Originally published Apr 8, 2019
The market typically loves a dovish Federal Reserve (Fed), and now it has one. The Fed’s turn amid more accommodative global monetary policy supported equity markets in Q1. But what that portends following the market’s best opening quarter in nearly a decade could be another story. Increasingly downbeat tones about growth will test investors in Q2. So too will corporate earnings, as the high from tax cuts fades and trade uncertainty lingers.
What to know: Fed pivots
A hawk just three months ago, the Fed held rates and guided toward the possibility of no interest rate hikes in 2019 at its March meeting. That is quite the reversal. The market began 2019 expecting two hikes. Now it expects the Fed’s next move to be a cut.
The dovish stance is likely a sigh of relief for consumers, and borrowers in particular. However, the degree of dovishness at the FOMC meeting in March seemed to startle market participants and ratcheted up concerns about future economic growth.
The Fed also signaled the end of its quantitative tightening plan. Balance sheet reduction will remain at $50 billion per month until May; thereafter, it will be reduced to $35 billion per month until it ends in September.
What to watch: Faltering growth and more
Any signs of weakness in the U.S. and global growth stories will be front and center. Softer consumer spending and a weaker environment for business drove a downward revision of U.S. GDP growth for Q4 2018 from 2.6% to 2.2%. Such weakness in economic activity is expected to continue into Q1’s GDP numbers.
For 2019, the Fed lowered its expectations for GDP from 2.3% to just 2.1%, and from 2.0% to 1.9% for 20201. In our view, the risks are high for growth to be even lower.
On March 22, the first meaningful inverted yield curve since 2007 stoked recession fears. The yield on 10-year Treasuries fell below that of three-month and one-year Treasury yields, a somewhat accurate recessionary signal at this part of the curve. The yield curve returned to positive territory a week later, but the market will be watching every flirtation with inversion closely.
The potential for global weakness to spread is a focus. The expected slowdown in earnings and the possibility of the Fed flipping on a dime again are too. But we also highlight that:
- The debt ceiling doesn’t get much attention, though it should. The U.S. government’s debt rating is at stake. Extraordinary measures in place to avoid hitting the debt ceiling are only expected to last until the fall.
- The U.S. and China continue to talk trade. The stakes increase by the day as the two sides debate intellectual property and market economy issues, as well as acceptable deal enforcement measures, e.g., tariffs.
- Taxpayers may not get the refunds they were hoping for or expected. A Fed indicating slower growth, coupled with small or non-existent tax refunds, could dampen consumer sentiment.
As for Brexit, the risk feels inherent almost three years after the referendum. The wide-ranging repercussions of a hard, soft, somewhere in between or no Brexit are many. But at this point, the market’s attitude appears to be, “Wake us when you’ve got something and we’ll deal.” A second referendum on Brexit is now possible.
Q1 recap: Lessons learned
Markets don’t always go up. That was Q4 2018’s lesson. The lesson from Q1 is don’t underestimate the market’s resilience. Another one is running from a correction - even a significant one - can be costly.
January proved to be one of the strongest opening months on record for the S&P 500 and set the stage for a strong quarter overall.
The government shutdown, the debt ceiling and the Brexit deadline did little to deter investors. Interestingly, investors knew all about those risks, and others, during the Q4 correction. But investors paid them no mind and moved back into stocks, likely emboldened by central bank easing amid cooling economic growth.
Equities: Pain subsides
The S&P 500 Index regained 98% of what it lost in Q4 and returned 13.6% for the quarter. International equities were strong too, as the MSCI World ex USA NR USD Index returned 10.4% and the MSCI Emerging Markets (EM) NR USD Index 9.9%. Canada was a standout developed market performer due to WTI crude prices rising 32.4% to $60.14/barrel.
Small-cap stocks got off to a strong start in Q1, but economic growth concerns weighed on performance relative to larger-cap stocks in March. The Russell 2000 Index returned 14.6% and the Russell 1000 Index 14.0%.
Growth stocks rebounded. The Russell 2000 Growth Index’s 17.1% return led the pack, followed by the Russell 1000 Growth Index at 16.1%. Value ended Q1 with the same performance across the size spectrum. Both the Russell 1000 Value Index and the Russell 2000 Value Index returned 11.9%.
U.S. sectors: Return to risk-on
Growthier sectors that pulled back at the end of 2018 found a supportive environment amid relatively subdued volatility throughout Q1. The Cboe Volatility Index® (VIX® Index) started 2019 at 25.42 and dropped to 13.71 by the end of Q1.
Overall, nine of the 11 Global Industry Classification Standard (GICS) sectors notched double-digit growth in Q1. Information Technology (+19.9%), Real Estate (+17.5%), Industrials (+17.2%), Energy (+16.4%) and Consumer Discretionary (+15.7%) performed the best. Notably, four of these sectors were the weakest sectors in Q4. Real Estate is the only sector to appear in the top performers list for two consecutive quarters.
- Information Technology (Tech) almost completely recouped its Q4 losses.
- Energy has a long way to go to get back to its September levels; however, higher WTI oil prices create a more supportive environment.
- Industrials led the pack through the first half of Q1 but retraced some of its gains when growth concerns resurfaced in March.
- Real Estate had a strong end to the quarter, fueled by the more accommodative Fed and the decline in yields.
