While the last quarter of 2018 turned out to be one of the worst on record, the first quarter of this year will likely be seen as one of the best. Santa Claus showed up right on time, and the January 4^th follow-through confirmed that we are still in a major bull market.  Perhaps most of the credit should go to Federal Reserve Chairman Powell, who reversed his interest rate tightening campaign and more or less guaranteed no further increases this year. We suspect, however, that the other defining factor was that investors finally realized that business is good and should get better in a low-growth, low-inflation, and low-wage-pressure environment. We think the economic expansion will continue for many quarters to come, a positive backdrop for equities.

To be sure, the business environment was always good with personal income and spending rising, while the core PCE deflator, the Fed’s favorite gauge of inflation, is below 2%. With such numbers, the Fed had no choice other than to shift to a neutral policy. We did see a slight inversion of the yield curve on the short end, but this has happened several times in the past without dire consequences. For the moment, we look at it only as a warning sign. A curve that was 25 basis points inverted for roughly a quarter would be more worrisome.

There are still a number of things that need to go right to sound the all-clear signal. We still do not have a U.S./China trade deal. Brexit, while postponed, is still on the horizon, as is the U.S. raising the debt-ceiling and other political considerations. Progress is being made however, and we expect to see more in the future. The most recent economic numbers are the most promising: The U.S. Manufacturing PMI was 52.4 in March—solidly in expansion territory. Though U.S. retail sales took a dip in February, both January and March were higher, with March showing the strongest increase in the past 18 months. Construction spending rose 1% in February. These are all indications of a slow-but-continuing economic expansion.

Since Standard & Poor’s started keeping score back in 1926, the index has delivered double-digit returns in the first quarter 14 times. There were only four years when the S&P 500 didn’t go on to post a 20% + year, and of those four only 1930 saw a decline. We expect that there will likely be normal pullbacks, particularly after such a strong first quarter and a fairly sloppy earnings season, but we are optimistic for the remainder of the year. We also like what we see in the equity market itself, with broadening participation and some of the more cyclical areas showing strength. These and other data points suggest more economic strength than currently forecast. One of our favorite indicators—copper vs. gold—is telling the right story. Copper, the most widely used industrial metal in the world, is rallying, while gold, the symbol for a safe haven, is not.

April 2019

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WELCOME TO 2019

The S&P 500 fell 6.2% last year, not including dividends. Volatility picked up as central banks became less accommodating with both federal funds hikes and balance sheet drain. The European Central Bank also started tapering. Most asset classes struggled while the U.S. yield curve flattened. Equity market volatility intensified in December and consumer confidence fell, partly in reaction to hawkish remarks by the Federal Reserve. Earnings, however, grew an estimated 22% last year, and perhaps a little bit more. The result of these seemingly contradictory factors? A contraction in the market’s price/earnings ratio—the fifth largest decline since World War II.

So far this year the S&P 500 is up 5%—and we expect further increases ahead. An analysis by UBS recently looked at 26 cases since WWII of meaningful price/earnings declines for U.S. stocks in a single year. It found that the median returns the following years were 16%.  Much will depend on the manmade headwinds negatively impacting the major economies. It would appear that the U.S. Federal Reserve has come off autopilot and may slow interest rate hikes. Investors are also starting to predict a possible resolution to the U.S./China trade discussions. No trade war escalation will eradicate a major headwind—though keeping the recent tax cuts in place, along with increased government spending, will more than offset current trade risks.  The removal of the tariffs should improve capital spending, the life blood of future economic growth, which has been hobbled in recent months. Additionally, 2018’s combined incremental benefit of consumer tax cuts and lower gasoline prices could increase in 2019.

While we have a constructive outlook on the future level of equity prices, we don’t think it is time to blow the all-clear signal just yet. A lot of what we have talked about is solvable but the resolutions still lie in the future. If we factor in the host of global economic problems and the disarray in Washington, there is reason for some caution. U.S. economic growth will probably slow to around 2.5% this year and corporate profits to the low single digits. But slowing economic growth and profits should not be confused with negative growth. Historically speaking, the former outcome does not end in a recession or a bear market. Our concern is the damage done to the equity markets in a very short period of time resulting in the worst correction since 2011. After such corrections, it often takes the market several months of volatility before it establishes a base from which to move sustainably forward.

January 2019

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