- Understand why the stock market has rebounded early in 2019.
- Understand the immediate forces that will influence the market going forward.
- Know what market challenges investors should pay the most attention to.
Stocks have broken strong out of the gates to begin the first two months of 2019 as the litany of investor concerns that plagued the markets in the final months of last year, while certainly far from gone, have definitely abated to some extent. As of the close of February 25, the S&P 500® and Dow Jones Industrial Average are up more than 11% on a year-to-date basis, and NASDAQ has risen more than 13%. These results, while still reflecting price levels below their record highs of last autumn, have seemed more than enough to help investors begin to put the misery of last year’s final months into perspective and, perhaps more importantly, the rearview mirror.
As we stated in our 2019 Market Outlook in January, several investor concerns coalesced much like a perfect storm in the final months of 2018. These included:
- Fears of rising interest rates and a potential Fed policy error
- U.S.-China trade dispute and pending tariffs
- Widening credit spreads in the corporate bond markets
- Slowing economic growth and fears of a recession
- Declining rates of corporate earnings growth
In looking at how the market now views these concerns, there is no question that, as we mentioned in the Outlook, a “wall of worry” had been set up for the markets to climb in the year ahead. Two months in, the climbing has been pretty good. While overall market concerns have certainly subsided to some extent, we believe investors should continue to view them all in their totality. In this regard, we believe it is important to consider the following:
At the top of our list would be relief that the Federal Reserve will not be further raising rates in the first half of the year nor is it on the brink of a Fed policy error. In the final weeks of last year, there was a widespread perception that the Federal Reserve was behind the curve and was therefore on the edge of making a major policy error, defined as raising interest rates into a slowing economy. Since that time, the Fed has clearly pivoted to being more patient and data dependent as well as less rigid and robotic in its policy implementation. As a result, current expectations are for a pause in rate hikes through at least the first half of the year. In addition, recent minutes from the Fed’s January meeting seem to confirm more market sensitivity and the willingness to reduce the pace of its balance sheet reduction program. All of this has been perceived favorably by the market, at least for the time being. (For more detail on recent Fed-oriented developments, please see our recent posting, “Fed pivots to patience, but for how long?”)
A growing recognition that the U.S.-China trade dispute, while still far from being reconciled, may have been previously viewed in a worst-case scenario framework and that there is a realistic path for pending tariffs to be potentially averted. As we also mentioned in the Outlook, we viewed the U.S.-China trade dispute and the pending tariffs associated with it, to be the single biggest wild card for investors in the year ahead. Perhaps one might say that last December the market viewed this wild card closer to the Two of Clubs. Today one might say it is being viewed somewhere between the middle of the pack and a face card. While there is no question tangible risk remains, recent negotiations seem to be making headway, and the fact that the Whitehouse has delayed implementing further tariffs beyond the initially stated March 1 deadline can, in our opinion, be perceived favorably. We also believe that should we see an agreement with pending tariffs omitted, or better yet existing tariffs withdrawn, this would be a further catalyst for the markets. However, we caution not to speculate on this event, as the recent rally in stocks has left little to no room for disappointment on this front.
Credit spreads have narrowed following the dramatic widening experienced in the corporate bond markets during the fourth quarter of 2018. In the final months of last year not only did stock prices fall precipitously, but the corporate bond market experienced an expansion in credit spreads not seen in almost three years. This could be seen in the high-yield market, where yield differentials to comparable Treasurys rose more than 200 basis points to 5.30%, creating additional angst in the markets and also stoking recession fears. So far this year, credit spreads have reverted noticeably and high-yield bonds are currently trading with tighter spreads to Treasurys of about 4.10% (ICE BofAML US High Yield Master II Option-Adjusted Spread as of February 25). The fact credit spreads have come in, we believe, also serves to represent that recessionary fears of last December have abated to some degree.
Although the market has for the most part recognized last year’s overreaction to Fed Policy, the U.S.-China trade dispute and volatility in the credit markets, certain challenges identified months ago, continue to exist in the current environment. Among them:
The U.S. economy is facing declining rates of growth for the year ahead. Since 2Q18, quarterly GDP growth has been decelerating on a year-over-year basis. With the first estimate of 4Q18 GDP growth coming in at 2.6% and expectations of 1Q19 now reflecting the impact of January’s government shutdown, we are now likely to see three consecutive quarters of declining year-over-year economic growth. While it looks like the final number on 2019 annualized U.S. GDP growth will be right at or slightly below 3%, seasonality and the effects of the shutdown could well put 1Q19 at or below 2%, representing trend levels of the past decade. We continue to believe the U.S. economy is capable of mid-2% growth in 2019, however much of that rate could prove dependent on the second half of the year.
Corporate earnings growth is also being challenged by difficult comparisons and will be well below last year’s levels. Following the stellar year for corporate profits in 2018, in which S&P 500 underlying earnings growth reached 20%, the year ahead should not be nearly as strong. As the comparative impact of lower tax rates wane and the economy is unlikely to provide as meaningful a tailwind, earnings growth for the year is probably best estimated in the mid-single digits with potentially negative growth in 1Q19. While decelerating earnings growth in 2019 has been widely expected for some time, the magnitude will need to be watched closely.
Stocks have rebounded strong over the past two months, as evidenced by the fact the S&P 500 is up almost 19% since its December low and is now within 5% of its record high of last September. With the Dow Jones Industrial Average and NASDAQ featuring similar profiles, we believe first quarter economic numbers and earnings reports will need to be the upcoming catalysts in order to see the next leg up in stocks, as investors will likely require better visibility in these areas for the year ahead. While the shift in perspective at the Fed and progress concerning trade relations with China are welcome developments, we believe the trajectory of the economy and corporate earnings will ultimately prove most important.
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