Week of March 18, 2019
Current economic events
The global economic slowdown narrative showed cracks last week, with mixed-to-strengthening data across many of the world’s major economies. Global stock markets rallied, with the S&P 500 closing the week above levels that were unsuccessfully challenged multiple times last autumn before the December plummet. Meanwhile, policy potholes continued to dot the global headline “highway.” The British parliament voted to once again reject Prime Minister Teresa May’s Brexit deal, as well as a “no-deal” exit, and to extend the timeline for an exit. Next up, the European Union must reach a unanimous vote before March 31 to agree to the extension. Though the situation seems to be at somewhat of a standstill, we feel the risk of a no-deal exit has fallen and the chances of a more orderly exit or a second referendum have increased. However, not all was rosy — one of our favorite metrics, the Organization for Economic Cooperation and Development’s (OECD’s) composite leading indicators, depicted weakness across much of the globe. The indicators showed worsening downtrends in the United States and a negative inflection in China, which previously looked to be in recovery. Data and optimism have picked up in 2019, but the indicators serve as a somber reminder that global trends are still pointing downwards.
U.S. economic data, on balance, continues to look like it has rebounded off December weakness. January hard data, including growth in headline and core orders of durable goods, construction spending, business inventories and JOLTS job openings, all picked up. Retail sales growth also bounced, though the ugly December reading was revised down even further. Additionally, consumer sentiment, as measured by the University of Michigan, moved higher in March, as did small business optimism from the National Federation of Independent Business (NFIB). However, there were some blemishes in the data. Inflation has been persistently weak, with consumer and producer inflation softening again in February. Growth in industrial production also continued to roll over, as did industrial capacity utilization. While many indicators have turned positive, we reiterate our view that the balance of data points to a continuing economic downtrend in the context of overall fair economic health.
Data in international developed countries was relatively sparse last week, though European industrial data stood out as incrementally positive. Eurozone production contracted much less than in December. There was marginal growth in industrial data in Italy and the United Kingdom while German production growth weakened. On the other hand, Japan’s core machinery orders contracted the most in a year. Japan has been an interesting economic case lately, because it seemed to be stabilizing early in the year while other developed economies declined, and now looks weaker as others have improved somewhat. In aggregate, we see foreign developed economic health as poor but not recessionary, albeit with some exceptions, including Italy and potentially Germany. Trends continue to be negative, but the level of growth appears likely to stabilize near flat, rather than decline into a recession.
Emerging market data was mixed last week after a big influx of data from China following its Lunar New Year holiday. On the positive side, fixed asset investment growth increased to its best rate since May, a possible sign of business confidence. More cautiously, loan growth and retail sales growth were both flat from the prior month and industrial output growth slowed to a nine-year low. However, the latter decline was entirely attributable to seasonality effects from the holiday and would have increased without the effects. Industrial production growth in other emerging markets was mixed, with contractions moderating in Mexico and Brazil but growth slowing in India. While some other markets have improved, China has recently weakened further, dragging emerging markets, in aggregate, down to the weakest point in two-and-a-half years as economic downtrends persist.
U.S. equities trended higher last week on technical strength, absent new meaningful or obvious fundamental drivers. On balance, restrained inflation, low interest rates and moderate earnings growth continue to provide valuation support while serving as a basis for our risk-on bias. Our year-end 2019 S&P 500 price target is 2,970, based on a multiple of 18 times estimated earnings of $165, roughly 5 percent above current levels.
Last week, the S&P 500 advanced 2.9 percent following the prior week’s worst performance in 2019, closing at 2,822 and at the high end of its near-term trading range. A technical breakout above current levels paves the way to retest the all-time intraday high of 2,940 set on September 21, 2018.
The strong performance year to date has occurred despite much skepticism, reflecting a year-to-date rally that has been largely unloved and unanticipated. Lack of excesses in valuation, inflation and sentiment, which typically accompany market tops, provide the basis for still higher equity prices. A potential upcoming market-moving catalyst is first quarter results set for mid-April. The first quarter reporting period unofficially begins on April 12 when several money center banks are slated to release results.
Fundamental and sentiment indicators appear disconnected, warranting a balanced perspective on risk and return.
- U.S. equities have trended higher since the beginning of the year even as the pace of earnings growth is being reset lower, which is a longer-term disconnect. First quarter results and forward guidance will provide increased visibility into earnings estimates for 2019.
- Year-to-date performance has been superb. The S&P 500 and all 11 sectors are in positive territory as of the March 15 close and eight of 11 sectors are up 10 percent or more. Broad-based favorable performance is typically indicative of a market that is poised to inch higher.
- A United States-China trade agreement remains a work in progress, with recent media reports suggesting that a trade agreement is unlikely to occur before June. Failure to eventually reach an agreement would presumably weigh on sentiment and equity prices.
- The Federal Reserve’s (Fed) recent dovish bias has resulted in modest multiple expansion, bolstering equity prices in early 2019. A potential more hawkish, less-dovish future stance would undoubtedly signal higher interest rates, pressuring valuation and overall price levels. According to Bloomberg, the S&P 500 closed Friday trading at 18.5 and 16.9 times trailing and forward 12-month estimates, respectively, each modestly lower than historical averages.
Fixed income markets
U.S. Treasury bond yields remained under pressure last week while investors digested relatively weak inflation data and priced in rising odds of a rate cut from the Fed this year or next. Subdued U.S. Treasury yields continue to support riskier asset prices for now, with corporate credit spreads falling and stocks rising last week.
The Fed will steal the spotlight this week when its two-day meeting concludes on Wednesday. We anticipate a relatively dovish tone and reiteration of a patient approach to monetary policy. The Fed is not expected to alter the policy rate at this time. The largest impact to markets is likely to stem from potential alterations to the “dot plot,” the compilation of Fed members’ expectations for the policy rate in coming years. Markets are pricing small odds of a rate cut this year and meaningful odds of a cut next year. If the new dots fail to converge substantially closer to market expectations, riskier assets could come under pressure. The Fed will also update economic projections and is expected to shed additional light on plans to end net balance sheet runoff, though details are unlikely to move markets.
We continue emphasizing that high quality bonds should comprise the majority of bond exposures to ensure adequate portfolio-level diversification. We prefer below-benchmark maturity profiles to mitigate the impact of a potential rise in bond yields and because of the limited compensation received for extending duration. Investment-grade corporate, high yield corporate and emerging market debt valuations remain slightly elevated by historical standards, and exposures should not be excessive. Reinsurance remains an attractive long-term exposure within fixed income, with compelling anticipated returns and strong portfolio diversification characteristics.
Publicly traded real estate investment trusts (REITs) were up last week and maintained solid outperformance so far this year relative to the S&P 500 stock index. REITs have traded well as interest rates declined to new recent lows. With property market fundamentals remaining fairly lackluster, performance may follow, since further price gains will likely require lower interest rates.
Crude oil had a big week, with West Texas Intermediate (WTI) rising 4.4 percent. For the year, WTI prices are up almost 29 percent. Prices rose as domestic inventory declined unexpectedly and U.S. production dropped from record highs. Also helping prices is evidence that the OPEC output deal is holding up as OPEC plus Russia announced additional cuts to future production. Persistent geopolitical risk, particularly in Venezuela, feeds the bullish sentiment, as well.
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