First Quarter 2019 – Quarterly Commentary
With winter gone, have markets blossomed?
What a difference a quarter makes! Three months ago, we were lamenting the terrible end to 2018 and now we can celebrate the start to 2019. At the end of such a great quarter, I can’t resist the opportunity to quote the Irish Rovers from their 1980’s hit, “Wasn’t that a party!” But that of course leads to the bigger question, is the party now over? And if so, how big will the hangover be? The good news is that at this time, we don’t expect a headache to follow the strong first quarter performance. But, sadly we also don’t anticipate the party to continue.
Let’s start by looking at the global economic growth expectations. Following a robust beginning to 2018, growth slowed towards the end of the year, declining further into the first quarter of 2019. One of the indicators we consider as we assess growth expectations is the Purchasing Manager’s Index (PMI). As the survey assesses activity at the beginning of the supply chain, it gives an indication of what to expect in the coming months. As can be seen in the chart below, the index peaked in early 2018 and has been steadily declining since. It should be noted, that any reading above 50 (the red line) shows an expanding economy while a number below 50 indicates contraction. Although the current level is still clearly on the expansion side of the line, it suggests slower growth is in the cards for the remainder of the year.
Part of this decline is due to the slowing Chinese economy, where the PMI drifted below 50 at the end of 2018 indicating a contraction, before creeping back up above 50 on the March 31st release. Stealing a reference from the boxing ring, China suffered a damaging one-two combination, as the government sought to slow the rate of lending due to concerns over the spiraling level of borrowings in the economy, only to have this jab to economic growth followed by a bruising cross as the U.S. hit Chinese imports with tariffs. If Trump were to follow through with his threat to increase the tariffs from 10% to 25% (something that currently seems unlikely) that could be a knock-out blow, sending Chinese economic growth rates lower.
How much has the Chinese economy slowed? That is difficult to tell with any certainty. Chinese statistics are generally viewed as indications not precise measurements as these readings can suffer from two issues. The first is difficulty collecting complete data while the second is the potential “smoothing” of data by government officials to present the desired picture to the world. The data is sufficiently robust to be able to state growth is slowing and as the world’s second largest economy, slowing growth in China has a cascading impact on the rest of the global economy.
The good news is that the first half of 2019 will likely see the worst of the decline in Chinese growth as the government has launched a stimulus program to try and stabilize the economy. This is not the “shock and awe” type of stimulus that China launched following the 2008/09 financial crisis, but a more modest effort. Therefore, it may not be enough to lift growth, but it should at a minimum stop the decline. The first signs of this can be confirmed with the rebounding PMI in March. If this uptick were to be further supported with a lifting of tariffs by the U.S. (a low probability event in the near term), that would provide a better framework for a resurgence in growth, not just in China, but globally.
However, as that appears unlikely we will maintain our expectation for slower economic growth, which also likely means slower earnings growth for companies in 2019. This shifting expectation for earnings growth is part of what led to the decline in equity markets in the final quarter of 2018, as earnings expectations slid from over 10% down to zero. Those expectations have now settled into low single digit numbers, which seems more rational to us, given the slowing growth environment combined with some pressures from rising wages.
So, if a surge in earnings growth is unlikely to occur, what could move equity markets higher? The answer is valuations. Investors need to be willing to pay more for each dollar of earnings generated by the companies they invest in. Is a shift higher in valuations possible or plausible? Let’s start with is it possible – absolutely!
As any experienced investor will tell you, equity markets can suspend rational behaviour for extended periods of time. It is a reminder of the quote, generally attributed to John Maynard Keynes, “The market can stay irrational longer than you can stay solvent.”
Therefore, the bigger question is whether this is likely. At the end of 2018 valuation levels, based on a price/earnings ratio, had fallen to levels below the long-term average, making equity markets relatively appealing. However, by the end of the first quarter, this was no longer the case. Could higher valuations be justified as we progress through 2019? A case can be made that a bounce back in investor sentiment or a lower interest rate environment could propel stock prices and valuation levels higher. We are not convinced that these conditions are likely to prevail during the remainder of 2019.
This provides an opportunity to discuss interest rates. One of the catalysts for the rebound in equity markets was the U.S. Federal Reserve backing away from its previous comments, which had indicated that much higher interest rates may be necessary. With inflation still relatively muted and equity markets in turmoil, the Fed did a 180 degree turn and changed its tune. The Fed no longer seems to expect interest rates to move higher in the first half of the year and it is highly questionable whether rates will move higher at all in 2019.
This sudden shifting of expectations has led to what is referred to as an inverted yield curve, when the interest rate on short-term government debt is higher than longer term rates. An inversion of the yield curve sends alarm bells through financial markets as each of the last seven recessions has been proceeded by an inverted yield curve, with the critical data point often being considered the difference between the 3-month rate and the 10-year rate. Is this a worrying signal – without a doubt it is.
However; like many things, the devil is in the details. If you examine each of the yield curve inversions, followed by a recession, since 1968, you will find that it took anywhere from 5 months to 16 months for a recession to begin and perhaps more importantly the return on the S&P500 during that window ranged from -14.6% to +16.5%. So, although the inversion of the yield curve is a warning signal, it is not a sufficiently clear signal to use to develop a tactical portfolio strategy.
With the Fed now thoroughly spooked, it seems increasingly unlikely interest rates will move higher in the latter part of the year. Markets are even beginning to toy with the idea that the Fed will complete its U-turn and begin cutting rates later this year. This is an important debate.
Since the early 1990’s markets have experienced three previous “mini-bear” markets, where the indices dropped by close to 20%, but no recession followed, as seems likely to be the case now. In each of those cases a dose of monetary stimulus occurred, and equity markets recovered, breaking through to new highs.
With earnings growth slowing, it is our view that some form of catalyst is needed to move equity markets to new highs. But we are skeptical that the Federal Reserve will begin cutting interest rates unless growth slows more dramatically than currently seems likely. The central banks have made great efforts to try and return interest rates to “normal” levels. They are not likely to be eager to reverse the gains made.
If trade negotiations with China fail or if Brexit turns messier ̶ if such a thing is possible ̶ a cut in interest rates may be justified, but the current economic conditions do not seem to warrant such a move. So, it appears most likely that equity markets will stumble around in this range for a period, meanwhile the portfolios will continue to benefit from the interest and dividends earned on the holdings.
Is the next recession coming? Unless you believe recessions have been eliminated, it is. But we have been having this discussion so long, it sometimes feels like we are waiting for Godot. The key during this period is not to become complacent, as it will come, we just don’t know when. The current data suggests that it will not be in 2019, but sadly, our crystal ball is unwilling to peer beyond that.
1 April 2019
Logan Wealth Management