Q1 2019 Recap
What a difference a quarter makes. Q1 2019 ended with global markets up sharply against the backdrop of weakening global growth. The first three months of the year registered the best quarterly return for the S&P 500 in over nine years. We have to go back to Q2 and Q3 of 2009, coming out of the depths of the global financial crisis, to find better quarterly results. Q1 was also the best start to a year in over 20 years (1998). In addition, over the last 50 years, whenever the S&P 500 started the year up more than 10% the index ended the year positive, and 1987 was the only year where the index closed lower for the year than where it closed at the end of Q1. Said differently, in all but one instance, when the market starts the year this strong it finishes even higher for the year. It’s important to note that despite the strong rally, global markets have not managed to completely reverse the severe drawdown investors experienced in the last quarter of 2018.
From a sector perspective, Technology, Real Estate, and Industrials led the way higher in Q1 while Healthcare and Financials were notable laggards. For the trailing six months, no surprise – interest rate-sensitive sectors performed the best, led by real estate and utilities.
Not to be overlooked, bonds also put up a banner quarter with the broad US benchmark returning 2.9% for the quarter, the best quarterly return in over three years and one of the strongest quarters this cycle. Credit sensitive sectors of the bond market showed even more impressive returns, but unlike risk-free assets, lower rated bonds were climbing out of a poor previous quarter.
What to Expect for Q2 and Beyond
Equity markets across the globe have returned more in the first quarter than the market expects for earnings growth for the full year. Consensus expectations for 2019 started to moderate late last year and have continued to do so. For the full year, consensus expects earnings growth of 3.9%, 4.9% and 7.0% in the US, EAFE and Emerging Markets, respectively. In our view, the next meaningful catalyst in the short to medium term will be a US/China trade deal and 2020 earnings expectations. As usual, the market has reallocated some of the previous expectations for 2019 into 2020. The market expects earnings growth of 11.7%, 7.7% and 13.1% across the US, EAFE and EM, respectively. The risk to this forecast will not be known until the second half of 2019. Starting next week, we will get the first meaningful Q1 earnings results. Perhaps surprisingly, the market is expecting the first negative year-over-year earnings deterioration since the oil & gas-led earnings decline in the first half of 2016. The market expects earnings to be down 1.5% year-over-year. We think there is risk to this forecast due to the large risk selloff in late 2018 and the government shutdown that lasted most of January this year. As a result, we expect negative surprises to be dismissed as temporary aberrations.
At 16.6 times forward earnings, the S&P 500 is slightly rich relative to historical valuations, however, they feel fair if not cheap relative to where interest rates are. Valuations have nearly completed the round trip. At the end of September 2018, US equities were trading at 16.8 times forward earnings. By the end of the year they were priced at 14.4x and at one point in late December were trading south of 14x.
Similarly, International and Emerging Market equities have bounced off their late 2018 levels. At 13.3x forward earnings, EAFE looks particularly cheap relative to the US and Emerging Markets as well as its own recent history. Emerging Markets valuations traded as low as 10x forward earnings and now sit at 12x. However, the rebound in valuations and returns has been accompanied by a continued decline in current year and forward EPS expectations.
After a year or more of talking about it, we finally have inversion across many parts of the US Treasury curve. At the Federal Reserve’s March 20th meeting, the majority of Fed Governors expected no interest rate hikes during all of 2019. This is a major departure from just three months ago where the majority of Governors expected at least two hikes this year. Additionally, the Fed announced they expect to end their balance sheet reduction program by the end of September this year. These significant changes in Fed policy in such a short time continued what has already been a major rally in the bond market over the past six months. In early November 2018, the 10-year treasury was trading north of 3.20%. At the end of Q1, the 10-year treasury had the same yield as the Fed Funds rate: 2.40%. This caused yield curve inversion from the shortest part of the curve all the way out through 10 years. This occurrence, of course, garnered a lot of attention in the financial press. An inverted yield curve is a rare occurrence and has historically signaled a future recession with a fairly high degree of certainty. However, the timing of the future recession is highly uncertain – in instances where it has correctly signaled the beginning of a recession, the recession has begun anywhere from 9-36 months later. Said another way, it has historically signaled the beginning of the end, but not necessarily the end.
If one takes a step back and thinks about what an inverted yield curve means, it’s quite extraordinary. In effect, the 10-year treasury is just an approximation of where the market expects the Fed Funds rate to be, on average, over the next 10 years. We have also made the argument the 10-year does not need to trade any higher than 25 bps over where we expect the long-run Fed Funds rate to be. That’s why we thought the 10-year looked very cheap at 3.25% because we did not expect the Fed Funds rate to top out above 3.00% this cycle. In our view, for the 10-year to go materially lower the market would have to expect a resumption of QE and/or a future maximum Fed Funds rate below 2.50%.
Lastly, the Fed Funds futures market is pricing in two full cuts in the next two years. Again, this is extraordinary. Against the backdrop of 2018 where earnings were up nearly 23% year over year, unemployment is sub 4.0% it would be hard to think of a reason for cuts except to explicitly support risk assets.
Brief Note on China
With the Federal Reserve out of the way and effectively on hold indefinitely, the focus has turned to China once again. The China trade deal is most likely the single biggest threat to the modest EPS expectations for 2019. We think the market is pricing in an amicable trade deal. The sticking point appears to continue to be around enforcement. It’s likely that China was holding out on making a deal until after the Mueller report was released. Had the report found collusion or other damaging information for the President, China would have found their hand strengthened in negotiations.
We will not go too deep on this issue other than to note we think the market had clearly priced in “no collusion.” The market rally in the weeks leading up to the release were likely aided by Democratic leadership starting to signal a finding of no collusion as the party started to track away from impeachment.
The views expressed in this newsletter represent the opinion of Custos Family Office, a Registered Investment Adviser. This material is for informational purposes only. It does not constitute investment advice and is not intended as an endorsement of any specific investment or services. The information provided herein is obtained from sources believed to be reliable, but no representation or warranty is made as to its accuracy or completeness. Investing in equity securities involves risks, including the potential loss of principal. While equities may offer the potential for greater long-term growth than most debt securities, they generally have higher volatility. International investments may involve risk of capital loss from unfavorable fluctuation in currency values, from differences in generally accepted accounting principles, or from economic or political instability in other nations. Past performance is not indicative of future results. Investments are not a deposit of or guaranteed by a bank or any bank affiliate. Please notify Custos Family Office if there have been any changes to your financial situation or investment objectives or if you wish to impose or modify any reasonable restrictions on the management of your accounts through Custos Family Office.