“Whenever you find yourself on the side of the majority, it is time to pause and reflect.” Mark Twain
As we review market returns each quarter to prepare this missive, it seems that we frequently want to write something along the lines of, “This quarter/year was the exact opposite of the LAST quarter/year.” We finished 2018 with a holiday bear market, something that hadn’t occurred in decades. As a New Year’s gift, investors enjoyed the second-best monthly price return of the S&P 500 in five years during January (+7.87%). In contrast, December and October 2018 were the index’s two worst months in the past five years. Whatever Spirits of Markets Yet to Come spooked investors at Christmas were chased way by discounted global-equity valuations and the U.S. Fed’s announcement of a suspension in its rate-hike program. U.S. and international stocks posted exceptional Q-1 rebound results. Investors in high-yield bonds, commodities and REITs also were quite pleased, as the ‘risk on’ trade led to a rebound in all markets. Quality investment-grade taxable and municipal bonds earned almost all their yearly coupon in the quarter, and nearly matched the full-year returns of 2017.
“The pause that refreshes” Coca-Cola slogan, 1929
Prognosticators and pundits have been devoting considerable blog and media space to advance their theories on the timing and severity of the next recession and ‘the end of the (U.S.) bull market.’ Stripping away some of the fear-mongering and bloviation, we find that the data indicates some concerns are warranted. More important, though, is the concept that future policy changes and macroeconomic management are the real keys to prolonging the U.S. expansion and the bull market. That’s why the Fed’s announcement of a pause in its tightening policies is so significant.
There’s a familiar market adage that says, “Bull markets don’t die of old age.” If investors were playing the classic board-game Clue, the most common culprit would be the Fed using monetary policy in the bond markets. While there are elements of truth to this analysis, the Fed has a very difficult job of guiding a long-term, low-inflation expansion at full employment. Its monetary adjustments usually create a ‘hard landing,’ which cause asset bubbles and the recessions and market crashes investors are familiar with. Their decision to ease-up on rate hikes has us considering the Fed may, in fact, engineer a ‘soft landing,’ a slow-down without a classic recession. Their current focus on the ‘natural rate of interest’ is a key to their thinking.
The natural rate of interest is, broadly, the rate that maintains stable economic growth absent economic shocks. It is usually defined as a long-term interest rate plus an inflation premium. The current Fed Funds rate is targeted in the 2.25%-2.50% range, which is consistent with the Fed’s current estimates of a neutral rate. This estimation is crucial to corporations and their financial planning; it’s also an important global policy and investment consideration, given the dominant roles of the U.S. economy and its Treasury bond market in the world economy.
“In bullfighting there is an interesting parallel to the pause as a place of refuge and renewal… called [the bull’s] querencia.” Tara Brach, psychologist and author
So, what are the risks to the U.S. and global markets now? They are primarily future policy errors. These include: Brexit, China’s economy, the global trade wars, the rise in and level of global debt, and the rising U.S. deficit (fiscal policy). These risks are not easily measured, and some have outcomes that may take years to manifest. Here are two issues that policy can affect and that we believe are important to near-term market psyche and dynamics going forward—earnings and debt:
In the left graph, we can see that global earnings estimates for 2019 have come in considerably during the first quarter. This is a result of a slowing global economy, macro policy concerns and some uncertainty about the direction of the U.S. dollar. In the right graph, we can see that profit margins for the S&P have reached a 3-year high and may experience some roll-over. This may be due to wage-inflation pressures, higher borrowing costs and commodity-price increases. Ending the trade wars, allowing for some higher wage growth and a weaker dollar may lessen these pressures.
With respect to debt, the left graph above estimates that corporations will roll ~$5 trillion in debt in the next eight years. If rates remain where they are now or drift slightly higher, the volume of refinancing and the possible upward reset in coupons will affect corporate cash flows and balance sheets. The right graph reflects the huge amount of debt financing that has occurred in the lowest ‘investment grade’ tranche (BBB) over the past 10 years. Previously a sweet spot for investors, this tranche is now a key to corporate-debt financing. Higher interest rates or economic disruptions will impact this crucial market segment. We have noted that some larger corporations are moving to shore-up balance sheets, sell assets and lower leverage ratios while the markets still afford cheaper financing options. A Fed pause may avoid negative shocks to the BBB market, which will affect bond indexes and investment mandates for mutual funds and institutional investors.
“Sometimes all it takes is a subtle shift in perspective, an opening of the mind, an intentional pause and reset…to see new options and new possibilities.” Kristin Armstrong, Olympic athlete
At times it seems difficult to comprehend that the U.S. expansion still seems to have some legs. We think the Fed’s pause will be a big boost to maintaining low-inflation growth. An added benefit is the Fed’s consideration of their policies’ effects on the global economy, as no country is an economic island and U.S. policy repercussions have global knock-on impacts.
While we expect some year-over-year comparative weakness in earnings, we still expect earnings growth in the U.S. and positive market returns. We also expect more value-hunting in international markets, particularly in select ‘emerging’ markets. Our original expectation of a rise in the U.S. 10-year Treasury to a level over 3.00% is less likely, but we still expect muted returns for bonds for the rest of the year.
Our final comment is to be prepared for more pronounced market fluctuations. The result of policy-driven market moves, as opposed to strictly data-dependent ones, is more volatility and uncertainty, not less. Useless noise and emotions, specifically fear, are heightened in this type of environment.
Please take a brief pause to review your financial plan and circumstances, and contact us with your comments and questions.
—Your Wealth Management Team at JJ Burns & Company
2019: 1st Quarter Summary