In last quarter’s commentary entitled “Ignore the Deafening Noise” I urged readers to focus on the likely future of Fed policy and economic activity at the expense of the media’s obsession with the current flattening of the yield curve, continued Fed tightening, expanding credit spreads, a U.S.-China trade war and slower earnings growth.
Today, the message is virtually unchanged. If you concentrate on the present — potentially negative first quarter earnings growth, slowing GDP, an unresolved US-China trade spat or the nearly inverted yield curve, you will miss out on a constructive investing environment. It’s important that we distinguish between the then and now: negative earnings growth and slower economic growth — the phenomenon which the market anticipated last year and slow, non-inflationary earnings and economic growth — the phenomenon which will likely occur this year and next.
To this end, stocks have moved beyond the past and into the present to capitalize on a non-threatening Federal Reserve and non-inflationary, steady and slow growth. This has driven a sharp snap-back in the first quarter with the Russell 3000, Russell 2000 Small Cap Index and the International MSCI All Country-US index posting total returns of 14.04%, 14.58% and 10.31% respectively.
Goldilocks and Utopia
What inspires my tempered bullishness is the removal of previous market headwinds combined with reasonable equity valuations. Slowing economic growth has caused Central Banks globally to pivot policy bias from restrictive to accommodative. Apparently, the “neutral rate” was less than previously estimated.
An example of the meaningful change is best illustrated by the decline in 2-year US Treasury yields (a strong predictor of the future Fed Funds rates) from 2.97% in November 2018 to 2.26% on March 29, 2019. With the current Fed Funds rate at 2.50%, the market has adjusted its policy expectation from two one-quarter point rate hikes to a single one-quarter point rate cut.
Additionally, low quality bond yield spreads to Treasuries have narrowed from 4.85% in December to a relatively docile 3.40% at March end. This signals less fear regarding credit conditions in just three months. Finally, next-twelve-month earnings estimates for large, mid-cap and small-cap stocks, which were persistently declining from their October 2018 highs to mid-March, have now begun to firm and advance. While I am not claiming that U.S. equities are living in a utopian economic state as threats always linger, the Goldilocks scenario of “not-too-hot and not-too-cold” provides me comfort.
Ignore the Inversion, the Trade War and the Earnings Recession?
Responsible investors manage risk and avoid dangers. As such, I cannot carelessly dismiss the historical significance of an inverted yield curve, the costs of the potentially never-ending tariff war with China and the fact that S&P 500 earnings may be reported lower than the prior year for the first quarter. Historically, yield curve inversions have done a remarkable job of anticipating economic slowdowns and have preceded each U.S. recession (with the exception of a single instance) for the last 50 years.
Based on the spread between 3-month Treasury bill and 10-year Treasury note, the spread dipped to zero in late March for the first time in over 11 years. While the spread has widened back into positive territory at 0.15%, signifying either greater confidence in future economic growth or a more dovish Fed moving forward, I am reminded that prior recessions have started five to 17 months after an inversion based on the seven data points.
With respect to the U.S.-China trade battle, the postponement on the final set of tariffs on the remaining approximate 50% Chinese imports from the March deadline has given investors hope of a potential resolution. Up until now, the existing tariffs on $253 billion of Chinese goods and nearly all of the $130 billion of U.S. exports have raised prices and suppressed output in both countries and potentially around the globe.
Taken together with poor demographics and rising levels of global debt, anticipated non-U.S. revenue growth expectation for 2019 has declined from 4.4% at the beginning of this year to 3.3% now and down from 7.4% last year. U.S. earnings growth has also declined from the 25% growth rates of the 2018’s first three quarters.
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