Quarterly Market Review and Outlook
Q1 2019 Economic / Market Re-cap
After the excitement and fear in the 4th Quarter, the financial markets rebounded substantially in the 1st Quarter of 2019. The S&P 500 was up over 13% in the 1st Quarter.i Foreign stock markets recovered as well and were up over 10% in the 1st Quarter.ii What was good for stocks was also good for bonds—the U.S. bond market experienced gains of about 3%.iii
In short, most that was lost during the 4th Quarter of 2018 was recovered during the 1st Quarter of 2019. This is a good lesson and reminder than even when the media is screaming that the global economy is headed toward an iceberg like the Titanic, it is prudent to focus on facts and not emotions to guide your investment decisions. As it turns out, there was no iceberg. Investors that decided to not jump ship were rewarded by the ship steaming away under full power.
Q2 2019 & Beyond Outlook
Interest Rate & Federal Reserve Update
One reason for the quick and powerful turn was a change in investor perspective on comments by the Federal Reserve. The Fed seemed to clearly say they plan to be data focused and patient in raising interest rates further in 2019iv, implying that rates may not go up again this year. This sentiment seems to have provided investors with confidence and faith that the Federal Reserve is not necessarily going to continue with interest rate hikes every quarter as they did in 2018.
Why are interest rates a big deal?
We have mentioned previously an interest rate phenomenon called an inverted yield curve. It short, during normal interest rate conditions, longer term maturities (i.e., 10 year, 20 year, 30 year bonds) pay a higher interest rate than shorter term maturities (i.e., 1 month, 1 year, 5 year, etc. bonds). This signals that the economy is anticipated to remain healthy and growth is likely. Conditions during an inverted interest rate curve are the exact opposite—shorter term maturities pay a higher interest rate than longer term maturities. Typically, this signals the possibility of economic recession.
The issue today is that the interest rate yield curve is as close to inversion as it has been since 2006-2007 timeframe. In fact, the yield curve did momentarily invert after Jerome Powell, Federal Reserve Chairman, spoke in late March.v This should not be cause for immediate panic, but it is certainly worth paying close attention.
There is a historically solid correlation between inverted yield curves, eventual recessions and stock market crashes. All seven previous recessions have been preceded by an inverted yield curve.vi Beyond the correlation between yield curves and recessions is the correlation between recessions and stock market crashes. We have previously written about and discussed that historically, stock market crashes (i.e., the stock market falling by at least 20%) typically are directly connected to recessions. In fact, 8 out of the previous 10 stock market crashes have been connected to recessions.vii
Said plainly, an inverted yield curve can precede an eventual recession, which can be associated with a stock market crash.
It would be prudent to provide one final piece of context (and good news). Historically, there has been a substantial lag time from the point of inversion to recession. In fact, the average length of time from inversion to recession over the last seven recessions is roughly 12 months.viii In addition, market performance leading up to a recession can be strong. Preceding the previous three inversion/recessions (1990, 2000 & 2008), markets all experienced gains after inversion ranging between approximately 5% and 23%.ix
For this indicator to have credibility, we think we would need an inverted yield curve to last several months—we will closely monitor this.
Global Economic Environment
The U.S. economy experienced its strongest year of growth in over a decade in 2018. It is absolutely possible that 1st Quarter data may not look great. However, we’d caution putting too much weight on 1st Quarter GDP data as you may remember our friends in Washington decided not to work some portion of the time because of the government shutdown! The importance of that is that different departments in Washington did not have the typical capabilities in tracking and reporting data with so many employees furloughed. In other words, the data may be fine, but the tracking of the data may be lacking.
In addition, most economists that we follow, and even the Federal Reserve, anticipate the US economy continuing to expand in 2019 with an average prediction of 2.4% GDP growth.xxixiixiii Historically, the stock market does not experience a crash during economic expansion. Even if economic growth slows in 2019 relative to 2018, growth is still growth.
Beyond our shores, the picture does become a little muddier.
The most immediate issue in Europe is the impending exit of the United Kingdom from the European Union, commonly known as Brexit. This process started almost three years ago when the United Kingdom voted to leave. Currently, the European Union has given the U.K. a deadline of April 12th. However, there are scenarios that could extend the deadline further.xiv Ultimately, the issue is whether the U.K. can reach a deal with the European Union on continuing a workable trade relationship after the U.K. leaves. The potential exists for the situation to spiral out of control and plunge an already sluggish European economy into recession.
The other significant international economic event is the ongoing trade/tariff negotiations between the U.S. and China. It appears that progress continues to be made between China and the U.S. as evidence by both sides rolling back or delaying additional tariffs.xv Assuming that a trade deal is ultimately reached, we would anticipate further economic and market gains. In addition, the U.S. continues to become more energy independent, which we would expect to strengthen the U.S. position in trade deals. In general, a dampening of the trade noise would be good for financial markets.
Global Stock Market Conditions
As the stock market does not typically crash or enter a Bear Market without the presence of a recession, we do not have immediate concerns of a stock market crash. We don’t see any stock market bubbles ready to burst either. Rather, we would continue to suggest that growth potential remains.
First, U.S. stocks have not completely returned to their peaks of September 2018. We would suggest that, while markets are no longer as cheap as in late 2018, they are fairly valued, not over valued.
Second, as interest rates have actually declined over the last month or so, alternatives to U.S. stocks have become a little more expensive. If investors are not going to invest in U.S. stocks, there are only left with a few other options. If those alternatives become more expensive, then U.S. stocks can appear to be attractive on a relative basis. Specifically, we would suggest that the U.S. is the “sweet spot” in the world today.
Third, Congress is unlikely to roll back regulatory changes or tax cuts implemented by the Trump administration and the Republican controlled Congress from 2017-2019. The political climate in Washington is toxic, but the financial markets like gridlock. We feel certain in saying that Republicans and Democrats will agree on nothing substantial for the foreseeable future. Even if the political fireworks of shutdowns and debt ceilings return, their impact upon financial markets tends to be relatively short-lived.
We are not saying that we believe the U.S. stock market will replicate its first quarter performance throughout the year. We would expect volatility to reemerge at some point this year. However, if the economic environment in the U.S. continues to remain on solid footing, we would view volatility as an opportunity to strategically add to risk positions.
After the volatility and fear mongering in the 4th Quarter, the stock market in the 1st Quarter has rebounded significantly. The Federal Reserve shifting to a more dovish path has helped ease investor concerns over rising interest rates that can restrict economic growth. Also, interest rates have risen enough to provide the Federal Reserve some “ammo” should the U.S. economic begin to show evidence of stalling. While members of the Federal Reserve are unlikely to publically admit this, we believe that a reason for hiking interest rates over the last couple of years was to replenish their ammo.
It is likely that various media outlets will continue to spew pessimistic messages about the U.S. economy being on the brink of recession. We’d like to remind our clients and friends that while the actual data may support the idea of a slowdown, there is little evidence of a recession over the next 6-12 months and growth of 2.4% is not recessionary. Be mindful of what you consume from the media—often their interests do not align with your interests.
Securities offered through First Heartland Capital ®, Inc., member FINRA/SIPC. Advisory Services offered through First Heartland ® Consultants, Inc. Walker, Higgins & Associates, LLC and Walker, Higgins & Associates Wealth Management, LLC are independent of First Heartland Capital ®, Inc. and First Heartland ® Consultants, Inc.