- The 3-month to 10-year U.S. treasury yield curve inverts in March as the 10-year yield falls from 2.75% to 2.38% in less than a month.
- S&P 500 experiences its best quarter since 2009, and is off to its best 1st quarter start since 1998
- A “Golden Cross” occurred for the S&P 500, a bullish technical indicator where the 50-day average passes the 200-day average to the upside.
- Setting the bar lower…Analysts estimate a decline in earnings of -4.2% for Q1 2019.
- Recession probabilities have increased, but a recession in 2019 does not appear likely.
What Piqued Our Interest
In 2018, we experienced a red-hot economy, the highest GDP growth in years, double-digit increases in corporate profitability, and the market ended the year in the red. So far in 2019, concerns are mounting as global growth is slowing, corporate earnings are declining, and the market is red-hot. Once again, we are witnessing a significant divergence between the state of the economy and that of the markets, which has many investors on edge and concerned of what lies ahead. Overall, flows into equity ETFs were negative for the first two months this year, and even after a strong March are still only a third of the flows into bond ETFs year-to-date.
The Fed held its second meeting of 2019 from March 19-20, and not only left rates unchanged but also indicated there is little probability of future rate hikes this year. Citing slowing economic growth and a decline in inflation measures, the Fed is now preaching patience around upcoming rate adjustments. While the market initially stalled following the Fed’s downbeat assessment, since March 25 equities have continued their upward climb and are now within arm’s reach of their all-time highs from last Fall. The Fed’s dovish pivot is remarkable considering Chief Powell’s comments just a few months ago when he stated “we’re a long way from the neutral rate”. The Fed also stated they plan to wind down their balance sheet reductions by the Fall, much earlier than originally predicted, which along with steady rates will provide a more accommodative monetary environment.
In case you missed it, the much hyped and anticipated inversion of the yield curve occurred late in March when the yield on 10-year treasuries dipped below the yield on 3-month bills. This occurred after a significant bond rally drove the 10-year yield from 2.75% on March 1st down to 2.38% on March 27th. Note, the more publicized 10-year vs. 2-year spread which we discussed last month is still slightly positive at 0.18% and was as low as 0.13% last month. Regardless of which spread one observes, the implications are generally comparable, as each recession going back to WWII has been preceded by an inversion by one of these measures. As before, we suggest not reading too much into this indicator in the short run, as the timeframe between inversion and the next recession has historically averaged 14 months. Nevertheless, this warning sign from the bond market is in stark contrast to what’s happening in stock-land, and therefore must not be overlooked.
The S&P 500 climbed another 1.9% in March, totaling 13.47% for the first Quarter which marks the biggest quarterly gain since 2009 and its best start to the year since 1998. Momentum has continued to drive stocks higher, as technical indicators suggest that the market could drive higher in the short run. One example, a “golden cross” occurred recently in which the 50-day moving average of the S&P 500 crossed the 200-day moving average to the upside, which is supportive for an upward trending market. Also, the Advance/Decline line which measures the aggregate difference between gaining stocks and declining stocks, has also steadily increased this year which helps verify the breadth of this market rally. Volatility, as measured by the CBOE VIX index, has dropped by almost 60% from the start of the year, and now sits around 14.4 near the lower end of its long-term range. Unlike large caps, small-cap stocks fell by 2.15% in March, although the group had been up over 16.5% though February so some mean reversion was to be expected. From a factor perspective, “Quality” stocks have led the way in 2019 according to MSCI data, followed by Small Size stocks, Momentum, and then Low Volatility. In addition, Cyclical sectors have continued to outperform Defensive sectors, although Defensive posted a 10% gain in the 1st quarter which is not too shabby for a more-conservative investment. International stocks are lagging the U.S. once again, as the All-Country ex USA index is up 10.3% year to date.
Turning our focus to fixed income, we witnessed a historically large drop in yields as bonds were bid higher in March. Lower inflation readings along with European yields dropping into negative territory seemed to propel investor’s appetite for treasuries, which helped drive the U.S. Aggregate Bond index higher by 1.92%, or 2.94% YTD. Across investment grade fixed income sectors, credit outperformed rates (treasuries), and taxable bonds performed better than municipals. High yield corporates lagged the overall bond market, as the spread between high yield bonds and treasuries widened by about 0.4% in March, although the spread has since reverted back to its original level. And lastly, given the drop in yields, longer maturity bonds significantly outperformed shorter maturity in March, although yields have rebounded in the early days of April.
By this summer, the economic expansion in the U.S. is set to become the longest in our country’s history. But given the fears over the inverted yield curve, rising wage growth, weaker manufacturing data, and slowing growth overseas, the question looms whether the countdown to the next downturn has already begun. According to research by Goldman Sachs, the firm currently estimates the probability of recession within 1 year to be 18%, which climbs to 34% in 2 years and 48% within 3 years. We may learn a lot in the coming days as the first quarter corporate earning’s season gets into full swing. According to FactSet research, companies in the S&P 500 are expected to report a 4.2% decline in the first quarter, which would mark the first year-over-year decline since 2016. Analysts are also expecting flat growth in the second quarter, growing to the low single digits by the third quarter. Negative estimate revisions have also been higher than average, which sets the bar lower for companies to surpass when they report later this month.
In our opinion, nothing is screaming for an immediate recession…yet…but we remain concerned about the viability of this expansion as we head our way into 2020. More importantly, we know that the stock market is the ultimate leading indicator of the broader economy and should recession fears escalate again as they did last Fall, the next major correction could be lurking around the corner. While we’ve enjoyed a strong start to 2019, we believe that now is not the time to be complacent. Wide ranging macro concerns such as what happens next with Brexit and what the final U.S.-China trade deal look like, continue to loom over the global economy. We also consider what the impacts of a broader recession in the Euro-area might be, particularly if the trade war extends beyond China. From a valuation perspective, equities are not necessarily overpriced, but they’re not cheap either. The trailing 12-month Price to Earnings ratio for the S&P 500 is currently around 18.7, roughly 1% higher than its 20-year average. We believe that equities could grind their way to new all-time highs in the coming weeks but are even more convinced that volatility will soon return, and another correction is looming later this year. In the meantime, we continue to participate in this market utilizing our prudent blend of high-quality and risk mitigation funds. The bond market may have just flashed a red warning sign, but equity indicators are still flashing green, for now.
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