Stocks staged an impressive rebound from 2018’s tough finish, with global markets posting double-digit returns. While the economy is slowing from last year’s pace, there are few signs of recession. The Federal Reserve’s dovish turn sparked a decline in interest rates, which boosted bond returns.
- What prompted the best first quarter for stocks since 1998?
What a difference a few months can make! On the heels of a nearly 20 percent drop at the end of last year, stocks came charging back. Both U.S. and international shares posted returns for the quarter that were above their long-run annual averages.
What caused this sharp reversal? Much of the brighter outlook stems from improvement in several issues that concerned investors at the end of last year:
- As recently as December, the Fed was expected to further raise rates in 2019. Now the consensus view is that rate hikes are over for this cycle.
- The government shutdown ended in February.
- Progress was made in the trade dispute with China, and a resolution could be near.
- Although the U.S. economy is slowing, moderate growth is expected this year.
In the December commentary we noted economic and corporate fundamentals were healthy despite the downturn in share prices. Once the market’s mood improved, this provided a solid base from which stock prices could launch.
- With stocks up nearly 14 percent in the first quarter, what can investors expect for the rest of 2019?
Market performance is impossible to predict in the short run. This has been well-illustrated over the past six months. Remember that the strong start to 2019 only served to recoup the negative performance of the last quarter. With that in mind, stock prices don’t appear to have gotten ahead of themselves.
According to Bespoke research, in the 19 instances since 1946 when the market has declined more than 10 percent in a quarter, the following two quarters produced gains 74 percent of the time, averaging an 11 percent return. While there are no guarantees of what lies ahead, history suggests potential for further gains.
Strong earnings combined with falling share prices caused stocks to become somewhat cheap entering 2019. After this year’s rebound, valuation levels are now back to normal. Trends in profit growth will be particularly important to returns the remainder of the year.
- Has the outlook for interest rates changed?
The outlook for rates has changed significantly. The Fed responded to the year-end market turmoil by backing down its plan to raise rates in 2019. The Fed also announced an end to the current program of shrinking its balance sheet. These changes had an immediate and significant impact. First, markets now reflect the probability that the next Fed move will be a rate cut. Second, the abrupt about-face from the Fed has caused investors to scramble to change positioning, amplifying the decline in rates. Since the end of last year, the 10-year Treasury yield has fallen from 2.66 percent to 2.41 percent, after peaking at 3.24 percent in November. The drop in rates has also led to a repricing in the stock market, as lower rates help to boost stock prices.
- Does talk of an inverted yield curve mean a recession is near?
An inverted yield curve occurs when short-term rates rise above long-term rates. All post-war recessions have been preceded by an inverted curve, so this is an important signal to monitor. However, there are some key details to note. First, an inverted curve doesn’t always mean a recession will occur. Second, inverted curves must be significant and sustained. Short rates need to move meaningfully higher than long rates, and this condition should last for more than just a couple of days. Third, the inversion should cover the entire yield curve (a preferred measure is the difference between 2-year and 10-year rates).
The current inversion fails on all three tests. The 2- and 10-year rates have not inverted; only 3-month rates rose slightly above 10-year rates—and the curve was only inverted for a single day! So while the yield curve is abnormally shaped and investors should stay alert for further signals, we do not believe a recession is looming. We continue to see the U.S. economy on pace to grow by 2 percent this year.
- Ten years after the Great Recession, how has the investment environment changed?
In 2009, the most severe economic downturn since the Great Depression ended. From the peak in October 2007 to the bottom in March 2009, U.S. stocks dropped 57 percent. Unprecedented policy actions were taken to stabilize the system. Ten years later, financial conditions have improved greatly. Here are some examples:1
- Total U.S. economic output (GDP) grew from $14.4 trillion in 2009 to $20.5 trillion in 2018, a 42 percent increase.
- Cresting at more than 10 percent in 2009, unemployment has fallen to 3.8 percent with more than 20 million jobs created.
- The S&P 500 index of U.S. stocks bottomed at 667 in 2009, and is above 2,800 today.
- S&P 500 operating profits have nearly doubled from their prior peak in late 2007 through December 2018.
- The median price of homes sold in the U.S. increased from $222,000 to $317,000.
- Oil prices have fallen from $140 per barrel to $60, and the U.S. has become the world’s largest producer.
The improvement in the economy and markets did not come without a price. U.S. government debt levels have soared over the past 10 years, from $10.7 trillion to $21.9 trillion. This is the main reason growth has been below normal during this expansion, running about 2 percent per year. High debt levels are likely to continue to cause slow growth going forward.
While stocks have been in a bull market since 2009, investors have generally been more skeptical than euphoric. U.S. stock returns have been well above average over the last 10 years, yet many continue to fret the next downturn.
That said, additional perspective may be helpful. After the 57 percent market decline from late 2007 to early 2009, an increase of 127 percent was necessary just to get back to even! It took the first four years of the rally to reach that break-even milestone in April 2013. Measuring from the prior peak (October 2007) rather than the bottom paints a different picture of market returns. From that point, stocks have returned 7.6 percent per year, which is below average and not excessive.
Importantly, corporate profits have risen along with stock prices since 2007, nearly doubling over that time. Because of this, valuation remains reasonable at 16.5 times expected 2019 earnings.
Investors have experienced greater volatility over the past year. But remember, these periods of turbulence are anticipated in our approach to portfolio construction and planning. Executing a well-designed plan is a great way to increase the odds of financial success over time, through both good times and bad.
1 Bureau of Economic Analysis, Standard and Poor’s, JP Morgan, Federal Reserve Bank of St. Louis. ↩
BKD Wealth Advisors, LLC is an SEC registered investment adviser offering wealth management services for affluent families and investment consulting services for institutional clients and is a wholly owned subsidiary of BKD, LLP. The views are as of the date of this publication and are subject to change. Different types of investments involve varying risks and should not be assumed that future performance of any investment or investment strategy or any non-investment related content, will equal historical performance level(s), be suitable for your individual situation, or prove successful. A copy of BKD Wealth Advisors' current written disclosure statement is available upon request.