In the midst of last quarter’s climactic downfall, investors couldn’t help wondering if the curtain was finally falling on the great bull market. But here we are at the end of the first quarter and instead of a closing bow, equities are once again showing resiliency and strength. US equities, represented by the S&P 500, had their best single quarter since 2009 and their best first quarter since 1998. Global equities, whose fourth quarter decline was less dramatic than their US counterparts, happily joined the party, rallying throughout the first quarter. Fixed income markets were also quite strong as interest rates fell. Bond sectors linked to equities – such as high-yield – did exceptionally well.
While the magnitude of the rally may prove a bit overzealous, the positive market direction made sense based on headline news and data early in the year. If you recall our comments in the midst of the decline, we focused on what it would take to spark a rebound and we determined it wouldn’t take much. We believed that if the Federal Reserve softened its stance on raising interest rates or the China/US trade talks showed progress, investors might suddenly feel better about the capital markets. That is exactly what happened. After what now seems a brief intermission, the bull market’s show has gone on.
Stocks Expected to Pause, Then Resume Upward Trend in Second Half
Earlier this year, I traveled to Singapore for the semi-annual Wigmore Association meeting. One of the questions we debated was “when will the S&P 500 recapture 2940?” That was the record set in September 2018. As usual, I was the most bullish at the table, asserting that the record would be reclaimed before our next meeting in September and perhaps even in the coming weeks. A month later, the S&P was at 2903 and since then has surpassed the record high on both an intraday and closing basis.
After such a strong run that set new record highs, we expect markets to pause, digest the large gain and solidify their footing. After all, delivering a 14% return for a full year is something of a feat, let alone over three months. That doesn’t necessarily mean a decline, but maybe no more significant gains until summer. Then, toward the tail end of 2019, as year-over-year earnings comparisons improve and trade tensions ease, we could see stocks resume their upward trend.
At end of 2018, analysts’ consensus called for the S&P 500 to show flat year-over-year profit growth. Though consensus forecasts now call for a 5% decline, we think profits will be closer to flat and view this as an earnings soft patch, not a case of continued deterioration throughout the year. We are still looking at S&P earnings of $160-$170 at 19x earnings, so I think there is a little, but not a lot of room for the S&P 500 to appreciate further. (See Chart A.)
US equity valuations were pretty cheap in December 2018 and now after the first quarter recovery, they are slightly above the long run historical average. However, those long run statistics have to be viewed in the context of prevailing interest rates. Given the current low rate environment, a higher P/E is justified.
Overall, we still see value in US equities and even more value in emerging market equities. The second quarter is probably a period of blocking and tackling, with no significant up or down moves, but look for better results in the second half of the year.
Though I always caution against letting politics sway investment decisions, I do think it is important to be mindful of policy actions that may affect near-term results. As I have remarked in the past, President Trump, rightly or wrongly, seems to equate stock market performance with the success of his administration. Setting political views aside, equity investors should recognize that he may take steps, either fiscally or through policy, to bolster US equity returns.
Focus on Where the Economy Is Heading, Not Where It Has Been
A recent headline in The Financial Times claimed that global economies were in a synchronized downturn, a reversal from the synchronized growth we saw last year. Like many headlines, I think this one is backward looking. Rather, global economic data is generally improving.
The US remains in a slowly developing economic cycle with historically low unemployment and little inflation. US growth and corporate earnings may be in a soft patch, but a second half pick up seems likely. We are very aware that the 3-month to 10-year segment of the US Treasury yield curve briefly inverted during the quarter, but are more interested in the fact that the 2- to 10-year segment, which we view as a recession indicator, did not. We do wish that future US growth and the market’s perception of future growth were stronger. It’s not ideal for long rates to be falling at this point in a 10-year market cycle. However, lower long-term rates don’t necessarily indicate a negative view of the US economy. With many sovereign notes paying negative yields, global capital is flowing to the US, which pushes our yield curve flatter.
Similarly, global deflationary forces are keeping wage inflation in check despite extremely low US unemployment. (See Chart B.) Lack of wage inflation and, in fact, any other significant inflation, is reinforcing the dovish tendencies of the Federal Reserve and other central banks. In this environment, our fixed income intelligence believes interest rates will stay low.
Elsewhere, Europe’s economy remains a bit shaky, but most of Latin America and China appear to have turned a corner and seem stronger coming off the bottom. Looking ahead, a US/China deal should boost confidence in global trade and get purchasing managers’ indexes (PMIs) moving in a positive direction. On the negative side, the North American trade agreement will probably not be worked out until 2020, given the political machinations of a coming presidential election.
