A total return of 13.6% from the S&P 500 would be considered to be a very satisfying year by most investors. After all, the long-term average annual return for this bellwether of the US stock market is just shy of 10% going back to 1926. This year, however, the strong result was achieved in just the first quarter, and represented the best start to the year since 1998.
Other equity markets also joined the party. The MSCI EAFE Index of developed market equities surged 10% and the MSCI Emerging Markets Index trailed slightly behind with a gain of 9.9%. It was the best start for the EAFE in 4 years and the best start for emerging markets in 8 years.
And the gains weren’t limited to just global stocks. Interest rates fell during the quarter, providing a solid lift to bonds (the Bloomberg Barclays US Aggregate Bond Index rose 2.9%, a broad municipal bond index gained 2.2%, while high yield jumped 7.3%) and especially interest rate-sensitive assets such as real estate investment trusts (global REITs up 14.3%) and infrastructure stocks (+15.9%). Oil surged by 26% during the quarter to just above $60 per barrel. The sharp rise in “black gold” sparked energy MLPs to a healthy 16.8% quarterly return.
The bullish sentiment stands in sharp contrast to the fourth quarter of 2018, when the S&P slumped 13.5% and other asset classes also fell sharply. Back then, investors were consumed by the prospect that the Federal Reserve was raising rates too quickly, and their objective of heading off future inflation would result in a crushing recession. The lack of meaningful progress on the trade discussions with China also contributed to the gloomy outlook.
The tide turned sharply around Christmas, buoyed by Fed Chairman Powell’s more conciliatory tone toward monetary policy. With inflation remaining below the stated target of 2% and no signs of imminent acceleration, the Fed felt comfortable announcing a temporary halt to its plans for additional hikes in 2019. Coupled with depressed stock prices and some progress on the China trade talks, the stage was set for the sharp rally across all asset classes that continued through the first quarter.
Outlook and Strategy
The good news is that a strong first quarter is usually followed by continued strength through the remainder of the year. According to Ned Davis Research, when the S&P 500 has gained more than 10% in the first quarter (14 times since 1930), it has risen the last 9 months of the year 85% of the time by a median of 7%.
With the Fed taking a more measured approach, investors appear to be less concerned about the prospects of a US recession in coming months. We expected a meaningful slowdown in US economic growth this year as the stimulative effects of the tax reform package began to wear off. In fact, US real GDP slowed sharply in the first quarter but is expected to rebound to a sustainable 2-2.5% rate for the rest of 2019. Employment growth remains solid, and the cyclical sectors of the economy (mainly housing, autos, and business investment) do not appear frothy or overextended. In short, barring some unforeseen event, we think the US economy can continue to grow at a reasonable pace.
Nonetheless, investors are still faced with a number of headwinds as we move into the second quarter. Global economic growth was disappointing in the first quarter, especially those countries with large export-oriented economies such as Germany, Japan, and South Korea. No doubt the ongoing trade disputes are creating uncertainty among business leaders, causing hesitation in their expansion plans. China’s growth rate has clearly slowed, impacted by high debt levels and the tariff duel with the United States. Despite optimistic announcements from both governments, no agreement has yet been announced.
The sharp rebound in stock prices in the first quarter has returned valuations to more normal levels, implying that future gains in stock prices will be driven largely by earnings growth. On that score, earnings should moderate from a robust double-digit rate last year to something in the mid-single digits in 2019.
As recent evidence indicates, the future direction of Fed policy will have a meaningful impact on asset prices. While the Trump administration is pushing Chairman Powell to aggressively cut rates to accelerate growth, the Fed is eager to build a cushion in its economic arsenal so that it has the tools to fight the next recession whenever that comes. At present, it appears that the Fed is comfortable with interest rates at their current levels. However, a resurgence of an inflationary threat (perhaps via sharply rising oil prices) could once again cause the Fed to reinstate its interest rate tightening policy, with renewed volatility as a likely outcome.
We recently revised our global tactical equity allocation to reflect increased confidence in the resiliency of the US economy. Despite attractive valuations, long-term structural problems led us to underweight our European equity exposure in favor of slightly greater exposure to the US. We are now officially neutrally-weighted to the US in our global equity portfolio. We remain overweight emerging markets, with a particular emphasis on the growth of the consumer in Southeast Asian economies. In general, we remain sanguine about the prospects for continued gains this year.
Learn more about our Director of Research, Bruce Simon.
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