April 1, 2019
Capital markets often act as a mirror that reflects the conditions in which they operate. As such they reflect the state of economic affairs — and at times they foretell things to come. However, a perfect mirror they are not. Indeed, there are periods when they distort the picture like a fun-house. Capital markets undoubtedly did just that during the closing days of 2018.
Recall in November and December when markets were signaling economic stress on the horizon. This stress manifested itself with worries about slowing global growth, rising interest rates, political dysfunction on an epic scale, and a trade conflict that threatened the second-longest economic expansion dating to Victorian times. Understandably, these drove double-digit dives in equity prices. Nothing was immune from the receding tide of confidence, leaving no place to hide but in cash.
Thankfully, this bout of pessimism vanished as quickly as it appeared. The zeitgeist pivoted from “risk off” to “risk on,” pulling nearly every major asset class higher. Indeed, gains across equity and fixed income markets during the first quarter were impressive, whether from U.S. stocks of both high and low quality; small company shares; emerging market equities; or high-yield bonds. Among domestic equities, large- and small-capitalization stocks have produced what may amount to a year’s worth of gains in the first three months of 2019.
The First Quarter Was a Relief Rally
The market’s gallop during the quarter reflected a collective sigh of relief when investors’ fears failed to materialize. This was due to the palliative words offered by central bankers, who said that they would once again be “data dependent” in their deliberations while tinkering with interest rates. Indeed, the central bank chief himself recently averred that the bank’s policy rate is “roughly neutral” and “in a very good place,” implying that there are no rate increases on the horizon. Investors, in apparent agreement, pushed the interest rate on the 10-year Treasury note to 2.35%, the lowest level since December 2017.1
Geopolitics in Brief
The market’s reaction to the trade war between the U.S. and China has been a mixed bag. As in any negotiation, there is an ebb and flow, progress and setbacks. This was very much the case during the quarter, as near-daily reports from negotiators attest. Still, there is a growing sense that some form of Sino-American trade agreement will be struck. In these matters, if past is prologue, the deal will be one that fails to deliver all that is sought but should deliver enough to make it palatable. The Chinese need a deal, as tariffs have had a material effect on their trade-dependent economy. In January, Beijing reported that China’s economy grew 6.4% in the fourth quarter and 6.6% in 2018, which marked the country’s slowest pace of growth since 1990.2 President Trump, on the other hand, would benefit from a deal in order to refocus the country’s attention on his economic wins, especially as he gears up for the start of his re-election campaign. Consequently, when both parties need a deal, there tends to be a deal.
Brexit: A British Comedy or Tragedy?
As Brexit machinations drag on to their inevitably chaotic end, the process has been described as “maddening,” “shambolic,” “tragic,” and “incomprehensible,” to name but a few. Without a doubt, there is a tragic element to what is unfolding in Great Britain as decades of economic integration are in the process of being reversed. It is uncertain what the ultimate benefits of the divorce will bring. There is also a dramatic and comedic element to watching the political process unfold— think Monty Python and the Flying Parliament. The cast of characters is wide and varied: the tousled-haired Speaker of the House of Commons, the unreconstructed socialist leader of the opposition, the Iron Prime Minister, the biting backbenchers straight out of Masterpiece Theater, and finally, the uniformly gray lot of European bureaucrats; all in a tussle of epic proportions. As of this writing, clarity remains as elusive as ever, even as a deadline approaches. The conflict between Britain and the European Union is going to drag on, whether the exit is hard or soft. Putting this into Churchillian perspective: this is the end of the beginning, not the beginning of the end.
The Good News: Earnings Could Be Stronger than Expected in 2019
Just as bullish investors may have overreacted during this relief rally, Wall Street analysts seem to be overly dour. Since the start of the year, consensus expectations have been falling for earnings growth across every sector of the S&P 500 index. The consensus forecast for 2019 S&P 500 profit growth was nearly 7.5% at the start of the year. That forecast has since fallen to around 3.8%.3
Our analysis is more optimistic: we expect profits will probably be higher than analysts’ forecasts. This follows a recurring pattern, in which earnings estimates start falling during the quarter and then overshoot the eventual mark. Since the start of the year, we have been projecting 6% growth in profits in 2019, and we still believe that to be the case.
Solid earnings growth — coupled with strong consumer and small business confidence, falling unemployment, and rising wages — paint a picture of an economy that may be slowing but remains in relatively good health.
