Tuesday, April 2, 2019
- The Fed's "dovish pivot" helped the S&P 500 register its best quarter in ten years.
- The 3M - 10YR spread inverted for the first time since 2007 and Fed Fund Futures are now pricing a 64% probability for a cut by December.
- 10-year Treasury yields made 15-month lows (2.34%) in late March.
- Lower rates drove alpha in the bond proxy Utilities and REITs, yet technology outperformed all sectors in March and Q1. The rate sensitive financials underperformed over both time frames.
- Earnings growth is expected to be negative in Q1 (-3.7%) and there is high risk for an earnings recession with current projections for Q2 at +0.1%.
- 2H'19 looks better with Q3 and Q4 earnings growth expected to rebound +1.7% and +8.1%.
- Speculation for a positive U.S./China trade resolution has helped stocks.
Coming off its worst quarterly performance since 2011, the S&P 500 rebounded 13.1% in Q1 for its best quarterly performance in ten years. The rebound is being largely attributed to an oversold bounce, improving expectations for a trade deal with China, and maybe most importantly a "dovish pivot" by global central banks. While the first two months of 2019 were a virtual straight line higher, a healthy dose of caution surfaced in March as inversion extended further out on the curve to the 3M - 10YR spread for the first time since 2007
For the quarter the Nasdaq 100 and Composite indices continued their leadership role with gains of 16.6% and 16.5% followed by the small and midcap Russell 2000 and S&P 400 indices with gains of 14.2% and 14%. The large cap S&P 500 and Dow Jones Industrials followed with gains of 13.1% and 11.2%. The Russell Microcap gained 12.8%. All indices registered gains in January and February, but for March the small and mid-cap indices (Russell 2000, S&P 400, and Russell Microcap) finished in the red. And while the large cap INDU and SPX underperformed, they are the closest to breaking out to fresh 52-week highs.
Technology leading the way
Despite global growth concerns and on again, off again trade discussions with China, the tech sector continues to stage a nice rebound this year with March being no exception. So far, the consumer continues to be willing to spend more on goods and services including technology. Confidence remains elevated helping to support the sector over the near term. In addition, the space has seen merger and acquisition activity pick up which has also been positive for the group. Earlier this month Nvidia announced it was purchasing Mellanox for $6.8 billion and just recently On Semiconductor announced it was acquiring Quantenna for $24.50 per share.
Technology was not only the top performer for the month but is also the strongest sector for the quarter, performing at its highest level since 2012. For the month information technology was +4.75% and for the quarter up a whopping 19.37%, largely retracing Q4 losses of 17.7%. Within technology for the month the hardware and equipment sector were up 6.47% followed by semi and semi equipment stocks at 4.18% and software and services at 4.10%. Looking at the quarter the hardware and equipment sector was up 20.07% followed by the software services index at 19.12% and the semi and semi equipment sector at 19.10%
For U.S. stock indexes to move meaningfully higher, technology stocks, as the largest weight in the S&P 500 index (21%) will have to participate. If not, Healthcare and Financials (combined 27% weight) will have to take the leadership mantle - and this seems difficult given Financials' recent performance. Otherwise 2Q could be tough. Put another way, Materials and Utilities can rally all they want but with 3% S&P 500 weights each, these groups don't really move the needle for the broader market.
10-year U.S. Treasury yields made 15-month lows in late March bottoming at 2.34%. At this time the yield on the 10-year bond dipped below the 3M bill for the first time since 2007. This was a risk which markets debated going into the last rate hike at the December 19 th FOMC meeting.
The primary concern is whether the inversion is signaling an upcoming recession, albeit with a lag. While the short end from the 3M out to the 7YR remains inverted, the 3M - 10YR spread quickly turned positive, and the longer 5YR -30YR spread has actually been widening since the summer of 2018.
