March 2019 Market Commentary
The returns achieved in Q1 2019 have many asset allocators, including myself, scratching their heads. While a rebound from the severe equity selloff (with many markets meeting the definition of a bear market) could have been expected, the speed and magnitude of stock gains over the last quarter demonstrates a belief that 1) the global slowdown will not turn into a recession, 2) that central banks will do whatever it takes to protect equity markets and 3) that interest rates will never (or at least almost never) rise again. How much longer we can balance on that knife-edge is anyone’s guess.
Last quarter I wrote that the end of bond purchases by the Fed and ECB would produce further losses as liquidity dried up. As quantitative easing turned to quantitative tightening, it would be naïve to believe that this slowing of liquidity would have no effect on the global markets. If, as it has been argued, QE suppressed volatility and inflated asset values, then its removal should logically be expected to have the opposite effect. Clearly the Fed and other central banks came to the same conclusion, with the result that monetary policy normalization has been suspended indefinitely.
But what if the Goldilocks scenario described above doesn’t continue? Can equity multiples continue to expand in the face of a recession? Or what about the opposite — can interest rates stay on hold if this growth scare abates and positive economic momentum resumes?
On a relative-value basis I maintain a neutral weighting in Equities because I believe the greater mispricing remains in Bonds. Nevertheless, in the current late-cycle environment investors needs to focus on downside-risk protection and manager alpha as there seems to be very few obvious beta or market-driven calls to be made. Dry powder (Cash) and non-directional Alternative Investments should play a prominent role in any portfolio.
Q1 2019 was impressive not only for the magnitude of its gains but also its breadth. It was the best quarter for WTI Oil (+32.4%) and the S&P 500 (+13.1%) since Q2 2009, US HY (+7.2%) since Q4 2011, the Shanghai Composite (+23.9%) since Q4 2014 and the Euro STOXX 600 (+13.3%) since Q1 2015.
S&P 500 companies are now trading at 16.7x their forward earnings, the same level as early October just before the start of the fourth-quarter rout. A slowdown in earnings could make further increases in stock multiples harder to justify. According to FactSet, analysts estimate S&P 500 profits in the first quarter contracted -4.2% from a year earlier. Moreover, they expect that there will be no growth in the second quarter, placing the broad index at risk of entering its first earnings recession since 2016. Companies that miss earnings estimates could respond by cutting spending on capital improvements and labor, further hampering economic growth and reigniting a stock-market selloff.
An “inversion” of the usual shape of the yield curve has been an accurate harbinger of recessions, preceding every US downturn since the end of WWII. Ominously, the US yield curve (or at least a part of it) has now inverted once again, with the 10-year Treasury yield on March 22 dipping below the three-month T-bill yield for the first time since 2007. Combined with the length of the post-crisis expansion and deteriorating economic data, the inverted yield curve has stirred fears that the countdown to the next downturn has already begun.
However, the yield curve might be less reliable than its US history suggests. Indeed, it has a poor record internationally, for instance, in Germany it provided no advance warning of the 2008 recession, the worst since reunification. At the moment the curve is not inverted in Europe, Japan or the UK thanks to record low or negative interest rates, even though all are struggling with greater economic troubles than the US.