On the other side, Health Care (+6.6%), Financials (+8.6%), Materials (+10.3%) and Utilities (+10.8%) were the weakest sectors in Q1.
- Health Care held up well in the second half of 2018 and had less ground to make up in Q1, though the renewed focus on dismantling the Affordable Health Care Act remains a headwind.
- Financials had a good start to Q1, but the Fed’s dovish turn weighed on performance due to the likely adverse effects on net interest margins.
- Materials experienced downward pressure due to concerns about slowing global growth as well as the ongoing U.S.-China trade dispute.
- Utilities was the only sector with a positive return in Q4, and while the performance was positive in Q1, it lagged the market.
Fixed-income: Duration and risk assets lead
Fixed-income performance was slow and steady in Q1. The Bloomberg Barclays U.S. Aggregate Bond Index returned 2.9%. The shift to a more dovish-than-expected Fed had a significant effect on the fixed-income market, as did the shape of the Treasury yield curve.
At the end of 2018, concerns about inversion at the short end of the yield curve rose. By March, concerns extended to the 10-year/3-month and 10-year/1-year segments. The 10-year yield started 2019 at 2.69% and ended February at 2.73%, before declining sharply to end the quarter at 2.41%.
Long duration underperformed short duration until mid-March. However, the sharp decline in long-term yields following the March FOMC meeting changed that amid the yield curve concerns.
With risk back on, preferreds, high yield corporates, emerging market debt and investment grade corporates had a good quarter.
Corporates benefited from a tightening yield spread with Treasuries. In particular, the spread between investment grade corporates and the 10-year Treasury, as measured by the U.S. Corporate BBB/Baa 10-year Treasury Index, started 2019 at 1.86%, declined sharply in January, plateaued thereafter and ended Q1 at a quarter low of 1.59%.
Treasuries and mortgage-backed securities were the two weakest fixed-income segments, as they took a back seat during the shift back into riskier assets.
Overall, during Q1, markets were less concerned about the uncertainty than during the prior quarter. Markets have greater confirmation that monetary policy will be flexible amid a global slowdown. And while Q1 proved to be a very strong quarter, investors should manage expectations for the remainder of the year, as Q1 is likely not replicable. Instead, investors should look at more focused exposures, which may include a component of thematics.
All data sourced from Bloomberg
1. Federal Reserve, Economic Projection Data Release, March 2019
S&P 500 Total Return Index: The index includes 500 leading U.S. companies and captures approximately 80% coverage of available market capitalization.
MSCI World ex USA Net Total Return Index: The index captures large- and mid-cap representation across 22 of 23 Developed Markets countries, excluding the United States. With 1,017 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
MSCI Emerging Markets Net Total Return Index: The index captures large- and mid-cap representation across 24 emerging market countries. With 845 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
Russell 1000 Total Return Index: Consists of the largest 1000 companies in the Russell 3000 Index. This index represents the universe of large capitalization stocks from which most active money managers typically select.
Russell 2000 Total Return Index: Consists of the smallest 2000 companies in the Russell 3000 Index, representing approximately 8% of the Russell 3000 total market capitalization.
Russell 1000 Growth Index: The index measures the performance of those Russell 1000 companies with higher price-to-book ratios and higher forecasted growth values.
Russell 1000 Value Index: The index measures the performance of those Russell 1000 companies with lowest price-to-book ratios and lowest forecasted growth values.
Russell 2000 Value Total Return Index: The index measures the performance of those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values.
Russell 2000 Growth Total Return Index: The index measures the performance of those Russell 2000 companies with highest price-to-book ratios and highest forecasted growth values.
Cboe Volatility Index® (VIX® Index): The Chicago Board Options Exchange SPX Volatility Index, commonly referred to as VIX, reflects a market estimate of future volatility, based on the weighted average of the implied volatilities.
Global Industry Classification Standard (GICS): This is a standardized classification system to sort business entities by sector and industry group. It consists of 11 sectors, 24 industry groups, 68 industries and 157 sub-industries.
Bloomberg West Texas Intermediate (WTI) Cushing Crude Oil Spot Price Index: Designed to track the spot price of WTI.
Duration: Is a measure of the sensitivity of the price of a fixed-income investment to a change in interest rates. Duration is expressed in years.
Bloomberg Barclays U.S. Aggregate Bond Index: The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-through), ABS and CMBS (agency and non-agency).
U.S. Corporate BBB/Baa 10-year Treasury Index: This is a Bloomberg-provided spread index of the difference in yield between the U.S. Corporate BBB/Baa Index and the yield on 10-year Treasuries.
U.S. Corporate BBB/Baa Index: This is a Bloomberg-provided yield index that is constructed daily using USD-denominated senior unsecured fixed-rate bonds issued by U.S. companies that have a Bloomberg composite rating of BBB/Baa.
Credit default swap: These are financial contracts used to mitigate the possibility of loss arising from default by the issuer of the bonds. As the probability of default increases, the premium rises. Similarly, as investor sentiment improves, or equity market volatility subsides, these spreads improve. An increase/decrease in the swap rate will put downward/upward pressure on the underlying bond index.
Markit CDX North America High Yield Index: This index tracks the credit default spread on 100 non-investment grade entities that are domiciled in North America.
Basis point: A basis point is a hundredth of one percent. It is predominantly used to express differences in interest rates.
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