Pendleton Street Advisors

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Investment Commentaries: First Quarter 2019

Index Returns 1st Quarter Trailing 12 Months
S&P 500 US Large Cap Index 13.6% 9.5%
MSCI All Country World Stock Index 10.3% -4.2%
Barclays Capital Aggregate Bond Index 2.9% 4.5%
US Core Consumer Price Index - (Inflation) 0.5% 2.1%

*All figures as of 3/31/2019 unless otherwise noted.

After an abysmal end to 2018, most asset classes reversed course and have been rising steeply so far in 2019. A halt in interest rate increases by the Federal Reserve along with growing clarity around global trade issues resulted in improvements in economic outlook and market sentiment.  Going forward, we expect markets to be highly sensitive to any changes in the Federal Reserve’s approach to monetary policy as well as any new developments in trade reform. While market reactions to those two topics will continue to drive volatility and likely dominate investor-attention, our primary focus will be on how those and other factors impact the fundamental drivers of investment value across security-types (stocks, bonds, etc…); economic sectors; and in underlying companies.       

Market Overview

Q1 was a good quarter for stocks, but markets are still recovering from 2018. After falling by close to 20% in December from its high in September, the S&P 500 index of US Large Cap stocks is now only 2% below its previous September 20, 2018 high.  Small caps and foreign stocks experienced similar gains during the quarter, but still have a wide gap to close in order to return to their previous highs.

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Downturns and increased volatility have been going on for a while. While US markets entered a downturn seven months ago in September of 2018, foreign stocks began their decline in January of 2018.

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Volatility stepped up in 2018 and has stayed higher. Market volatility was unusually low in 2017 but has not returned to those lower levels since spiking in January of 2018. Stock market volatility is a concern, and while it is not entirely avoidable, we strive to manage portfolios with a long-term perspective that recognizes short-term volatility for what it usually is: noise.

Investor-confidence has returned right along with market levels. Investor-confidence has historically been significantly higher just-before market downturns. Given the quick return of high confidence, more near-term volatility should not be a surprise. 

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The US Treasury bond yield curve has been a major source of concern for markets, as an inverted (i.e. downward sloping) yield curve has been a fairly accurate predictor of past recessions. We are concerned that the yield curve inverted in late March, although the 10-Year Treasury yield has since climbed back above the 3-month T-Bill yield.

Keep in mind that while an inverted yield curve has been a good indicator of recessions, it has been terrible at indicating WHEN a recession will begin. Since 1968, recessions have begun anywhere from 5 to 18 months after the yield curve becomes inverted. Market performance in the intervening period has ranged from  -14.6% to 16.5%. 

The inverted yield curve is more like a tornado watch than a tornado warning.   The conditions for a tornado are present, but no funnels have been spotted, yet. When and where a twister starts is unknowable until it happens. Until then, everyone is watching the skies and the weather-radar for indications that a touch-down is imminent. For investors, this means staying aware of changes in economic conditions and company fundamentals.

Economic Conditions

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Key indicators suggest that the economy is currently in the late phase of the expansion that began in 2009. Real GDP (which excludes the impact of inflation) grew by 2.85% in 2018, which is higher than the two previous years, and just below the 2.88% growth seen in 2015. If GDP growth remains positive in the first quarter as expected, the current expansion will be three months away from matching the longest expansion on record (121 months from 1991-2001). 

Underlying indicators are mostly positive: Personal Consumption Expenditures, which make up approximately 70% of GDP, grew in January (the latest data-point) at an annualized rate of 2.29% vs. the same month last year. The labor market continues to show signs of strength, with the unemployment rate dropping to 3.8% in February (close to the 49-year low of 3.7% reached in September 2018).  Job-creation extended a record in February by reaching 101 months in a row of net job gains. As it stands, the labor market indicates smooth travels, with the caveat that labor markets have historically been at their best just prior to the start of a recession. This suggests investors should remain vigilant.  

Residential and Non-residential (i.e. commercial) fixed investment make up another 17% of GDP. While Non-Residential fixed investment increased by 7% during 2018, Residential Fixed Investment declined by -3.26% for the year. Going forward, we expect higher mortgage rates to continue to negatively impact Residential Fixed Investment.

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While we expect Non-Residential fixed investment to continue growing, we have seen erosion in manager outlooks at both large and small companies. For example, the National Federation of Independent Business Index of Small Business Optimism has dropped significantly over the last few months, suggesting that small business owner/operators are losing confidence in the expansion. Additionally, a majority (53%) of business-owner respondents to the CNBC/SurveyMonkey Small Business Confidence survey now expect a recession to begin sometime in 2019.


Respondents to McKinsey & Co’s Global Economic Conditions survey, which includes larger companies that operate globally, have become increasingly less certain that economic growth will continue in the near-term. While 65% of respondents expected growth to increase in the six months following the March 2018 survey, that number dropped to 34% in March 2019. This increase in business uncertainty could result in reduced business investment, following a year of strong growth.

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Corporate Earnings are expected to grow in 2019, albeit at a significantly slower pace than the previous two years. The expected slow-down in growth is mostly attributable to the end of the temporary boost to growth caused by tax reform, as well as expected impacts of friction caused by uncertainty regarding global trade relations.

Valuations based on earnings are higher than average, indicating that stocks are currently fair-to-over-valued in aggregate. While prices have climbed much higher relative to earnings in the past, above-average valuations with slower growth are more reason to be prepared for the possibility of a more significant and prolonged market decline.

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Bottom Line: Currently, the economy and corporate profits are still growing, but the presence of historically low unemployment; an inverted yield curve; a declining housing market;  and worsening business and consumer confidence, combined with  the fact that we are late in the current economic expansion all suggest that the number of threats to continued market strength is catching up to the number of opportunities.  

In client portfolios, we continue to assess and adjust current holdings based on quality. In other words, we want portfolios positioned to weather the storm before the “watch” becomes a “warning.”

We value frequent communication with our clients, to discuss changing conditions and to ensure that we understand and stay updated on your objectives. We do not take lightly your patience or the trust you place in us as advisors, and we look forward to speaking with you soon.

Matt A. Morley, CVA, CEPA
Chief Investment Officer

CommentariesMatt Morley