HIGHLIGHTS:
Stocks enjoyed the best January in 30 years.
“The U.S. economy is in a good place.” The Fed will be “patient.”
Fourth quarter earnings growth slowed but remained in double-digits.
Via Nova’s outlook remains positive, but risks remain.
Stocks enjoyed the best January in 30 years.
Stocks enjoyed the best January in over 30 years, as investors responded positively to progress made on several key issues on our Via Nova Worry Checklist. First, despite a healthy U.S. economy, the Federal Reserve declared it would be “patient” and not raise interest rates as previously projected due to the risks posed by trade tensions and slowing international growth. Second, the trade talks with China held in Washington showed progress toward resolution and concluded with a proposed summit between Presidents Trump and Xi in China in late February before the March 1 deadline for additional tariff hikes. These two risks are at the top of our Worry Checklist. Third, energy prices firmed after falling to levels that might risk layoffs and production cuts in the oil sector. Lower oil prices reduce costs to consumers, which is good for confidence and purchasing power, but a severe decline in prices could result in cutbacks and layoffs like those occurring in 2016 that reduced overall growth. Fourth, the Q4 corporate earnings season got off to a solid start with most of the reporting companies beating analysts’ forecasts. A fifth item, an end to the record government shutdown, was also a positive for the economy and the markets, though the temporary spending agreement only extends to the middle of February. Stay tuned. Not all the ten items on the Worry Checklist showed improvement, but the progress on key items was enough to bolster investor confidence and stock prices
The impressive 8% gain in the S&P 500 was the best start to the year since 1987 and was the largest single month increase since October 2015. Moreover, the composition of the advance suggested budding strength and sustainability in the market with all sectors showing some gain. The economically sensitive industrials, energy, and discretionary sectors generated double-digit returns as did communication services, while the more defensive utilities and staples sectors lagged. The advance was also broad-based. The Russell 2000 Small Cap Index, comprised of 2000 smaller and mostly domestically oriented companies, surged over 11%. International stocks also rose for the month but lagged the S&P 500, in part due to slowing growth concerns overseas. Emerging market stocks, which have been severely hurt by the mounting trade tensions, outperformed the S&P 500.
Bonds benefited from the more dovish Federal Reserve policy statement, and improving economic confidence helped corporate credit spreads to narrow. The result was a moderate 1% increase in the Bloomberg Barclays Aggregate Bond Index. The yield on the 10-year Treasury note closed the month below 2.7%, well off the 3.25% high back in November which pushed mortgage rates up to 5%. Lower interest rates and narrower credit spreads reflect a healthy economy and ample credit availability which are positive for the economic outlook. In other markets, oil prices surged above $50/barrel, in part due to cold weather, which pushed up demand, but also improvement in the global supply/demand imbalance. Gold, Real Estate Investment Trusts (REITS), and Treasury Inflation-Protected Securities (TIPS) all improved in January, while the value of the dollar eased ½%, but was up 7% over the past year. A stronger dollar makes exports more expensive to overseas buyers and so is something of a headwind to sales and earnings growth for many large companies. Conversely, the stronger dollar lowers the cost of imports for consumers and increases purchasing power.
“The U.S. economy is in a good place.” The Fed will be “patient.”
The record government shutdown reduced the number of economic reports available in January, but available information suggested the domestic economy remained healthy, while foreign economies struggled. Federal Reserve Chairman Jay Powell said, “The U.S. economy is in a good place, and we will continue to use our monetary tools to keep it there,” in a press conference following the latest Federal Open Market Committee (FOMC) Meeting. Moreover, the Fed forecasts continued economic growth in the coming quarters. Inflation remains near the 2% target set by the Fed.
However, the Chairman cited slowing economic growth overseas, trade tensions and an uncertain and potentially disruptive outcome from the Brexit negotiations as risks to the outlook and next policy moves by the FOMC. An example of the growth disparity between the U.S. and the rest of the world was the “expansion” level in the latest U.S. manufacturing survey compared to “neutral” in the EU and Japan and a slight “contraction” reading in China. “In light of global economic and financial developments and muted inflation pressures, the [FOMC] will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate to support these outcomes.” Via Nova believes the Fed will remain “patient” at least through the middle of the year while many of these risks are resolved, which is positive for both stocks and bonds. If the FOMC decides to resume rate hikes, it will probably be because the U.S. and global economies have strengthened.
In addition, the FOMC is exploring whether they should slow the runoff in their balance sheet of Treasury and mortgage securities. This policy shift would also be positive for both the stock and bond markets. As background, the Federal Reserve employed two extraordinary policies to support the economy in the aftermath of the Financial Crisis. The first was to lower interest rates to zero and commit to leaving rates low for an extended period. The second move was for the Federal Reserve to buy trillions of dollars in Treasury and mortgage debt to help keep rates low and improve market functionality or liquidity. Neither policy was intended to last indefinitely. The Fed would gradually raise interest rates to a “neutral” level and would let the portfolio of securities gradually mature and runoff to a level consistent with financial market functional needs. Thus far, the Fed’s intention has been to use interest rates alone as its primary policy tool and let the portfolio of securities mature on “autopilot.” When the Federal Reserve holds fewer securities, the private market must hold more, which tends to prop up bond yields and reduce liquidity in the system. This runoff is viewed by many as another, stealth, form of Fed tightening. Revisiting the “autopilot” policy of letting securities runoff could add liquidity to the markets and support both the stock and bond markets during this period of economic and policy uncertainty. This shift would be in addition to delaying additional rate hikes.
Fourth quarter earnings growth slowed but remained in double-digits.
Concerns about trade tensions, slowing overseas growth and other issues prompted analysts to reduce earnings estimates for the fourth quarter, but companies have been stepping over the lowered expectations bar and beating forecasts, which is a positive for stocks. Corporate profits are expected to increase over 20% for all of 2018, due in large measure to corporate tax cuts. Earnings growth is currently expected to slow to just 5% in 2019, though these estimates could be subject to significant swings depending on the outcome of trade negotiations and other risks on our Via Nova Worry Checklist.
Stocks are not expensive in our view, and so can continue to appreciate as the risks to the outlook subside. The valuation of the S&P 500, using the ratio of the index price to projected earnings or P/E Ratio, closed January near 16 times, which is near the long term average. The P/E was as low at 14 in December during the selloff.
Via Nova’s outlook remains positive, but risks remain.
Via Nova remains positive on the prospects for economy and the equity markets in 2019. Several of the items on our Via Nova Worry Checklist have been or are being addressed, lowering the negative risks to our outlook and reflecting, at least in part, in the January market gains. Currently, the risks of recession are very low, and we expect continued growth in consumer spending, corporate sales and earnings which supports further gains in stock prices. Risks remain, but we look for stocks to trend higher, albeit in a volatile fashion.
Via Nova’s most likely scenario in the months ahead is that the Federal Reserve will not raise interest rates too rapidly and short-circuit the current expansion.This view was confirmed in January following the FOMC meeting.Interest rates are still historically low, and borrowers are still able to obtain loans.While the Fed could make a policy mistake, it is not likely at this point.Still, we believe interest rates are trending gradually higher, and so we favor stocks over bonds.We also believe the chances of a trade deal with China have increased significantly, which would remove a huge cloud over the market.Still, we are monitoring all the data and events closely for signs of notable deterioration, and we will adjust strategy as needed.