Ironically the 3M - 10yr inversion was driven by the March FOMC meeting whereby the Fed double downed on its dovish pivot following a number of hawkish miscommunications in Q4. The Fed now expects to end to its balance sheet reduction program (QT) by September, an about face from December's "autopilot" commentary, and it also reduced its 2019 rate hike expectations from two to zero. Markets seemingly view this less as a "Fed put" and more as a sign the economic cycle could be near the turn. While Powell said there was no bias about the next direction, hike or cut, markets were pricing in as much as a 75% probability (currently at 64%) the Fed's next move will be a rate cut by December.
Commodities had their best quarter in three years with the Bloomberg Commodity Index (BCOM) gaining 5.7%. Crude oil was the main driver due largely to supply concerns as demand held relatively steady. WTI rebounded 32.4% in Q1 after a dreadful 38% decline in Q4.
Earnings estimates have been falling since the beginning of the year. Fortunately for the stock market, interest rate expectations have also fallen sharply, supporting equities. When January began the aggregate estimate for S&P 500 earnings growth was 2.9%. However, analysts have been cutting 1Q estimates every week during the quarter and the expectation is now for an earnings decline of 3.9%, which would be the first decline in quarterly earnings since Q2 2016.
Second quarter estimates have also been falling, currently hanging on to positive territory by a thread at +0.1% for the past three weeks. Bulls seem to be hoping for an earnings rebound in Q3 and Q4 (+1.7% and +8.3% growth respectively), but this feels tenuous since Q3 estimates have also been declining and Q4 just feels as though people have not gotten around to revising them yet.
Part of the reason the market is not reacting more negatively to the low earnings growth number is the fact that revenue growth is still looking positive with estimates ranging between 4.3% and 4.8% for all four quarters in 2019. Wall Street can be more patient with a margin problem than a broader macro revenue problem. For the first quarter, the Fed's dramatic change in posture towards rate hikes has allowed equity holders to be patient. One-year forward P/E's have recovered from their December lows below 15 and sit at about 17X expected 2019 earnings. Still, P/E's remain below September 2018 levels despite the lowered earnings expectations.
Investors are concerned about global growth as evidenced by simulative central bank policies in Europe, the U.S. and China. This fact was brought home dramatically on March 22 nd when preliminary Germany Manufacturing PMI results were released. Analysts were expecting a 47.8 reading and instead were treated to a multiyear low reading of 44.1. Germany, for which exports represent almost half of GDP, is a key engine for Eurozone economic growth. PMIs have indicated a slowdown for this export powerhouse in 2019 but the magnitude of the miss surprised investors and caused the Dow to fall over 400 points on fears of decelerating global growth. German 10-year bond yields turned negative that day for the first time since September 2016 and have stayed under water since. If there is little global growth it will once again fall upon central banks to support economies (and stocks).
One positive development: On the first day of April the Dow gained 329 points after China's PMI figures indicated growth for the first time since November. U.S. figures followed suit with a better than expected 55.3 reading vs. 54.5 expected. Germany has seen declining manufacturing growth for over a year, while China's efforts to stimulate its economy may be working. Recall that index values over 50 indicate growth. Can a growing China offset Europe's weakness?
Volatility has been trending lower since Christmas but spiked on March 21st following the German Manufacturing PMI report.
The VIX had been dropping all year falling as low as 12.9 on 3/15 before spiking to 16.5 on 3/21, then resuming a downward trend to end the quarter at 13.7 compared to the 12/31/18 value of 25.4.
Stocks and bonds are adjusting to a new paradigm of lower growth and a belief that the Fed overshot by raising rates in December. The Fed is now on hold and markets are pricing in a cut by year end. While the "Fed put" is generally seen as a positive for stocks, history shows the start of rate cuts typically marks a turn in the economic cycle and the reason why spreads go from inversion to positive. We have not yet reached this point. Despite slowing economic activity and flat to negative corporate earnings growth, a shift towards accommodative polices coupled with hopes for a China/U.S. trade resolution has stocks close to all time highs.
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