Capital Market Comment
March 25, 2019
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
Following the sharp equity market correction/bear market from October through December 24, 2018, stocks recovered handsomely in January and February. For the most part, March continued the trend.
In recent days, growing concern about the slowdown in world economic growth enveloped investor thinking and occupied much of the media’s time. The estimate of global economic growth by the OECD (Organisation for Economic Co-operation and Development) has been reduced to 3.3% from 3.5%.
Moreover, the European Central Bank (ECB) lowered its growth and inflation expectations significantly for 2019. GDP growth was lowered to 1.1% from 1.7% and inflation to 1.2% from 1.6%. At the same time, the ECB indicated that monetary policy will be even more accommodative.
Moreover, China’s pace of business activity continues to slow with exports declining. It is internal growth, particularly consumption, that is sustaining growth. As we discussed in our January 23, 2019 commentary, “a move toward synchronized monetary accommodation may be underway.” The Fed’s rate decision confirms this development. At the March 19-20, 2019 FOMC meeting the monetary authorities indicated no rate change and no additional ones are expected this year. Furthermore, the balance sheet runoff was addressed, expecting it to end by September, with fewer bonds maturing starting in May. Consistent with these decisions, the Central Bank has lowered its forecast for economic growth in 2019 and 2020, as well as the estimate for inflation. Unemployment is expected to increase slightly and still remain under 4%.
The inability of the Federal Reserve to achieve its inflation objective in part explains the decision to become more accommodative in its policies.
Undershooting inflation, particularly with unemployment so low, raises concerns that deflation may reemerge as a concern. A symmetrical goal of 2% inflation suggests that the rate needs to be above 2% for an extended period to offset the time for which it was below 2% historically. Consequently, a bias to re-liquifying the financial system becomes a higher priority. The headwinds from the ongoing “never ending” Brexit saga, the trade conflicts, and now the near recession conditions in Germany elevate growth concerns as an even greater policy concern. Friday’s (March 22) market decline, and more importantly the fall in interest rates surprised market participants and policymakers and raised numerous questions. Does the rate structure signal that a recession is imminent? Are we seeing the lagged effect of 9 rate hikes? What is the neutral rate? Are we there yet? What are the implications for the equity market?
In our judgment, economic growth is slowing in response to the lagged effect of the 9 rate increases (a move toward rate normalization) and the deceleration of overseas business activity as trade tensions intensified. The decline in the 10-year rate places policymakers on notice that yield curve inversion, a concern expressed months ago by a number of Federal Reserve bank presidents, is near at hand and the neutral rate may well have been achieved.
The 10-year government bond rate is still slightly above the Federal Funds rate, but slightly below the 3-month bill rate. Yield curve inversion has a history of predicting recessions on average by approximately 18 months.
In the past the inversions were triggered by the Monetary Authorities’ raising short term rates in response to rising inflation and the need to puncture inflation psychology. To date, the rate increases were an attempt to normalize rates in a strong economy following the zero-rate strategy of the 2008 financial crisis. The recent Federal Reserve decision signals an important change. Many FOMC members may be asking themselves if they had gone too far or moved too fast. Have they already reached the neutral (normal) rate? The March FOMC meeting suggests that it was time for them to change their thinking.
It is important to note that for yield curve inversion to be predictive of a recession, it has to persist for some time, not just a few days. Even during periods of inversion, the equity market has generally risen for over a year. At this juncture it is premature to draw any meaningful conclusions on the imminent nature of a recession.
What we do know is that the monetary environment has changed significantly and reliquification is underway. Moreover, the decline in rates has been worldwide, with the yield on the German 10-year bond falling below zero (0). Consequently, on a relative basis, U.S. financial assets (stocks and bonds) are quite attractive. The 10-year U.S. Treasury yields 2.43%, the dividend yield on the S&P 500 is approximately 2%, and the estimated earning yield exceeds 6%.
Although the near-term is likely to be volatile as investors sort out the changes and their implications, the risk that the monetary authorities would become an adversary is gone. As we indicated in our January 23 commentary, this interest rate environment suggests “an emphasis upon growth becomes a viable option.” Recent rates and policy actions indicate more specifically that growth and a more offensive focus should offer the best opportunities. Cyclically sensitive sectors appear more vulnerable to the economic growth slowdown. In addition, banks, an area we have significantly underweighted, become victims to declining net interest margins, thus placing downward pressure on profitability.
Over the next two months the monetary climate, the trade negotiations, and the release of the first quarter earnings and guidance will dominate market behavior. Managing through slowing economic growth, the effects on earnings, and the changing monetary climate remains our focus. Secular themes and stock selection become even more important.
If you have a question or need further information, please contact:
Don Keeney, CFA, CFP, Principal & Portfolio Manager in Nashville at 615-866-0882, or email@example.com
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or firstname.lastname@example.org
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors.
104 Woodmont Boulevard, Suite 320
Nashville, TN 37205
200 Concord Plaza, Suite 500
San Antonio, TX 78216
© 2019 Mastrapasqua Asset Management, Inc. All rights reserved.
The information and opinions contained in this report should not be treated as fact or as insight that will produce desired investment results over time. Investment conclusions always bear risk, and that risk may not be reasonable for any particular reader. Obviously the writer, even assuming good intentions, does not know of the reader’s particular financial circumstance and therefore is not able to assess the propriety of whether a named security makes sense as part of a given individual, family, or institutional portfolio. Mastrapasqua Asset Management clients may, from time to time, own some of the companies mentioned. We hold out no duty to give readers of this column advanced notification of when we may change an opinion. To our knowledge, none of the information contained in our column would, when it becomes publicly available, have an influence on the valuation of a particular stock. Investors should receive investment advice based on an assessment of their own particular investment circumstances and not on the basis of recommendations in this report. Past performance is not indicative of future returns.