by: Richard A. Anderson
It’s been an eventful few months. After posting its worst quarterly return since the fourth quarter of 2008, the S&P 500 rebounded strongly in the first quarter of 2019 to post its best quarterly return since the third quarter of 2009. The S&P 500 has now recovered much of its fourth quarter losses as oversold signals have faded and investor optimism has been buoyed by a favorable shift in monetary policy by the U.S. Federal Reserve.
As was widely expected, following its March meeting the Federal Reserve left the federal funds rate target range unchanged at 2.25% to 2.50%. Federal Reserve Chair Jerome Powell had signaled throughout the first quarter the Fed planned to practice patience in regard to changing short-term interest rates. While investors were not surprised by the Fed’s decision to keep its target rate steady, they were surprised by the Fed’s future interest rate projections.
The Fed’s “dot plot,” which is a chart that shows the level each member of the Federal Open Market Committee (FOMC) believes the federal funds rate target should be at the end of the years ahead, shows policymakers’ expectations are for no interest rate hikes this year and only one increase in 2020. This is a major shift for the Fed, which indicated after its last meeting in December it would hike rates twice in 2019 and three times in 2020.
The Fed’s reversal has mixed implications for investors. In the short-term, it is favorable. Both short-term and long-term interest rates may have peaked, as the Fed is unlikely to raise rates this year and market participants are placing a higher probability the Fed’s next move will be a rate cut rather than a rate hike.
However, the Fed cited its reduced expectations for economic growth and inflation for its decision to temper interest rate expectations. This should be a headwind for stock investors, as slower economic growth could weigh on corporate earnings and profitability.
Although interest rate concerns have eased, the concerns have been shifted to the global economy. The consensus expectation is that global economic growth should slow in the next twelve to eighteen months, with the U.S. converging towards the rest of the world. This has policymakers around the world exploring ways to increase economic growth by keeping interest rates low and introducing tax cuts.
However, much of the outlook for the global economy hinges on the outcome of trade talks between the U.S. and China as well as the United Kingdom’s exit from the European Union.
The trade negotiations between the U.S. and China are still unresolved, though both parties remain optimistic a deal will get done. Both countries delaying scheduled escalations in tariffs is a sign trade talks are moving in the right direction.
Brexit is a completely different story. In March, U.K. Parliament voted down the deal Prime Minister Theresa May negotiated with the European Union and voted to extend the Brexit deadline from March 30th to June 30th. Theresa May will continue to negotiate with the European Union on a Brexit deal that will be favored by Parliament. Markets are pricing in a better than 50% chance a Brexit deal will eventually get ratified with a smaller chance of a second referendum to reverse the Brexit decision and an even smaller chance a hard Brexit takes place.
A hard Brexit, or a scenario where no deal is in place between the U.K. and E.U., is a worst-case scenario. The markets have priced in a low probability of this occurring, but the Bank of England estimates U.K. GDP could fall as much as 10.5% over a five-year period if no deal is reached. The fallout for global investors may be limited though. According to Factset, the U.K. makes up less than 4% of sales for companies in the MSCI World Index and less than 5% for companies in the MSCI Europe ex-U.K. Index. Plus, businesses have had more than two years to prepare for Brexit.
With concerns over both the U.S. and global economies slowing, the U.S. Treasury yield curve inverted for the first time since 2007. Normally, the yield curve is upward sloping, with long-term interest rates higher than short-term interest rates. But, every once in a while, the yield curve becomes downward sloping, with short-term interest rates moving above long-term interest rates. This is called an inverted yield curve and when that happens, it is historically an ominous sign. The yield curve has inverted prior to the past seven recessions, with only one false signal. Although the predictive power is clear, the timing to a recession ranges from five months to sixteen months after the initial inversion.
However, this is historically a good time to be invested in stocks. The S&P 500 has been positive on average in the 1 month, 3 month, 6 month, and 12 month periods following the initial yield curve inversion. The chart below shows historical returns of the S&P 500 following a yield curve inversion.
Against this economic backdrop, global stocks rebounded strongly from a tough fourth quarter of 2018. In what seems like an all-too-common occurrence, U.S. stocks once again led the way, with international stocks lagging behind. Global stocks received a boost due to positive developments in trade talks, favorable global monetary policy, and a bounce back from oversold territory in December.
Fixed income returns were also positive for the quarter, benefitting from falling global interest rates. In the U.S., the 2-year Treasury yield closed the quarter at 2.27%, down from 2.48% at last quarter’s end. The 10-year Treasury yield closed the quarter at 2.41%, down from 2.69% at last quarter’s end. Outside of the U.S., yields remain much lower. For example, yields on German and Japanese 2-year and 10-year government bonds are negative, meaning investors are purchasing these bonds fully expecting to get paid back less than they invested.
With the negative returns of the fourth quarter of 2018 in the rearview mirror, investors are looking ahead and wondering if this recent rally can be sustained. Given low inflation, accommodative monetary policy, and low interest rates, the environment for stocks and bonds remains positive. What could pose a risk to this sunny outlook is the U.S. economy stalling out rather than slowing down, the Fed prematurely raising interest rates, or an escalation of trade conflict. We believe, however, discipline and diversification remain important as we prepare for the inescapable end of this expansion, even if the end can’t be precisely pinpointed.