as a starting point, may boost confidence but will do more to inflate financial asset prices (causing bubbles) having little impact on economic growth or inflation. Shifting trends of manufacturing inputs and supply chain disruptions due to trade could impact inflation more than the Fed so their patient pause is prudent at this time.
Sell in May?
Though it’s catchy, and sometimes even works, investing around calendar anomalies like “Sell in May” does not constitute an investment strategy. The chart below encompasses 90 years of market history and reflects the average three and six month-end returns for the S&P 500 at each month-end. The best and worst three and six month time periods are highlighted in yellow with October being the weakest month-end for both. While this makes for interesting conversation, we must take each time frame in context with prevailing data, trends and sentiment.
Earnings at a Crossroad: Corporate earnings have flat-lined after peaking during Q4 2018 with help from the remnant tailwinds of tax reform. Earnings downgrades heading into 2019 have stabilized with overblown calls for an earnings recession unlikely. An overcautious earnings outlook heading into 2019 pegged S&P 500 earnings growth at -5% but with more firms than usual beating estimates, actual results should come in slightly positive after all companies report. Flat earnings coupled with a substantial rally have once again valued U.S. stocks at a PE of 16.5 up from December’s oversold 13.8. What happens next depends on forward earnings.
The chart below reflects a continued trend of flat earnings expectations (in red) through Q3 with a Q4 rebound and 2020 strength. For this to occur, global economic growth needs to gain traction. If it doesn’t or is delayed, than there is a risk to Q4 downgrades and increased volatility. Once again, we will closely watch the fragile balance between economic stability and earnings growth and provide updates.
An outright earnings recession is unlikely for three reasons:
- Recession risks remain low: Earnings are most sensitive to GDP growth. After an admittedly noisy 3.2% Q1 GDP estimate, stocks have enjoyed support. An unresolved trade dispute remains the largest known risk that could accelerate recession risks in a worst-case (but unlikely) scenario.
- Macro-Economic conditions remain supportive: Though indicators have weakened versus mid-2018, mixed data continue to suggest modest growth ahead with no signs of systemic financial risk. Again, fragile is the operative word.
- Even Sector Breadth: Unlike 2008 when financials led the market decline and 2016 when energy led the decline, there is no dominant sector that appears at risk of bringing down broad-based index earnings.
Takeaway: Stock markets are a discounting mechanism often advancing ahead of expected earnings growth (2017) and declining ahead of expected earnings contraction (2018). The Fed’s patient stance needs help from growth abroad in China along with the removal of headwinds such as trade and Brexit to put global growth and therefore earnings on more solid footing.
Index performance for a variety of stock (in red), bond (in orange) and hard asset (gray) classes is shown below.
Equities: Global stock markets are off to a fast start in 2019 despite the ongoing tariff tantrum. There have been 15 occasions since 1950 when, like this year, the S&P 500 earned positive returns in each of the first four months of the year. The average return for the rest of the year (May-December) on those 15 occasions has been 10% with an average drawdown of -8.1%. Like the “Sell in May” theme, this does not a strategy make but instead reflects broad-based market strength with an expectation for improving global growth.
U.S. markets once again lead the way, but international markets have also provided attractive YTD returns with currency volatility having little impact on returns. Concerns about slowing growth have led investors to favor growth stocks over value. A sustainable acceleration in GDP growth could reverse this pattern returning more cyclical value sectors to favor. REITs have been a highlight in 2019 benefitting from lower interest rates and a modest flight to safety for equity investors seeking income.
As the chart above shows, Oil has been a standout performer in 2019 as oil prices have rebounded from the 2018 lows.
Bonds: Bond markets have provided both portfolio ballast and respectable YTD total returns across all bond segments. Outperformers include the higher credit-risk areas of corporate and municipal high yield and emerging market bonds. In addition to the incremental returns gained in credit sensitive areas, interest rates declined in response to dovish global central banks and concerns about slowing global growth.
For a brief period in late March and again last week, the U.S. experienced its first inverted yield curve between 3-month and 10-year Treasury obligations since 2007. This has since corrected, but we remain in a flat yield curve environment that, like in 1998, is likely to persist for the foreseeable future absent any unexpected economic shocks.
It is unlikely to expect these types of returns going forward so keeping your coupon is the most likely path for the balance of the year.
- The Fed should remain on pause for the balance of 2019 with no rate hikes or cuts.
- U.S. recession risks remain benign with elevated concerns in Europe. Failed trade negotiations would be a game changer.
- The consumer is confident, but the CEO is not, according to surveys. Confidence drives pro-growth behavior that can accelerate economic growth due to business capex and investment.
- Chinese fiscal stimulus is slowly helping growth and can likely counterbalance any near-term tariff induced weakness. More proof is required however.
- Brexit hampers an already weak European economy with daily shifts in the dialogue.
- Global equities have resynchronized with future growth being earnings dependent and U.S. led.
- Q1 bond returns are likely to be the high water mark for the year trading sideways for the balance of 2019.
Thank you and please see your BB&T Wealth advisor or portfolio manager with additional questions.
Jeff Terrell, CFA Chief Wealth Market Strategist
BB&T Wealth Portfolio Management Team
Sources: Strategas Research Partners, Evercore ISI, FactSet, Goldman Sachs Global Investment Research, Morningstar, BCA Research, Standard & Poors
The Morningstar indexes are unmanaged, weighted indexes of stocks and bonds providing a broad indicator of price movements. Individual investors cannot directly purchase an index.
The information set forth herein was obtained from sources, which we believe reliable, but we do not guarantee its accuracy. Neither the information nor any opinion expressed constitutes a solicitation by us of the purchase or sale of any securities. Diversifying investments does not ensure against market loss and asset allocation cannot eliminate the risk of fluctuating prices and uncertain returns. Past performance does not guarantee future results.