The Oarsman Outlook: April 2019

What a difference three months make! On the heels of last-year's horrific final act, the opening quarter of 2019 featured heroic rebounds in the prices of nearly all investment categories. Major U.S. stock indices jumped 12% to 14%, with growth-oriented and technology-related issues leading the way. Overseas equities posted strong gains, too, as both developed- and emerging-/frontier-market benchmarks rose around 10%. Real-estate- and Commodity-related investments also advanced smartly, paced by a 30% surge in crude oil; gold inched ahead less than 1%. Bond yields were broadly lower (the benchmark 10-year U.S. Treasury ended March at 2.41%, compared with a yearend level of 2.69%) and credit spreads narrowed from elevated levels seen in late 2018, producing solid results from fixed-income investments.

Among large-company U.S. stocks, the biggest advances came among stocks in the Industrials, Consumer Discretionary, Energy and Technology sectors. Relatively weaker returns prevailed in Consumer Staples, Financial Services and Health Care. Relative performance of the growth and value investment styles was mixed, with growth handily ahead among large-cap stocks, while value led (though by a smaller margin) in the small-cap sphere.

Benchmark Performance - Equities

Benchmark Performance - Fixed Income

Review

The first three months of 2019 were full of big news: surging asset prices; swooning bond yields; market-moving economic data; and flinching central banks. We found it difficult to take our eyes off the Bloomberg terminal.

Double-digit gains by nearly all categories of stocks largely erased losses suffered in late 2018. Though the rally left major benchmarks some ways below all-time highs, the breadth of the advance was strong: within the S&P 500, the cumulative total of advancing-less-declining stocks reached new highs, while the proportions of stocks trading above their 50-day moving-averages as well as those reaching new 52-week highs were the highest since early 2018. Despite dour economic news and falling bond yields, U.S. stock-market gains were strongest in economy-sensitive sectors (e.g., Industrials, Energy, Technology); similarly, the largest gains overseas were in markets featuring notably negative headlines (e.g., China, Italy, the U.K.). After spiking late last year, volatility ebbed, though it remained above historically low levels seen through much of 2017.

Economic data released during the quarter indicated a continuation of the down-shift in global growth that began last year, though the U.S. remained a relative bright spot. While the American economy slowed to a +2.2% growth rate in the final three months of 2018, the full-year figure (+2.9%) was the best since 2015. Employment remained strong: job creation averaged 186,000 in the three months through February; the unemployment rate dipped to 3.8%. Annual wage gains accelerated to +3.4% - easily the best of the current recovery. March's purchasing-managers survey suggested the manufacturing sector remained resilient. Residential real-estate was a relative weak spot, with price gains and sales volumes well off cycle highs. Further caution flags came from consumer confidence, which dipped precipitously in March (though it remained at an elevated level), and retail sales, which have exhibited a weakening trend for several months.

Outside the U.S., economic news was almost uniformly downbeat. Fourth-quarter GDP figures from the Eurozone were weak, while more recent readings - including purchasing-managers indices, business-confidence surveys and industrial-production measures - pointed to near-recessionary conditions. After contracting in last year's third quarter, the Japanese economy skirted recession by posting fourth-quarter growth of almost 2%, though more timely data suggested growth around 1%.  China reported official fourth-quarter growth of +6.4%, bringing the full-year 2018 rate to +6.6% - the slowest expansion in 28 years. Current-period data from China has been mixed. Of note, both official and commercial purchasing-managers surveys picked up meaningfully in March, suggesting stimulus measures implemented in recent months may be gaining traction.

Against a backdrop of slowing growth and stubbornly low inflation, bond yields fell across the globe. The U.S benchmark 10-year Treasury yield, which hit a recent peak above 3.2% in October, fell below 2.4% in late March. Investors were briefly unnerved when the 10-year yield fell below that of three-month Treasury bills - fulfilling one definition of an 'inverted yield curve,' historically a reliable harbinger of an economic downturn. Elsewhere, the yield on 10-year German government bonds, which had been above 0.75% in early 2018, slipped below zero for the first time since late 2016. By the end of March, the amount of debt trading at negative yields around the globe exceeded 10 trillion dollars - approaching levels not seen since 2017.

Among the quarter's most salutary developments was a remarkable 'dovish' shift by major central banks. Meeting in December, the Federal Reserve board indicated the U.S. central bank would likely raise short-term interest rates twice during 2019 and described shrinking its balance sheet (effectively unwinding prior 'quantitative easing') as a process 'on auto-pilot.' Market turmoil, which only intensified following the meeting, suggested investors feared the Fed was ignoring clear signs of flagging growth and tightening financial conditions. Apparently, the bankers took notice: at subsequent January and March meetings, and in between-meeting public pronouncements, the central bank made a stunningly abrupt change of tack: 2019/2020 growth forecasts were lowered; additional rate hikes were removed from the outlook; and plans were announced to slow the balance sheet contraction almost immediately and end it before yearend. The European Central Bank offered an only slightly less dramatic volte-face in March, when it slashed growth projections, pushed out the expected timing of its first post-crisis rate hike, and offered a new round of cheap financing to the continent's banks.

Much less helpful was a substantial downgrading of Wall Street's expectations for near-term corporate profits. In a notable shift from recent quarters - when they repeatedly nudged estimates higher on the strength of a healthy global growth, lower corporate tax rates and lavish government spending - analysts shifted into reverse, cutting the collective projection for the coming year by more than seven percent. The consensus now eyes a gain of around 5% for the first quarter (to be reported in coming weeks) and less than 10% for the full year - compared to in-the-books gains of 17% and 22% recorded in 2017 and 2018, respectively.

