By JOHN SPEAR, CFA
Chief Investment Officer, USAA Mutual Funds
The U.S. stock market is stacking up the superlatives in 2019 – the Standard & Poor’s 500 Index of large-cap equities just wrapped up its best first quarter in more than two decades and, in doing so, extended what is already its longest-ever bull run.
Since bottoming out in early March 2009, the S&P 500 has gained more than 300% and the Russell 2000 index of small-cap U.S. stocks has done even better. In the first quarter of 2019, they were among the top performers among key asset groups (Figure 1) as equities rebounded after a dismal final three months of 2018.
But while many investors have been enthusiastic stock buyers, many other investors have been urgently loading up on longer-dated bonds in response to a slowing global economy. The yield on the 10-year Treasury note was driven down from 2.8% in mid-January to 2.4% by quarter-end (yields fall as bond prices rise).
In other words, the strong risk-on sentiment reflected by sharply higher share prices both in the U.S. and overseas is locked in a duel with a strong risk-off sentiment expressed by sharply higher bond prices as recession-fearing investors seek out less volatile assets.
So is the stock market right, or is the bond market? A great question to be sure, but one that can’t be answered now and may not be answerable for a while. Underlying that question is another question: Are we headed for a recession in 2019? We don’t think so.
TROUBLE WITH THE YIELD CURVE?
The U.S. economy is almost certain to grow at a slower pace than last year as sluggish conditions overseas start taking a toll and the sugar-rush effects of the 2017 federal tax cuts and other fiscal measures wear off.
Still, we’re far from recession territory – the 1Q GDP growth forecast from the Federal Reserve Bank of Atlanta stood at 2% (annualized) in late March, up from 0.4% early in the month after a series of key indicators came in above expectations.
Nervous investors have stormed into the Treasury market, pushing up prices and driving down yields for longer-maturity bonds. In late March, the Treasury yield curve inverted for the first time since 2007 – the 3-month Treasury bill offered a higher income return than a 10-year note (Figure 2).
A yield-curve inversion warrants attention because it has been a reliable indicator in recent decades – a downward-sloped curve has preceded every U.S. recession since the 1960s. Adding to the worry is that, based on history, we appear overdue for an economic contraction. The average period between U.S. recessions is roughly five years – it’s been nearly twice that long since the Great Recession ended in mid-2009.
Less reliable with the yield-curve inversion has been the timing between inversion and recession – it has ranged from less than a year to more than two years, with no clear pattern from past iterations to provide useful guidance.
While we seem to be late in the business cycle, we don’t see a recession on the horizon for a couple of reasons. One is the solid economic data, which tends to suggest positive (if unspectacular) growth. The other is the Fed is wrapping its protective arms around the economy – it has signaled plans to pause its monetary tightening cycle in 2019, and there is a growing belief that the central bank may even cut interest rates this year.
CAN STOCKS KEEP UP THE PACE?
The post-Great Recession recovery is largely defined by its persistently low GDP growth rate, and in this environment, the stock market has thrived. So an economic slowdown in 2019 is not by itself a kiss of death for U.S. equities, and tempering that slowdown could propel the current bull market deeper into 2019.
Moderation could come in the form of government policy – with Fed interest rate hikes on hold and some talk in Washington about boosting fiscal spending, the negative effects of any slowdown could be cushioned and stocks could benefit. A favorable trade deal with China could also provide help by removing a key global risk and encouraging more economic activity at home and abroad.
The strong start for U.S. stocks in 2019 (Figure 3) comes at a time when unemployment is under 4% with modestly rising wages, there are more job openings than job seekers and inflation is close to target rates. U.S. manufacturers are in expansion mode, and consumer confidence is still relatively high.
But stocks have a high-profile vulnerability – earnings growth. After double-digit gains for five straight quarters, 1Q 2019 earnings are forecasted to be slightly negative compared to the same period in 2018. Equity prices tend to follow earnings, so we are focusing closely on the 1Q results to determine how they compare to the dour outlook. Beating the forecast could add to the tailwind that stocks have enjoyed into the second quarter.
But it’s important to remember that sentiment and volatility are prone to sharp swings, as we saw when stocks tanked at the end of 2018 and then fully rebounded in a matter of a few weeks. Conditions were calm at the end of 1Q, but investors should be ready in case the ride gets bumpy again.
We advise members investing for the long term to expect the unexpected and not get swept up in short-term market moves – either positive or negative. Our consistent advice is to remain focused on the long-term investment plan that you have put so much thought into. For those uneasy about market risk in general or with concerns about too much exposure to specific asset classes, we recommend consulting with a USAA advisor.
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