April saw markets soar to new highs with the S&P 500 and the Nasdaq making the concerns over a recession following the inversion of the yield curve seem like a distant memory. More impressive than the rebound in equity prices, the forecast for Q1 GDP growth has risen from virtually 0 to just under 3% in just one month. (GDPNow) The markets have embraced the 'Powell Put,' but the recovery from the late 2018 selloff appears to be the dovish pivot by the Fed Chair.
The markets are placing confidence in more than just Jerome Powell, however. Entering 2019 the slowdown in China was a primary concern for many market participants fearing the global economy would follow China lower. President Xi of China has essentially provided markets with a put as well, adding stimulus to spur growth and keep Chinese growth rate above 6% (at least in official figures) (World Bank). We cannot forget that President Trump remains eager to tout a rising stock market as validation that his policies (tax cuts, deregulation, and trade) are working and creating prosperity.
The question investors must answer is whether or not earnings will continue to rise at a pace to justify the new highs. According to FactSet data, earnings in Q1 are projected to be 3.9% lower than they were in the same period in 2018. The S&P 500 is 12% above where it ended Q1 last year, suggesting valuations are being stretched. Also contributing to the strength in stocks is how companies are choosing to allocate higher cash flow from lower taxes and repatriation of cash from overseas. Over $1 trillion in stock buybacks have occurred over the last 12 months as companies have taken advantage of low-interest rates in a speculative debt-for-equity exchange. Price-insensitive buying of record levels of company stock with the markets at all-time highs could be viewed as a sign of desperation as companies see margins fall and profits decline.
The Fed's 180-degree turn in January did boost confidence for consumers taking the University of Michigan Consumer Sentiment survey back near the highs of 2018. Small Business Optimism is also very high with 60% of respondents to the NFIB survey saying they have recently made capital outlays. Lagging behind in sentiment readings is CEO Confidence that remains closer to the lows of late 2018. The gap between those optimistic about the future and those pessimistic is at a cautionary -30.
Powell has given confidence to consumers and investors that they can go back on offense after they were forced to play defense when the consensus was that the Fed was going to go too far in tightening monetary policy. What seems clear is the relative level of interest rates is far less important than the direction the Fed signals it is taking monetary policy. At some point, however, the economy is going to need CEO's to have enough confidence about the future to commit to capital spending rather than buying back their own stock.
We are entering the time of the year that has historically been the seasonally weak period (May through October). Earnings are contracting, and uncertainty about trade is growing. Prospects for a mutually beneficial deal with China appear high at the time this is written, but Trump has gone to Twitter to express the possibility of tariffs on European cars if more favorable trade terms are not agreed to. The wishful thought that domestic politics would simmer after the publication of the Mueller report was overly optimistic as the thought of initiating impeachment hearings seems to be magnified. The inversion of the yield curve in March was short-lived and no longer appears to point to a recession in 2019.
Momentum is strong to the upside and with almost 50% of S&P 500 companies already reporting their Q1 earnings, three out of four companies have exceeded consensus estimates. The expectations of a rate cut before the end of the year is creating a Goldilocks scenario. Inflation, using the Fed's preferred Personal Consumption Expenditures (PCE), remains muted, taking all pressure to tighten financial conditions off the table for now. The summer trading season with low volumes and higher volatility still pose a risk, particularly for conservative investors who do not have the stomach for rapid drawdowns.
In Search of a Recession
One of the most compelling indicators that demonstrate the state of the global economy is how many countries are in a recession at any given time. All economies are in a constant state of flux and expanding or contracting at different paces. Using the formal definition of a recession — two consecutive quarters of negative growth — there are currently fewer nations in recession than ever before and the number is expected to decline over the next two years, according to the IMF. This phenomenon can in part be attributed to aggressive monetary policy, negative interest rates, and QE for example, that appears to keep slowing economies from tipping over into negative growth. Those same policies are very likely to stifle long term growth in those same economies.
• The Eurozone is at risk of making the IMF forecast extremely inaccurate. Each of the 19 countries has seen Industrial Production fall to contractionary levels, raising the likelihood of a recession within 12 months.
• Global trade remains one of the greatest risks to economic expansion as countries jockey with each other to create "free trade." If tariff wars were to intensify or spread to additional regions, growth would be impacted.
• Many economists openly question the value of focusing on whether a country is in expansion or contraction and suggest long term growth rates are a much better sign of economic health and future opportunity.
Technical - Calm Before the Storm?
After rising sharply in December, the CBOE Volatility Index has trended lower for most of 2019 (thanks in large part to the Powell Pivot). In mid-March, the 50-day moving average on the VIX crossed over the 200-day moving average in what amounts to a buy sign for equities to many technical traders. There have been horrendous terror attacks, no solution for Brexit and the possible disruption it will cause, a report from the special counsel that amazingly convinced each side they were right, yet investors have treated these events with a yawn and a ho-hum. Earnings, while forecasted to be lower than the same period one year ago, continue to come in slightly higher than expected in over 75% of companies. Time will tell if the world is as safe for risk assets as the VIX is suggesting.
Fixed Income - Who is Your Master?
An ancient Proverb states that the borrower is a servant to the lender, and has been proven true, both corporately and when individuals overindulge in debt. While much is made of China being a major holder of U.S. government debt, the reality is that over 70% of the more than $21 trillion in total debt (does not include the massive level of unfunded liabilities) is held domestically. China and Japan each own approximately $1 trillion in U.S. Treasuries, and Russia, not surprisingly, has been the largest seller of UST's, reducing their holdings from $150B to just $15B today. U.S. investors are the largest block of debt holders, led by private and state pension plans. These investors are also acquiring approximately 80% of the new issuance of debt, and demand for this safe haven paper does not appear to be slowing.