What's Changed?

To provide insight regarding recent stock market performance, we can deconstruct the three-month return from stocks into three components:

1. Dividend Income (for three months this is the annual yield divided by four)
2. +/- Change in Earnings per Share* (average for S&P 500 companies)
3. +/- Change in Valuation (Price/Earnings Ratio)

= Total Return

* based on forecast earnings for next 12 months (Source: S&P Outlook)

So, what changed during the recent quarter to produce the +13.7% S&P 500 total return?

Our read: The change-in-earnings component turned negative (i.e., the year-ahead figure today is lower than the corresponding figure from three months ago). Accordingly, the quarter's jump in prices resulted in a hefty increase in valuation, though the measure remains below the highs reached early last year.

Outlook

Investors are justifiably perplexed by the Jekyll and Hyde character of the past two quarters, not to mention conflicting signals currently emanating from the stock and bond markets. As the current economic expansion and investment bull market both near record lengths, it seems that choosing the optimal path forward only becomes more challenging.

Though they have lifted from their late-March lows, bond yields well below levels that prevailed through most of 2018 suggest investors anticipate persistently weak economic growth and anemic inflation. The structure of the U.S yield curve indicates investors, on balance, think the Fed's next move will be to cut short-term interest rates, presumably to head off a recession. Other indications of pessimism include a recent Duke University survey of chief financial officers that indicated 82% expect a recession to begin before the end of 2020; a similar poll found that a majority (75%+) of National Association for Business Economics members agreed. And to be sure, global data continue to indicate widespread weakness, inducing independent forecasters like the IMF to ratchet back views of 2019-2020 multiple times since the middle of last year.

Offsetting these yellow flags are indications that economic conditions may firm in coming months: stock-market gains, narrowing credit spreads (especially among below-investment-grade (junk) bonds that are acutely sensitive to economic weakness), firm commodity prices, and signs of bottoming in some economic data. Optimists note that much overseas weakness is attributable to transitory/idiosyncratic issues (disruptive changes to European vehicle-emission standards, Brexit drama, gilets jaunes protests in France) or to predictable knock-on effects from China's downshift - which many believe will soon abate, given stimulus already in the pipeline and likely more to come. The receding threat of all-out trade war between the world's two largest economies can be added to the glass-half-full column.

Contradictory market signals and ambiguous economic data have resulted in an unusual degree of disagreement among market forecasters. The Bank Credit Analyst and Pantheon Economics judge the pace of growth has bottomed and expect the Fed to resume raising short-term rates later this year or early next. Meanwhile, Capital Economics believes growth will continue to underwhelm, inducing the Fed to cut rates by as much as three-quarters of a percentage point in the same timeframe. Given our interpretation of the late-2018 market swoon - that it primarily reflected investors' sudden, panicked realization that monetary policies eminently appropriate for the robust global expansion of 2017 were potentially dangerous amid the much-weaker growth regime of mid-/late-2018 - we will be watching carefully for signs of renewed investor discomfort as we gradually learn whose forecast is closer to the mark.

Further muddying the waters, investor sentiment and market valuation provide mixed signals. On one hand, investors seem quite skeptical of the current rally - which we view as bullish. Mutual fund industry data indicate money consistently flowed out of U.S. equity funds during the first quarter. Likewise, a recent Bank of America fund-manager survey found the lowest exposure to U.S. stocks since early last year and the highest cash holdings since early 2009. So there are plenty of potential buyers with ample dry powder to sustain a rally, given the right cues. But as we note in the What's Changed? box above, valuation has deteriorated (again). Whether measured against reported (trailing) earnings, or the consensus view of year-ahead profits, U.S. stocks are substantially more expensive after the recent rally. By our preferred measure, the S&P 500 Index recently traded at approximately 16.5 times year-ahead earnings - up from less than 14 times just before yearend, though still a ways below the early-2018 peak of 18.5.

We think earnings can expand this year and next, but rising wages threaten to squeeze margins, limiting the scope for profits to 'grow into' higher prices. According to research by the Leuthold Group, margin expansion allowed earnings to grow more than two percentage points faster than sales over the past decade; we doubt that feat can be repeated. The same research highlighted the somewhat obvious but important observation that future returns are usually sub-par when starting valuation is high: the compound annual return to U.S. stocks has been just 7% since late-2007 (just before the Global Financial Crisis); since the 2000 dot-com market peak it has been around 6% (interestingly, a bit below the return from holding 10-year Treasuries over the same period).

To sum up, our sense is that economic pessimism is likely overdone, especially in light of the recent change in central bank attitudes. But it also seems the remarkable performance of financial markets over the past 15 weeks largely reflects that judgement. The risk of a U.S. recession is probably lower than surveys suggest, though not negligible. Global growth may be troughing, but any upturn seems likely to be subdued. There is some room for investor sentiment to improve and for Wall Street analysts to become less negative, but perhaps not much. Accordingly, it is prudent to maintain stock market exposure, while being prepared to lock in profits if global growth fails to perk up, on one hand, or if a continuing rally pushes valuation to an extreme, on the other. And finally, elevated valuation of U.S. stocks continues to argue for portfolio balance, including ample diversifying exposure to income-oriented investments and less highly-valued overseas stock markets with arguably less challenging profit outlooks.

We encourage questions and comments regarding our management of your investments.