What a difference three months makes. In mid-December the Federal Reserve raised the Fed Funds rate by 0.25%, the 4th such increase during 2018. The December increase in the Fed Funds rate caused elements of the yield curve to invert (short-term rates higher than long-term rates) which is often a precursor to recession. The economic data was slowing, but it is was still generally sound and indicative of growth in excess of 2%.
The inverted yield curve, however, spooked investors and triggered a global sell-off in stocks. The S&P 500 was down 13.5% and the MSCI All World ex US index was down 11.4% in the 4th quarter. The US market bottomed on December 24th (Merry Christmas!) and has been rising ever since. The S&P 500 rose 13.6% and the MSCI AW ex US index was up 10.4% in the first quarter. This was the best 1st quarter for stocks since 2010.
What changed? After Christmas, markets began anticipating a new tone from the Federal Reserve and indeed on January 4th Fed Chair Powell made his first of a series of calming comments. On that date he stated that inflation was low and the Fed could be “patient”. In February, Chairman Powell stated that the Fed was in “no rush” to move on rates and in March the Chairman signaled that there may be no rate hikes in 2019. To put this in context, as recently as September, the market had been expecting three rate hikes in this year.
It is now believed that the next move by the Fed will be to cut rates rather than increase them further. With this shift in sentiment, interest rates have fallen considerably. The yield on the 10-year U.S. Treasury bond has fallen from a peak of 3.24% last fall to 2.41% at the end of March – a decline of 26%. Lower rates should support the economy.
Economic growth in the U.S. is expected to slow from the 2.9% rate reported last year as the benefit from tax cuts fade. The backdrop is still favorable, however, as unemployment continues to be at 50-year lows at 3.8%, inflation is low, interest rates are low and energy prices are in a healthy area (not too high or low). A resolution to our trade disputes would further support growth.
Corporate profit estimates have come down considerably to very achievable levels. S&P profits are expected to be flat in the first quarter and only increase 4% (to $168) for the entire year. The S&P ended the 1st quarter at 2,834, so the S&P is trading at 16.9 times earnings. This is above the 30-year average of 15, but not unreasonable in the context of inflation below 2% and the 10-year U.S. Treasury bond yield of 2.4%.
Current 2020 profit expectations are for growth of 11% to $187.5, thus stocks are trading at 15.1 times earnings a year out. With 2020 being an election year, our leaders in Washington will do what they can to support the economy. Conditions look favorable for investors.
