Although 2018 ended dismally amidst tumbling financial markets, 2019 kicked off with optimism. Risk assets surged during the first quarter. Global stocks, led by the U.S., soared 12%1. Corporate debt including high-yield produced mid to high single digit returns. The transition by investors from extreme risk aversion to “risk on,” inspired by a shift in Federal Reserve policy, was almost instantaneous.
The Fed Reserve (the “Fed”) hiked the Federal Funds rate by 0.25% every quarter in 2018. After initially projecting 3 or 4 additional increases in 2019, the Fed began to walk back its projections in December 2018. At the Fed’s more recent March meeting, the Fed indicated that no further rate hikes were likely this year and that it would curtail reducing its balance sheet (quantitative tightening) ahead of schedule. Fed speak became progressively more dovish and shifted away from interest rate normalization, leaving little doubt that policy would follow suit in response to market turmoil. As Chairman Powell stated at his March 20th press conference, “The U.S. economy is in a good place and we will continue to use our monetary policy tools to keep it there.”2
The strength of the rally indicates that investors have faith that the central bank’s new tack will keep the economy on track for at least another year or so. This is despite the fact that U.S. GDP growth likely slowed during the past quarter to approximately 1.7% from 2.2% in Q4 20183. While the Fed has merely decided to stand pat, rising prices for financial assets and lower market volatility have contributed to easier financial conditions that are, in and of themselves, supportive of future growth. For example, the interest premium that issuers of high-yield bonds pay over Treasury notes fell 135 basis points (bp) during the 1st quarter 2019 to 3.91% from 5.26%1.
Not only were stocks and corporate bonds rallying during the 1st quarter 2019, Treasuries also performed well. The yield on the 10-year Treasury note declined 27 bp to 2.41% while the 2-year yield fell 21 bp to 2.27%, resulting in a narrowing spread of only 14 bp between the two securities4. Historically, a spread of over a full percentage point has been more typical. Markets are sending a mixed message in that investors usually bid up Treasuries to find a safe-haven in times of financial stress. Strength in Treasuries, and a flat, or inverted yield curve, can signal an economic slowdown or worse. Hopefully, this time is different.
Based on our assessment of fundamental economic data, we continue to believe that the U.S. will enjoy another year of healthy, if moderating, GDP growth in 2019 that should approach 2.5%4. The consumer is well positioned to propel the economy. The labor market remains robust. The weak February jobs report was not corroborated by other data and the subsequent March report rebounded to trend. Wage growth has been solid but not strong enough to cause concern from an inflation standpoint. Gains in real disposable income should continue, and the savings rate of 7% is high by U.S. standards3.
Consumers, therefore, have the wherewithal to spend and a healthy increase in consumption is likely. Household debt service ratios are hovering near record lows. With mortgage rates having retreated nearly 0.50% since the start of the year, not only is an increase in refinancing likely but, more importantly, a sluggish housing market should be reinvigorated as affordability improves. Residential investment detracted from GDP in all four quarters of 2018 and we expect a marked improvement this year.
Capital spending was relatively healthy over the course of last year and a continuation of the trend is likely, aided by the rise in energy prices. However, the uncertainty over trade remains an obstacle. Relatively strong growth in the U.S. versus the rest of the world may lead to a further deterioration in our trade balance. Of greater concern for the outlook in 2020 is that growth in government spending may soon “peter out.”
We hold a relatively simplistic view that there are two main drivers of equity market performance: earnings growth and interest rates. After a stellar 2018 when corporate earnings grew in excess of 20%, earnings are only expected to rise in the mid-single digits this year4. Interest rates and bond yields have declined sharply since peaking in November 2018, helping fuel the stock market rally. While short rates appear steady, our sense is that the yield on the 10-year Treasury note has possibly overshot on the downside and will settle into a range of 2.5% to 3.0%4.
Stocks have discounted a lot of potential good news rather quickly. In the span of the first three months of the year, the price/earnings ratio of the S&P 500 Index, based on 2019 forecast earnings, has increased from 15.3x to 17.3x. We believe that the S&P 500 Index is fairly valued in a range of 14x to 18x forward earnings and we can no longer argue that stocks appear cheap while sitting near the top of our valuation range. A sluggish global economy could pose downside risk to our 2019 S&P 500 Index earnings forecast. Geopolitical risks also remain in abundance and we are reluctant to be swept up in the current stock market enthusiasm, becoming overly aggressive.
Given our favorable outlook for the U.S. economy and a benign Federal Reserve, we maintain a positive bias towards the U.S. stock market and anticipate a tame bond market. However, with stocks having climbed so sharply in the past quarter, gains are likely to be more muted for the balance of the year. We would, in fact, encourage investors to double check their asset allocation and pare back equities into the current strength to their target, if necessary.
Sources: (1) Factset; (2) Federal Reserve Board; (3) US Bureau of Labor Statistics; (4) Washington Trust Wealth Management. The views expressed here are those of Washington Trust Wealth Management and are subject to change based on market and other conditions. Investment recommendations and opinions expressed in these reports may change without prior notice. All material has been obtained from sources believed to be reliable but its accuracy is not guaranteed. Investing entails risk, including the possible loss of principal. Stock markets and investments in individual stocks are volatile and can decline significantly in response to issuer, market, economic, political, regulatory, geopolitical, and other conditions. Investments in foreign markets through issuers or currencies can involve greater risk and volatility than U.S. investments because of adverse market, economic, political, regulatory, geopolitical, or other conditions. Emerging markets can have less market structure, depth, and regulatory oversight and greater political, social, and economic instability than developed markets. Fixed Income investments, including floating rate bonds, involve risks such as interest rate risk, credit risk and market risk, including the possible loss of principal. Interest rate risk is the risk that interest rates will rise, causing bond prices to fall. Past performance does not guarantee future results. The S&P 500 Index is an unmanaged index and is widely regarded as the standard for measuring large-cap U.S. stock-market performance. In addition, the S&P 500 Index cannot be invested in directly and does not reflect any fees, expenses or sales charges. Further, such index includes 400 industrial firms, 40 financial stocks, 40 utilities and 20 transportation stocks. The information we provide does not constitute investment or tax advice and it should not be relied on as such. It should not be considered a solicitation to buy or an offer to sell any security. It does not take into account any investor’s particular investment objectives, strategies, tax status or investment horizon. Please consult with a financial counselor, attorney or tax professional regarding your specific investment, legal or tax situation.