Portfolio & Market Review: Q1 2019
Global markets surged in the first quarter of 2019 as both equity and credit markets rebounded sharply from the lows reached in December of last year. Global equities posted their best quarterly performance since 2010 driven by renewed optimism that the world’s central banks will remain accommodative and that trade negotiators between the US and China might find some common ground. In January, the US Federal Reserve Bank (Fed) signaled an intention to pause its current rate hiking cycle and a willingness to adjust its policy regarding the balance sheet reduction. This more “dovish” stance was further enhanced with an announcement in March that they intend to reduce their projected path of interest rates further, essentially eliminating the possibility for a rate increase in 2019. Outside the US, central banks were singing a similar tune, as the European Central Bank (ECB) along with Chinese policy makers announced plans to provide or continue to provide additional liquidity to local markets.
The release of pressure from the threat of higher interest rates increased investor risk appetite across the globe. In the US, stocks increased 14% with 100% of the stocks in the S&P 500 index posting a positive return for the quarter. The strong performance of the US markets was led by mid and small cap growth stocks that increased 16.5% and 17% respectively. Additionally, all major sectors were positive led by technology stocks up almost 20%.
Equity returns outside of the US were strong as well. For the quarter, the MSCI All Country World x-US Index fished up 10% with roughly an equal contribution from developed and emerging markets. In the Eurozone, markets were supported by the ECB’s guidance that interest rates will be held at current levels for the remainder of the year along with the announcement of a liquidity program aimed to add support to the banking sector. Equity returns in the emerging world were led by China, up 24% mostly in response to improved trade talks and central bank support.
Commodity markets continued their trend higher over the quarter returning almost 15%. Oil led the way rising almost 30% and is now up over 45% since bottoming in November 2018. Production cuts from OPEC and other major producers, along with the situation in Venezuela, put pressure on supply. Outside of energy, industrial metals moved higher, led by iron ore which was supported by large mine outage in Brazil.
Global bond yields fell as the prospects of lower interest rates, guided by the world’s central banks, enticed investors to lock in current yields. In the US, the benchmark 10-year Treasury yield fell 28 basis points (0.28%) to 2.4%. The rally in US bond yields caused the spread (difference) between 3-month and 10-year Treasury yields to briefly move into negative territory resulting in a yield curve inversion in late March. The inverted curve was short lived as investor demand for shorter maturities increased driving the spread back into positive territory. That said, the yield curve inversion is notable and requires attention. Historically, inverted yield curves have preceded recessions but the timing of when a recession will occur is less certain. On average, the yield curve has inverted 18 months prior to a recession, so there may still be some room for the economy to grow.
The big story over the course of the quarter was the change in central bank sentiment and the subsequent decrease in interest rates which, in the absence of a severe economic downturn, have historically been positive for equities. The decrease in the discount rate (i.e. interest rates) used to value stocks helped push the price-to-earnings ratio (P/E ratio) of the S&P 500 from 14x to 16.5x over the quarter. While an increase in the P/E ratio and higher equity prices are positive outcomes, a closer look at what drove the multiple expansion is more telling of where we are in the economic cycle. Earnings growth, the “E” in the P/E ratio, has started to slow. Corporate earnings sharply accelerated in 2018 on the back of tax reform leading to record setting margins by the end of the third quarter. However, now that the adrenaline shot from the tax reform is wearing off, profit margins are feeling the pressure from higher wages, a stronger dollar, and higher input costs. Earnings in 4Q 2018 reflected these effects increasing just 3.5% vs. the 28% average we experienced over the prior three quarters.
For 2019, earnings are expected to remain positive but slow from the torrid pace of last year. It is important to keep in mind, that over the long-term, higher equity prices are positively correlated with higher earnings. A rising market driven solely by valuations, rather than earnings, is typically not sustainable. That said, there does seem to be more risks to the downside for earnings which could lead to another volatile year for stock prices. However, as long as earnings remain positive there should be support for the market.
Model Portfolio Update
There were no model changes made during the last quarter.