Central Bank Pivot Spurs Vigorous Rebound in Stocks
If the closing months of 2018 showed how quickly sentiment can curdle in the global equity markets, the opening months of this year demonstrated how swiftly it can rebound. The willingness of the Federal Reserve and other central banks to step back from monetary tightening provided a jolt of horsepower. The gains were aided by a sense that the gloom pervading markets last year was overblown, as the U.S. economy once again provided ballast for the rest of the world. Still, the global economy must contend with ebbing growth, particularly in China and Europe, and the markets’ direction may hinge on whether economic activity reaccelerates.
The forces that have long guided the U.S. economy — low unemployment, rising wages and healthy consumer confidence — continued to hit their marks. The S&P 500 jumped 13.7% in the quarter, ending a mere 2% off its peak last September. The MSCI EAFE Index gained 10%, while the MSCI Emerging Markets Index rose 9.9%. Including their superior results during last year’s selloff, defensive stocks have led the market over the past six months.
However, the signal from the Fed that it is likely to halt interest rate hikes for the rest of the year — and conclude its balance sheet reduction on an early timetable — underlined risks lurking below the surface. Despite solid numbers overall, the pace of economic activity has moderated. GDP and earnings growth are expected to slow this year, and the twin pillars of corporate tax cuts and bulked-up government spending that goosed the economy in 2018 have begun to weaken. Beyond that, the heavy debt that companies have taken on to finance stock buybacks, dividends and mergers looms as a potential millstone at a time when the recent rally has driven U.S. equity valuations back above their 15-year average.
With the U.S. already in a late stage of the business cycle, these risks led to a sharp decline in interest rates and raised concerns about a potential recession. Capital Group economists do not believe a recession is imminent, although current data suggest one could begin in 2020 or 2021. One of our U.S. economists delves into this subject in the story here.
Even as the first quarter underscored the economic challenges, it also highlighted the risk of trying to time the market, as anyone who exited stocks when the outlook dimmed last year would have watched the rebound from the sidelines. In fact, history shows that missing just the first month of an equity recovery can significantly reduce overall results. Since 1990, the S&P 500 has suffered 14 corrections. On average, the index ballooned 29.1% over the following 12 months. However, a sizable chunk of that gain came early on, with stocks jumping 9.2% in the first month.
Trade tensions aggravated China’s economic woes.
The near-term prospects of the U.S. may depend in part on the rest of the world, especially China, where growth has throttled back to its lowest pace in nearly 30 years. Major segments of the economy have cooled, including housing, exports, manufacturing, consumer spending and business confidence. The deceleration stems partly from structural trends such as a declining workforce and lower productivity growth, and has been worsened by the trade dispute with the U.S.
In contrast to its actions in past economic hailstorms, the Chinese government appears disinclined to initiate dramatic efforts to spur growth, according to an analysis by Capital Group’s Asia economist. Policymakers fear that a cloudburst of stimulus measures could aggravate the country’s daunting debt and send the housing market barreling into bubble territory. The government has taken modest steps, such as tax cuts and lower reserve requirements for banks, but those are unlikely to move the needle significantly.
Of course, China’s muddied short-term prospects must be placed in the context of the country’s longer-run appeal. Though China’s official 6.6% annual growth rate has declined from the double-digit numbers of the past, the country’s sheer size and the swelling ranks of its middle class will have a significant impact on world economic growth.
Soft demand from China has contributed to plodding growth in Europe, with Germany suffering sharp declines in industrial output, car production and export activity. The outlook has also been blurred by the political convulsions over Brexit in the U.K. Just months after phasing out a huge bond-buying program on the logic that rigorous stimulus was becoming unnecessary, the European Central Bank recommitted to some of those efforts, including a pledge not to raise interest rates this year and a renewed effort to spur bank lending.
On the bright side, retail spending has been relatively strong as unemployment nears its previous cyclical low. Negative interest rates throughout the Continent limit the ECB’s ability to roll out additional monetary measures to rejuvenate growth. But Capital Group’s European economist believes that governments may be forced to undertake more-pronounced fiscal stimulus activities.
Industries with secular growth appear poised to do well.
Our portfolio managers are drawn to sectors that are expected to benefit from long-term trends and consumer buying patterns regardless of temporary economic conditions. For example, competitive video gaming, known as e-sports, is surging in popularity. It features multiperson video games that are often played by professionals in front of live or online audiences. Though e-sports make up a small segment of the gaming industry, there is enormous potential for advertising, ticket sales and broadcasting rights. International prospects are particularly strong.
Managers also have found value among European consumer staples companies. These businesses benefit from close proximity to the emerging world, where the number of consumers making the leap into the middle class continues to expand. Equity valuations for these companies tend to be lower than their U.S. counterparts’. More broadly, rising discretionary income in the emerging markets and elsewhere is boosting demand for a range of high-end products, including premium beverages and other branded goods.
Economic jitters caused bond yields to tumble.
Economic uncertainty drove down bond yields, with the 10-year Treasury finishing the quarter at 2.41%, a sharp decline from a recent high of 3.24% in early November, and briefly dipping below the three-month yield. Such an inversion of the yield curve has historically foreshadowed recessions.
It’s unclear how much of a threat this represents. Some in the market believe the quantitative easing program the Fed deployed after the 2008 global financial crisis diminished the indicator’s predictive ability. Furthermore, the magnitude of inversions matters. In the past, the Fed continued to raise rates after inversions occurred, but the central bank is currently on pause. Our U.S. economist notes that the post-inversion onset of recessions has varied from one to four years, and equity markets have typically continued to rise from the time of the inversion through the start of
Given the current unpredictability, our fixed-income investment team has taken a cautious approach and is seeking to avoid undue credit risks. Our managers have been drawn to high-quality securities to help minimize the potential effect of adverse market conditions.
Meanwhile, the municipal market has gotten off to its best start in more than a decade amid compelling supply-demand dynamics and attractive yields relative to Treasury securities. For more details, read the article by one of our fixed-income portfolio managers here.
It’s important to remember that bonds play an essential role in well-balanced portfolios regardless of shifting economic conditions. They can help to provide diversification from equities, generate income and preserve capital. That’s always important but especially so in an environment of economic uncertainty around the world.
The above article originally appeared in the Spring 2019 issue of Quarterly Insights magazine.