Equity and balanced accounts registered strong absolute returns for the three months ended March 31, 2019. Our equity portfolios lagged a bit relative to the S&P 500’s largest quarterly gain in a decade due to a conservative investment posture. Recalling last year’s difficult fourth quarter helps put perspective on 2019’s fast start.
Last October investors quickly came to the opinion that the new Chairman of the Federal Reserve Board was blindly determined to tighten financial conditions by raising interest rates and shrinking the Fed’s balance sheet. Given that economic data was indicating softening in near-term activity, fear of a Fed engineered recession rapidly translated into violent declines for risk assets. By late December, the Fed “pivoted” by clarifying that policy would be “data dependent.” Said differently, the Fed would not be raising rates anytime soon. Relieved investors have bid up the stock market in 2019 to the point where it is only about a percent below its all-time high. (This is a grossly simplified version because, believe it or not, we don’t get paid by the word.) A bumpy ride but almost a round-trip nonetheless. That said, looking backward is much easier than forward.
From where we sit today, our outlook is constructive but with the caveat that equity valuations are no longer at the depressed levels seen at the beginning of the year. The S&P 500 is now trading at roughly 17 times this year’s projected earnings; a good working multiple given low interest rates as long as the perception remains that the worldwide economy is growing. On that issue, after trade tensions and tightened financial conditions induced an economic slowdown in the latter part of 2018, investors now appear to be putting their faith in the efficacy of Chinese stimulus coupled with a favorable resolution of the U.S./China trade war. A rebound in China’s growth rate is key to improving worldwide growth. It is the largest swing factor. The policy mandate in China is broad reaching, including monetary, regulatory, and fiscal (income tax and VAT tax cuts) actions. The focus today is more on consumer spending as opposed to prior emphasis on infrastructure. We think that it will work. In fact, some of the recent data, the so-called “Green Shoots,” point to either stabilization or improvement in economic activity. For example, China’s March Purchasing Managers’ Index registered strong gains in both the manufacturing and non-manufacturing sectors, while U.S. housing activity appears to be the beneficiary of lower mortgage rates. Soon to be released first quarter corporate earnings face difficult comparisons but investors are likely to look through temporary weakness. Stocks may take some time to digest year-to-date gains but we think that the trend is in place.
In light of this improving setting, we tilted the portfolio a bit towards more economically sensitive stocks by purchasing a restructuring railroad, a cruise line operator and adding to a secularly growing semiconductor designer. Each pick is stock specific but we like adding to this type of economic exposure now. We also re-entered the leading social media company and boosted our exposure to a streaming-video service provider. Much of the funding for these purchases was sourced by significantly reducing our weighting in the health care sector. After a great run in 2018, this group is now feeling anxiety brought on by the 2020 election cycle. Our guts tell us that “Medicare for All” is too disruptive to become a reality but voters may feel differently. Either way, the headwind of this uncertainty is not likely to lift this year. We remain underweighted defensive sectors.
On the fixed income side, our point of view is that yields will be range-bound for an extended period and are currently at the lower end of their range. At the margin, we now favor Corporates over Treasuries. We will hear from the Fed again but expect a more measured approach than last October.
As always, the environment presents us with risks. Since the Financial Crisis, economic growth rates have lagged historic norms at comparable points in the cycle. Current expectations for a rebound in worldwide growth may be disappointed with the magnitude of the bounce back under the “new normal.” That said, we are focused on the duration of growth since we see little in economic indicators to portend a near-term recession. With low interest rates, stable inflation, and full employment, it is important to remember that economic expansions do not die of old age. The more likely threat comes from change in government policy. With the exception of a “bull’s eye” sector like health care, it still seems early to discount the 2020 elections. Make no mistake, it will be a growing part of our thinking as the year progresses.
For now, we are close to fully invested and look forward to navigating through first quarter earnings. As always, we remain sensitive to change and are positive about prospects over the longer-term.