Capital Market Comment
May 29, 2019
Frank Mastrapasqua, Ph.D.
Principal, Chairman & Chief Investment Officer
The strong market performance in the first four months of the year, following the precipitous drop in the last three months of 2018 could have easily created vertigo for many market participants. The so-called market mavens and media maniacs did little to help the confused state of affairs, articulating economic and monetary scenarios that had little grounding in reality, but played havoc with expectations and psychology.
The U.S. economy continued to perform with a 3.2% real GDP growth rate in Q1 and employment increasing at a 150,000 – 200,000 rate per month. Earnings growth expectations for the first quarter has proved to be too pessimistic, as more than 75% of the S&P companies exceeded expectations. Most importantly, the Federal Reserve changed direction after its December rate increase and has held rates steady for the last three Federal Open Market Committee (FOMC) meetings (January 30, March 20, and May 1). Moreover, the move to a more accommodating policy is underway as they lowered the rate they pay on excess reserves and are lessening the burden from the runoff on the balance sheet which will end in September. The minutes from the most recent FOMC meeting and the comments from Federal Reserve board members and Federal Reserve bank presidents suggest that at worst, rates will remain at these levels for an extended period of time even if the economy improved further and inflation did move up to target. Some members suggest the Central Bank needs to allow inflation to exceed target for a period of time to communicate to the markets that they mean what they say – the inflation rate target is symmetrical. Some members of the committee are now expressing more diverse views, suggesting that the inflation performance may not be transitory, and they may have gone a bit too far. If this is so, a rate cut may well be the Central Bank’s next move.
Moreover, changing economic conditions, in part emanating from the trade crisis, may warrant an even more aggressive policy:
- First, 2Q GDP growth is likely to slow to the 2% area as the inventory build of Q1 wears off.
- Second, tariffs are effectively a tax and are likely to dampen growth the longer they are in place, particularly as business confidence and decisions are altered.
- Third, in the face of these changing conditions, inflation has not accelerated and moved to their 2% target. Although, it has been argued that certain price declines are likely to be transitory, the slowdown in world economic growth serves to dampen price pressure.
- Fourth, the recent drop in oil prices does work as a deflationary factor and often is an indication of world economic conditions.Fifth, the strong dollar exerts downward pressure on prices and is particularly harmful to emerging market countries that are tied to the dollar.
- Finally, the decline in rates across the yield curve, with little movement at the very short end, raises the question once again of an impending inverted yield curve.
Unless there is a sudden resolution of the trade conflict and/or a de-escalation of the hostile rhetoric, more and more discussion of a rate cut will surface, both inside and outside the Federal Reserve. It is quite likely that dissenting votes will be part of future FOMC meetings.
Should the employment data falter, an even more speedy response for a rate cut will emerge.
Recent volatility and weakness in the equity market reflects the rising levels of uncertainty. They include recent escalation in the trade conflict, the Brexit debacle, slowing growth in Europe as evidenced by Germany, the Iranian difficulties, the conflict in Washington (infrastructure and impeachment), and the impending debt ceiling. As a result, valuation parameters are becoming more attractive. The dividend yield on the S&P 500 which is at 2% and increasing, now compares to a 2.25% yield on the 10-year Treasury. Many individual stocks yield well in excess of the treasury rate. Moreover, the estimated earnings yield on the S&P 500 is over 6% creating an even wider gap with the 10-year Treasury of just four, six, and eight months ago. It is interesting to note that at the market high last year, the 10-year Treasury was yielding approximately 3.25%, a 100 basis points (1 percentage point) above the current level. At the same time, earnings and dividends have increased, highlighting the valuation bias toward equity as discussed earlier.
From an international perspective, negative yields persist in Germany with a -0.12% on their 10-year and -0.06% on Japan’s. The favorable rates in the U.S. and the strong dollar do provide incentives to foreign investors.
In the coming months, greater clarity surrounding the market uncertainties are likely to emerge. As a result, the monetary landscape should change with a focus upon adding liquidity. Such a change could be the catalyst to move the equity market into a more balanced relationship to the bond market.
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 firstname.lastname@example.org
Claude Koontz, CFA, Principal & Portfolio Manager in San Antonio at 210-353-0519, or email@example.com
Mastrapasqua Asset Management, Inc. does business as M Capital Advisors.
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Nashville, TN 37205
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San Antonio, TX 78216
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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.