In this commentary, we discuss:
- The recent change in perspective at the Federal Reserve and what it means for interest rates and the Fed balance sheet
- The prospect of an inverted yield curve and how it should be interpreted
- The current environment for bond investors in the credit markets
- The potential impact of a U.S.-China trade agreement
- What catalysts are likely necessary for stocks to move higher from current levels
- Opportunities for value stocks
In a month when millions of people are watching pivots on the basketball court, nothing seen in this year's NCAA Tournament can compare to the dramatic change in course witnessed in recent months at the Federal Reserve, which, in concluding its March meeting last week, continued along its fast-break pace toward more dovish policy.
It was widely expected there would be no action taken at the meeting and the current Fed Funds rate would remain within its target range of 2.25% – 2.50%. But the Federal Open Market Committee further assured the market that the remainder of 2019 would be nothing like last year and that rate hikes and balance sheet reduction — cornerstones of its policy just months ago — will soon appear to be about as outdated as Villanova's championship run of a year ago.
All of this was widely cheered by the market initially. However, the reasons behind the Fed's decisive change in perspective could wind up creating its own market volatility as equity indexes are now close to record highs.
First, let's look at the key highlights of what the Fed signaled last week:
In all likelihood, there will be no further rate hikes for the remainder of this year. As seen in the Fed's newly updated "Dot Plot," there is now a wide belief among committee members that there will not be any more rate hikes in 2019, a fairly substantial shift from the two rate hikes signaled last December. This change was to some degree viewed as a formality, given how the market had correctly discounted in recent weeks that this would be the case.
The Fed also announced its balance sheet reduction program would soon slow and come to an end in September. This was a meaningful development as the apparent rigidity of the Fed's balance sheet reduction plan last December is believed to have played a major role in year-end market volatility. This concern can now be officially eased to a large degree as the Fed has now committed to cutting its monthly runoff (non-reinvestment of principal) in Treasury bonds from $30 billion to $15 billion beginning in May and then to zero in September. This was also widely cheered by the market.
However, there is no free lunch here as the Fed’s newly found trend of more dovish policy is based on a downgraded view of the economy . Specifically, the Fed now views the U.S. economy as more likely to achieve 2019 GDP growth of 2.1%, down from its earlier expectation of 2.4%. This could also create further concerns when recognizing that the bulk of this growth is back-weighted in 2H19 as first quarter growth is expected to be lower than 2%.
Given these developments from last week’s Fed meeting, here is what we believe investors need to be most keenly aware of as we look toward the rest of the year:
The yield curve could soon invert, creating recession fears. Amid this new course at the Fed, the U.S. 10-year Treasury yield has declined materially, and at 2.43% (as of March 25), has officially inverted against the 3-month yield of 2.46%, and is now only .12% above the 2-year yield. Given recent trends, there is a realistic probability this widely watched metric of the 2-year vs. 10-year portion of the yield curve could also invert, further encouraging speculation of a recession in 2020. As we said in our January 2019 Market Outlook, while widely recognized as a potential precursor to a recession, there are other reasons why the yield curve might invert. This, in our opinion, would include the anomalously low and now negative overseas 10-year yields in Europe and Japan, pension fund investing based on age demographics that is creating greater demand for longer-term bonds, and the after effects of the Fed’s zero interest rate policy and asset purchasing programs of the past decade. While we do not believe the U.S. economy will experience a recession this year or next, a sustained inverted yield curve would almost certainly increase this concern and potentially impact market sentiment.
The U.S.-China trade dispute remains a major market focus, and expectations are high that an amicable agreement will be reached. In addition to the Fed's more dovish approach to monetary policy, we believe the strong year-to-date move in the equity markets has also been driven by the perception that the U.S. and China will soon reach a resolution to their ongoing trade dispute and that further tariffs can be averted. While we believe this remains a strong probability, any agreement will likely be more complicated than most realize, and in the event there is a breakdown in negotiations, the market would likely react negatively.
Equity markets will need additional catalysts to move past the record highs of last year. With close to a full recovery from their late-December lows, equity markets, in our opinion, will need new catalysts besides Fed policy and the prospect of a trade agreement with China to successfully move higher and sustain levels above last autumn’s record highs. This will likely have to come from economic and corporate earnings growth, both of which are facing difficult first quarter comparisons versus last year. For 1Q19, GDP growth forecasts are averaging in the low-to-mid-1% range, and earnings growth for S&P 500 underlying companies are anticipated to be flat-to-slightly negative. This puts a good bit of pressure on 2H19 GDP and corporate earnings to improve considerably, or for 2020 estimates to come in at higher rates.
Despite these difficult economic and earnings comparisons, we believe downside risk to current equity markets have been mitigated by a more dovish and market friendly Fed. The greatest individual fear during last year's market turmoil, that of a Fed policy error (raising rates into a slowing economy), is now for the most part gone. Thus, when you take away the worst-case scenario, you likely also take away the worst-case market reaction. In addition, the Fed appears more equipped at this point to take action in the event markets were to take a material downward turn.
We believe the equity markets will prove to be more conducive for value rather than growth stocks in the year ahead. This is because we are likely to see a deceleration in economic and earnings growth in the year ahead, as well as the anniversary of last year's lower corporate tax rates, which favorably impacted profit growth. The catalysts that favored growth stocks going back to the end of 2016 (fiscal stimulus, deregulation, lower taxes, and higher economic growth) now appear to have run their course to some extent, and we believe this should provide a relative advantage for value stocks in the year ahead.
Credit markets have embraced the more dovish Fed; however recent spread compression should also be taken into account. So far, the first quarter of 2019 has been a strong one in the credit markets as bond investors have not only banked the higher coupon rates made available to them from the credit spread widening in 4Q18, but have also seen those spreads compress considerably. High-yield spreads versus comparable maturity Treasurys have narrowed about 1.4% to just over 4%, BBB credit spreads have declined about 0.40% to approximately 1.6%, and traditional investment grade spreads have fallen close to 0.30% to about 1.25%. Much of this spread narrowing, in our opinion, has been driven by the market’s recognition that since the year began, risks of a Fed policy error have close to evaporated, and the overall default environment remains benign. Nonetheless, given this reduction in spreads, we believe bond investors should expect total returns in line with current yields during the year ahead that we would still view as historically attractive.
In summary, we believe equity and credit investors should be prepared to be patient as we transition into the spring and summer months. The market gains so far in 2019 have been well above what most expected just a few months ago and, while justified in our opinion, will now need more wind at their backs than just the Fed and the prospect of a trade agreement with China. That wind could well come in the second half of the year when better visibility comes to light on economic and corporate earnings growth in 2020. So we are by no means telling investors to jump off the boat, but merely to remain patient until a second gust emerges.
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