The Bad, Unpriced News: The Fed May Not Be Done
The equity markets have been trading on the expectation that there will be no more Fed rate hikes this year. In fact, investors believe there’s a greater likelihood that the Fed’s next move will be to lower rates rather than raise them.4
That is fanciful thinking. The strength of the U.S. economy, punctuated by stronger-than-expected earnings growth and rising wages, could force the Fed to conclude that one more rate hike is warranted in 2019. That would push the target for short-term rates up to the 2.50% to 2.75% range. At this level, the benchmark policy rate in inflation-adjusted, real terms will be only slightly above its longer-term historic average (Exhibit C). However, it will remain significantly below the rate that can induce recessions. Furthermore, long-term rates may be bottoming out and could start to climb again if economic growth exceeds current expectations. The yield on 10-Year Treasury Notes could rise from the current 2.35% to 3% before the end of the year.
That Dreadful Yield Curve
Without a doubt, this is not the consensus view on interest rates. Indeed, as the quarter ended, investors were thoroughly rattled by an inversion of the yield curve, which occurs when the yield on longer-dated government debt is lower than shorter-dated debt. A sustained inversion has been the clearest predictor of impending recession. Fundamentally, it signals that the economy is slowing, and investors are betting that interest rates will fall as economic activity recedes.
The problem investors face is discerning signal from noise. Is the bond market forecasting an economic slowdown and recession? Perhaps. There is no doubt that the pace of economic activity is slowing compared to last year, but that should not come as a surprise as the impact of the tax law changes fades into history. Confounding this analysis is the fact that the Federal Reserve, through its balance sheet reinvestment program, is creating demand for government securities that might actually distort prices and, therefore, yields. Add that to the global flow of capital and negative interest rates in Europe caused by central banks, and it begs the question: Are markets an independent arbiter of price? Put differently, if governments were not buying sovereign debt in the developed world, would longer-term bonds sport yields lower than their shorter-term brethren? I suspect not.
To be sure, a recession will inevitably grip the U.S. economy; however, the probability of it happening this year is quite low.
Expect Volatility to Make a Comeback
As investors sort through the flow of economic data, the impressive gains posted this year will be challenged by under or unpriced events. As these unfold, our late-cycle portfolio stance — favoring high-quality stocks and bonds, shortened duration in fixed income, and modestly higher levels of cash — should help portfolios during the period of churn.
The Long View: A Growing Debt Problem
As the business cycle ages, acquiring a line of sight on those things that could complicate or exacerbate the cycle’s next phase is important. In this effort, the matter of rising global debt levels deserves special attention. In 2018, worldwide government debt reached $61 trillion, more than double the level of 15 years ago. America’s share of that burden is rising faster than the level of worldwide debt itself. In 2003, the U.S. accounted for roughly 13% of global government debt, or approximately $4 trillion. Last year, our debt share jumped to around one-third, or $21 trillion.5
This figure could grow even higher. President Trump’s proposed 2020 budget calls for more than $1 trillion of additional deficit spending. Normally, good economic times are when one pays down their outstanding obligations, but today the United States is doing the opposite. This raises two future risks: When the economy inevitably hits a rough patch, what might deficit spending then do to those debt totals? Furthermore, how might that constrain the normal policy response?
Perhaps more troubling is that the bull market in debt issuance is not isolated to sovereign issuers. Globally, corporate debt has been growing at an even faster clip over the past 15 years. Since 2003, non-financial corporate debt has nearly tripled to $74 trillion.6 Eventually, the amount of debt sitting on the balance of the corporate sector threatens companies’ ability to feed the engines of stock price appreciation — capex spending, stock buybacks, and dividend growth. To be sure, corporations are carrying debt that is roughly 47% larger than the amounts carried in 2008 or $9.75 trillion.7
Ominously, former Fed chair Janet Yellen has warned that mounting corporate indebtedness could serve to prolong the next downturn, reminding us of the age-old warning label that comes with the use of credit: “Beware, for money borrowed is money that has to be returned.”
1 Yield on the US Generic Government 10 Year Yield via Bloomberg
2 Trading Economics
3 Factset Earnings Insight
4 Based on Federal Funds Futures via Bloomberg
5 Institute of International Finance via Bloomberg
7 US Debt Outstanding by Corporate Sector Flow of Funds from the Federal Reserve via Bloomberg