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Q2 2019 Market Outlook: Assessing Slowing Earnings Growth and Fed Rate Pause

With moderating economic growth, benign inflation and low unemployment, the Federal Reserve (Fed) indicated in March that it expects a relatively long delay in further rate hikes. See Fed Pivot Should Aid Economy

Image 1

On the heels of that announcement, intermediate and long-dated U.S. Treasury security prices rallied sharply as their yields fell markedly lower. At the same time, short-term Treasury bill yields with maturities of six months or less remained relatively stable.

Ten-year Treasury bond yields, in fact, fell below the yields on three-month Treasury bills, creating a modest inversion of the yield curve (Exhibit 1).

Exhibit 1

In the past, an inverted yield curve has been a relatively good predictor of recessions, albeit with long and varying lead times. Looking back, the time span from inversion to recession has averaged 331 days during the seven rate inversions since 1969. (Exhibit 2.)

Not all inversions lead to a recession – and that may be the case this time – but it’s one factor that can raise concerns among economists. The unusual factor in the current case is that the inversion was not due to rising short-term yields, but rather because 10-year yields dropped while short-term yields remained the same.Exhibit 2 If the inversion is sustained – or widens further – the likelihood of an economic downturn would be elevated.

But if the inversion is relatively brief, that would improve our chances of avoiding recession.

Corporate Earnings Growth Slowing

April marks the beginning of the first quarter earnings reporting season for stocks. Since the beginning of the year, there has been a rather substantial reduction in earnings growth expectations. At the end of 2018, earnings forecasts for the first quarter suggested 2.9% growth for S&P 500® earnings. (The S&P 500 Index is a market-cap-weighted index that represents the average performance of a group of 500 large-capitalization stocks.)

But that positive perception has changed. Instead, industry consensus projections through late March now indicate that earnings could actually decline by 3.7% in the first quarter, with reductions across most industries. The corporate tax cut that was put in place in 2018 will not provide the tailwind to earnings in 2019 that it did in 2018 when it added approximately 7% to 8% to earnings growth totals.

We believe that revenue growth for the first quarter will be about 5%, which normally would be supportive of good earnings growth. But profit margins have finally come under pressure beginning late in 2018 and continuing into 2019.

Capital spending has picked up, which is a positive trend for the long run. But in the short term, it puts pressure on margins. In addition, wage increases have picked up while corporate pricing power remains weak. Earnings growth for the full year is expected to be around 4%, but that assumes a rather robust growth rate in the fourth quarter.

Despite the dour outlook for near-term earnings, stocks have performed quite well this year, with strong gains in January and February and more muted results in March. Investors appear to be increasingly concerned with the outlook for economic growth, particularly globally. The shift in tone by the Fed reinforced (and was a reaction to) those concerns.

Some of this was evident in the performance of certain sectors in March. Large cap stocks, as measured by the S&P 500, were largely flat for the month, while the NASDAQ 100 experienced a solid advance, led by big technology companies, which are perceived to have less exposure to a slowing economy. (The NASDAQ 100 is an index of 100 of the largest domestic and international non-financial companies listed on The NASDAQ Index, which is an electronic stock exchange with more than 3,300 company listings.)

Small cap stocks also experienced a sell-off, likely a function of higher sensitivity to slowing economic growth. Growth equities outperformed value, with tech shares leading the growth segment while the slumping banking sector dragged down value stock indices. Banks have come under pressure as interest rates declined, which could negatively impact their lending margins.

Major international indices largely performed in line with large cap stocks in the U.S.

Our economic research has detected some weakness in the domestic economy, but we do not have any indication at this point that we are on the cusp of serious economic decline.

However, we can’t say the same for major economies outside the US. The Euro area, particularly Germany, is seeing a meaningful slowdown, as is the United Kingdom. The UK outlook is clouded by the lack of progress on a plan for Brexit, which has impacted business confidence and spending.

Germany has been impacted by the slowdown in China, as well as its southern neighbors in the European Union, with Italy officially in recession.

China’s weakness is the other wildcard. Policymakers there have taken steps to stimulate growth, but the cloud of tariff disputes remains. We are monitoring these issues closely and have taken a modestly defensive position in our equity portfolios, but at this point, we feel the most likely course is a stabilization of global growth and perhaps a pickup as the year progresses.

See First Quarter 2019 Market Recap: Stocks Edge Up and Yields Slide as Fed Eases Policy

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