February Analysis: A great start to 2019.

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  • The S&P 500 continued its rebound in February.

  • Domestic economic growth is solid but will likely slow in 2019.

  • Global economic growth has slowed.  Is it temporary or cyclical?

  • Fourth quarter earnings growth also slowed but remained in double-digits.

  • Central banks around the world have shifted to more supportive policies.

  • Our expectations for a China trade deal.

  • Via Nova’s outlook remains positive, but risks remain.

The S&P 500 continued its rebound in February.

Stock prices continued moving higher in February, helped by further progress on China trade talks and confirmation from the Federal Reserve that it will refrain from additional interest rate hikes while economic uncertainty remains high.  Trade tensions and excessive interest rate increases have been at the top of our Via Nova Worry Checklist, and a successful resolution of these risks would help quell corporate and market uncertainty and likely fuel more market gains. 

The S&P 500 added over 3% in February, and the 11% gain in the first two months of the year represents the strongest start to the year since 1991.  The sharp recovery followed a difficult fourth quarter decline.  Importantly, the trade-sensitive industrial and technology sectors led the advance, suggesting improved confidence in the economic outlook.  The breadth and strength of the market increase was also reflected in the continued outperformance by small cap stocks.  International and emerging market stocks also rose, but lagged U.S. equities, reflecting the slower economic growth in the rest of the world.

Aggregate bond returns were essentially flat in February as higher Treasury bond yields, a negative for Treasury bond prices and returns, were offset by narrowing corporate credit spreads, a positive for returns.   Narrower credit spreads reflect improving confidence, a healthy economy and ample credit availability which are positive for the economic outlook.  Bond yields remain low by historical measures and will likely remain low over the near term based on the Federal Reserve’s decision to hold off on additional rate hikes while global economic uncertainty remains high.  Low and steady interest rates are supportive of continued economic and earnings growth.

In other markets, oil prices rose to over $57/barrel, in part due to cold weather, which pushed up demand, but also by reductions in global supply - most significantly, output cuts from Saudi Arabia and Russia as well as reduced output from Iran and Venezuela related to sanctions.  While higher energy prices raise costs for consumers, we believe prices above $50/barrel limit the risk of production cuts and layoffs here in the U.S.  Other inflation-related investments, such as gold and Treasury Inflation-Protected Securities (TIPS) fell.  The value of the dollar rose in February and increased 6% 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 their purchasing power.

Domestic economic growth is solid but will likely slow in 2019.

Here at home, the economic reports suggest solid, if somewhat slower, economic growth this year with limited recession risks.  The broadest measure of economic activity, GDP, grew slightly faster than expected in the fourth quarter lifting the 2018 increase to almost 3% compared with 2.2% growth in 2017.  Job growth was robust in the latest report, consumer incomes are growing, and confidence has improved following the end of the Federal government shutdown. 

While the U.S. economy remains on solid footing in our view, repeating 2018’s strong economic performance could be a challenge.  The initial surge related to the tax cuts and stimulus will ease in 2019, and export growth has slowed in response to weaker foreign demand and trade tariffs.  Moreover, the uncertainty surrounding trade negotiations has made corporate investment decisions more difficult and has delayed numerous projects and initiatives.

Global economic growth has slowed.  Is it temporary or cyclical?

Via Nova believes slowing economic growth outside the U.S. is due in part to a combination of several factors that appear to be either temporary in nature or one-off events.  These events do not suggest the typical cyclical imbalances that lead to recessions, but rather temporary headwinds to fundamentally healthy economies.  Resolution to these varied challenges could help firm international economic growth and support a rebound in foreign markets.  Trade tariffs are an important source of uncertainty over the near term, not only for overseas sellers to the U.S. but also U.S. companies trying to control costs and secure steady and reliable supplies for production.  However, the adverse effects could be temporary if addressed over the near term through successful trade negotiations.  Other issues dampening foreign economic growth include the diesel scandal with German auto manufacturers (a significant component of the German economy), the earthquake damage to nuclear power plants in Japan, protests in France and Brexit in the UK.  Still, we will continue to monitor these forces for signs of improvement or deterioration.

Fourth quarter earnings growth also slowed but remained in double-digits.

Corporate profits in 2018 were exceptionally strong by historical standards.  Healthy economic growth and a boost from lower corporate tax rates were the main drivers of the increase.  Fourth quarter corporate profits growth slowed to just over 16% in the fourth quarter, but increased over 20% for all of 2018, according to data collected by Refinitiv, more than double the long-term average.    However, profits growth is expected to slow significantly in 2019 due to slower economic growth here and abroad as well as the roll off or anniversary of the tax cuts.  Profits growth this year is projected to rise around 5%, slightly below the long-term average.

Stocks are not expensive in our view, and so can continue to appreciate as the risks to the outlook subside.  One common valuation metric for stocks, the ratio of the index price to projected earnings or P/E Ratio, closed February near 16.5 times for the S&P 500, which is near the long-term average.  The P/E was as low at 14 in December during the selloff.  If the headwinds to growth subside as we expect, trade negotiations achieve a measure of success and the Federal Reserve remains patient, stock prices can move higher.

Central banks around the world have shifted to more supportive policies.

Central bankers around the world recognize that growth has slowed, and they will retain accommodative monetary policies.  These policy shifts should help support economic growth and also the stock and bond markets.  Federal Reserve officials repeated their belief that the domestic economy remains solid, but that they plan to hold interest rates steady during the current period of global turbulence.  “Patient” is the buzzword to describe current Fed policy.  In addition, the Federal Reserve could slow or even end the reductions in its portfolio of Treasury and mortgage securities purchased during the financial crisis.  Central banks in both the EU and the UK have backed away from plans to raise interest rates and China has resumed fiscal stimulus to help restore flagging economic momentum.  All these moves can help stabilize the global economy and reduce recession risks. 

Via Nova agrees that the U.S. economy is on a solid footing and showing signs of resilience.  Job growth is firm, the unemployment rate is the lowest in half a century, and confidence has improved since the end of the record government shutdown.  Indeed, the decline in mortgage rates over the past several months appears to have rekindled activity in the sluggish housing market.  If the U.S. can avoid the self-inflicted wounds of a looming trade war and replace it with more favorable terms and conditions, economic and earnings growth should reaccelerate later in the year.

Our expectations for a China trade deal.

Via Nova believes there is a strong chance of some form of trade agreement with China that would remove the cloud that has been hanging over the economy and the markets for more than a year.  Like most negotiations, however, compromise is often a crucial element to progress, and we do not believe the U.S. will get all the items on its wish list in an initial deal.  Key elements that we do see as likely include a significant reduction in the trade deficit with China, greater access to China’s financial markets, an increase in the number of U.S. majority-owned companies in China, a forum to address disputes on intellectual property, and some framework for the re-imposition of tariffs in the event of an agreement violation.  We do not expect the iron clad protections for U.S. intellectual property demanded by Wall Street, as it might impose too much stress on China’s long-term economic development plans.

If such a deal is forthcoming, economic growth would increase and companies would have greater clarity on funding new investments.  This combination should provide a meaningful boost to the equity markets in the coming quarters. 

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.Currently, the risks of recession are very low, and we expect continued growth in consumer spending which supports further gains in stock prices.Risks remain on several fronts, but we look for the economy, earnings and stocks to trend higher, albeit in a bumpy fashion.We are monitoring all the data and events closely for signs of notable deterioration and will adjust strategy if needed.