Aside from trade, most geopolitical uncertainty revolves around Europe, which faces pressure from both sides as Italy, the perennial financial bad boy, and the UK, a solid member of the Union, both eye the exit. The UK got its Brexit delay until October, but this situation needs to resolve before tension in Europe will calm down. European equities had a good quarter, mainly because they were so cheap. Europe is a perpetual value sector, which makes sense because the continent’s long-term growth potential is lower than most of the rest of the world, including the US, Latin America, Asia and emerging markets as a whole.
Southeast Asia’s Boom Has Global Growth Implications
We had the opportunity to study Southeast Asia’s dynamic growth first hand at the Wigmore Association’s Singapore meeting. Rapid growth of capitalist consumption has changed Asia dramatically, with some negative impacts, but mostly good. Many of the people I talked to in Singapore were just one or two generations removed from incredible financial hardship. Yet, they have now created solid economic futures for themselves. Singapore has an amazing story, having served as the partner/conduit for companies in the US and other western countries seeking to do business with China. Singapore’s future is a bit less certain as many wonder whether investors and businesses will now go directly to China and where will that leave Singapore.
As we discussed last quarter, China’s government is still actively stimulating its economy, which has responded to policy action. Money supply was up 8.6% year-over-year, while aggregate government financing in March was 1.88 trillion yuan. Loans grew 13.7% year-over-year and M1, a money supply measure, increased 4.6%. There have been a few negative numbers such as weak auto sales, but China’s economic data should improve in the second half of 2019 with the government stepping on the gas pedal. On the strength of better economic news, Chinese stocks performed quite well in the rebound.
India, however, stands as Asia’s star market. The Reserve Bank of India expects structural and land reforms to drive economic growth above 7.2% this year, surpassing China. The country’s equity market was up 7% for the quarter. Though India faces challenges, particularly mounting political tensions between its Hindu and Muslim populations, resilient consumption, improved export data and ongoing reforms are expected to support continued economic growth.
You can always count on me to be optimistic and I am unreservedly optimistic that capitalism, which has improved people’s lives throughout Southeast Asia, will continue to advance societies from very low economic standards to modern standards, with significant global growth implications.
US Plays Stronger Hand in Trade Negotiations
Anticipation of a US/China trade deal positively affected capital markets this quarter, but we still await an actual deal. What has become clear to me is that trade tensions and threat of a trade war are more punitive for other countries than ours. In our last quarterly letter, we noted that both the Trump administration and China needed a deal. Fast forward a few months and US negotiators find themselves in a position of strength as trade-dependent foreign countries feel pinched. Consequently, US negotiators feel empowered to seek not just any deal, but a good deal. That will take longer and may extend negotiations into the summer. There is a risk that a lengthy push for an ideal pact could negatively affect global and US growth, but I don’t see that happening. I think US negotiators will aim for the best deal they can get by summer rather than extend trade tensions into the next election cycle and potentially hurt re-election chances.
Fed Has Soft Landing in Its Sights
The Fed is trying to stick a soft landing just as it did in 1995. We think there is a real possibility the Fed can achieve this delicate balance that staves off both high inflation and recession. The lack of current inflation is a major factor in the central bank’s favor, allowing the Fed to maintain the current low interest rate, easing money policy longer with less retribution.
The Fed’s mandate and its independence have recently become topics for debate as some see the Fed being pressured to enact pro-market policies for political purposes. While continued Fed independence is in the economy’s best interest, this is certainly not the first administration to accuse the Fed of stepping too hard on the brakes. However, in this case, the Fed has barely tapped its toe on the brake pedal and has ended rate hikes at a much lower level than it would have in the past.
Based on its own conclusions, the Fed probably won’t raise interest rates for the rest of 2019, believing the economy can’t handle it. However, the Fed probably won’t cut rates either because that might rattle confidence. As for potential undue influence, we are closely watching any pressure put on the Fed because though it may be harmless long term, it could have a short-term impact.
Still Bullish After 10 Years of Equity Gains
The first quarter of 2019 marked 10 years of the bull market run. We are very pleased that Pitcairn’s client families participated in the gains of the past 10 years and that they did so in a disciplined, diversified manner. Now it is essential that we put the past 10 years into context as we apply capital market assumptions to our forward-looking planning.
Equity returns are unlikely to be as robust over the next 10 years as they have been in the past 10. There may be a significant downdraft at some point. However, this is still a very slowly evolving cycle and because of the factors that have led to this low growth recovery and non-inflationary climate, we cannot assume the bull market has to end just because it’s been 10 years. My intuition tells me this bull has room to go further, maybe even two or three years longer.
At the same time, my head reminds me to always manage risk. Whatever happens in the capital markets, I believe that investors with disciplined, diversified portfolios will get to the end of the next decade having gone a long way toward meeting their goals.
In conclusion, we are generally bullish. We believe that the market and the economic conditions that brought us these good returns for the last 10 years will work a bit longer. But we will listen to our heads and we will look for the right inflection points in the market’s evolution to modestly reduce risk so our clients are as well-positioned for the future as they were for the last 10 years.