QUARTER 1 2019 COMMENTARY
In the first quarter, central banks around the globe abruptly reversed course on monetary policy. Initially responding to declining asset prices and then to weakening economic activity.
Stock prices achieved some of the most robust returns since the end of the global financial crisis in 2010.
The economic activity in the second half of the year has now come under more intense scrutiny. The primary focus will be whether economic strength continues to bring a resurgence in corporate earnings growth.
There is an increasing queue of privately held “Unicorns”, i.e. Lyft, Pinterest, etc., looking to go public in 2019. Second quarter sustained economic confidence is key to their successful offering.
The first quarter of 2019 brought with it a sharp and broad rebound in asset prices. The foundation for this change was put in place in late 2018 when central bankers around the globe pivoted significantly on monetary policy. Initially the Fed responded to increased market volatility and then data indicating a broad economic slowdown.
In the first quarter, global equities were up more than 12% in response to the new monetary policy accommodation. High-yield bonds were up 7.0% while commodities gained over 6%. The last time these asset classes enjoyed such robust and simultaneous gains was in the third quarter of 2010 when the world was emerging from a global financial crisis.
To better understand the recent rally, we must look back to late December when the Federal Open Market Committee (FOMC) formally guided the market to expect one or two interest rate hikes in 2019—half of what had been expected coming into the fourth quarter. This announcement was followed by Federal Reserve Chairman Jerome Powell’s February statements, which teed up markets for an even softer monetary policy:
2018 4Q: Key Market Total Returns
“We are now facing a somewhat contradictory picture of generally strong U.S. macroeconomic performance alongside growing evidence of cross-currents. Common sense risk management suggests patiently waiting greater clarity.”
Then, in March, the FOMC’s dot plot report (which shows interest rate projections for all members) indicated zero increases for 2019. Also in March, the Fed formally released its revised balance sheet normalization schedule, which further confirmed a softening in monetary policy. Previously, the Fed’s balance sheet was slated to shrink by $600 billion in 2019. The reduction was then revised to be just $200 billion. Reports of benign inflation helped the Fed justify its pivot on monetary policy.
The Fed’s actions are part of a worldwide shift in monetary policy. In the second half of 2018, the Chinese government announced stimulus measures that included a cut to the required reserve ratio and liquidity injections. The European Central Bank announced in March its plan to launch a third Targeted Longer-Term Refinancing Operation (TLTRO).
Throughout the first quarter bulls were sharpening their horns. In addition to monetary policy pivots around the globe, they were buoyed by the argument that poor U.S. economic data was the result of the federal government shutdown, rather than inherent economic weakness. Meanwhile, the bears were gnashing their teeth, pointing to slower economic growth and significantly reduced earnings expectations.
As if the bull-bear debate wasn’t complicated enough, enter the Unicorn. Traditionally, unicorns are mythical creatures with magical capabilities and a single, pointed, spiraling horn coming from their foreheads. In the investing world, a “unicorn” is an endearing term used to describe a startup company that has achieved a valuation of more than $1 billion. Yet these unicorns also have some mythical properties. They amass a significant amount of value in private and do not share financials until they file for their IPO. They also tend to be disruptive companies that challenge the status quo or, in some cases, create entirely new industries, like social media. This innovation can create mystery around how to appropriately value these kinds of stocks. Lyft was the first Unicorn to enter the fray in the form of a $20 billion, highly touted initial public offering (IPO). However, Lyft disclosed operating losses of nearly $900 million last year.
Other unicorns are expected to follow at a record pace in 2019, including Uber, Pintrest, Slack, and Airbnb. Uber is expected to command a market capitalization larger than Facebook’s $104 billion IPO, and the combination of these five are expected to be among the nine largest IPOs since 2012. The unicorns will certainly be cheering for the bulls: a positive capital market backdrop has been crucial for successful IPOs over the past decade. However, when a significant number of unicorns emerge at the same time as a record-setting IPO market, this typically signals the end of a market cycle. That’s because peak IPO volume tends to be associated with equity market tops, as occurred in 2000 and 2007.
During the quarter, small cap stocks outperformed large cap stocks while growth outperformed value. The Russell 2000 Growth Index gained 17.1% while larger growth companies, as measured by the Russell 1000 Growth Index, gained 16.1%. Both the Russell 1000 and 2000 Value Indexes were higher, returning 11.9%.
All sectors were materially higher during the quarter, and there were no strong underlying themes. Nine sectors generated double-digit returns; only health care and financials returns were in the single digits. Financials have declined by 5% over the past twelve months and are the clear laggard over that time period. In contrast to the rest of the market, financials fell by nearly 3% in March alone. Much of this weakness took place as Treasury yields declined materially, though the shape of the yield curve remains relatively unchanged.
For the quarter, the yield on the 10-year U.S. Treasury note moved significantly; it dropped by 28 basis points to end the quarter at 2.41%, which is the lowest level since December 2017. Nearly 20 basis points of the move occurred in the final week of trading after the March FOMC announcement and press conference. The two-year note followed a similar path; yields dropped 19 basis points to finish at 2.27%, the lowest level since April 2018. The spread between two- and 10-year yields finished the quarter at 14 basis points— a decline of seven basis points.
Lower quality fixed income securities were the best performing parts of the markets by a wide margin due to plunging interest rates and dovish central bank rhetoric. Municipal bonds, as measured by the S&P National Municipal Bond Index, gained 2.2%. The Bloomberg BarCap U.S. Aggregate Bond Index was up 2.9% in the quarter.
Both developed and emerging markets performed similarly to start the year. The MSCI EAFE Index was higher by 10.1% while the MSCI Emerging Markets Index was higher by 10.0%. Every country except Turkey posted positive returns.
In EU markets, the risk of a “hard” Brexit, whereby the United Kingdom chaotically leaves the European Union, appears to have increased dramatically, but that doesn’t seem to have affected the UK equity market, which returned 11.9% during the quarter. Even with Prime Minister Theresa May offering her resignation in order to resolve the Brexit issue, the government remains deadlocked. This “kick-the-can” mentality will only placate the markets for so long, so this situation remains increasingly important to monitor.
The European Central Bank’s third Targeted Longer-Term Refinancing Operation (TLTRO) is slated to begin in September. (The first two occurred in 2014 and 2016, respectively.) This recent move is in response to evidence that the economy is contracting, such as Germany’s Markit PMI dropping from 51.5 in December to 44.7 in March. It also comes less than three months after the central bank’s quantitative easing program ended.
China’s stock market reversed its slide by generating the second-best return in the MSCI Emerging Markets Index, up 17.7%. After the Caixin manufacturing PMI fell into contraction territory during the fourth quarter, it rebounded to 50.8 by the end of the first quarter. This may be the first sign that last year’s stimulus measures are improving the country’s underlying economic fundamentals. The Trump Administration continues to tease progress on the China trade front, which has the potential to move markets once details are announced, but it remains nearly impossible to gauge probable outcomes.
A historic accommodative stance seems peculiar, given the backdrop of record high prices across asset classes, a still growing economy, inflation near the ideal 2% level, and an unemployment rate of 3.8%.
The Fed is charged by the congress with two primary mandates: to maintain stable prices and foster full employment. We believe investors should consider that the Fed and other central banks have assumed a third mandate: to prevent short term declines in equities.
Combined with the “just-in-time” monetary policy we recently experienced, markets could quickly get pushed to extremes, which in turn would increase the probability of major policy errors down the road.