With the Fed messaging that they are on “pause,” financial conditions have eased significantly and this has led to a very fast-paced and significant equity rally in last three months. Since the low point of the steep market decline at the end of last year, the market, as measured by the S&P 500, is up 19.8%. High-beta stocks, as characterized by companies that tend to be more risky, more cyclical in nature, or more heavily levered, are up an even stronger 25%. Is the broad market’s strong rally justified?
A 25% rally in pro-cyclical, high-beta stocks in three months would seem to indicate that the economy is not going into a recession in the near future. But the 10-year Treasury Note is at 2.44% even though it started out 2019 at 2.68%. We would normally expect that with a moderately accelerating economy we would see some upward pressure on the 10-year rate. Perhaps the bond market is ahead of the equity market in sensing that the economy isn’t quite as robust as the early 2019 equity rally would indicate. The inversion of the 3-month/10-year yield curve on Friday certainly raised those concerns. What we are seeing is that the U.S. economy is still healthy, just not quite as robust as the current equity rally would indicate.
There are a handful of other indications of some slowing in the U.S. economy including Q1 GDP forecasts for the Atlanta Fed, the St. Louis Fed, and the NY Fed, which are at 1.2%, 2.2%, and 1.3%, respectively. These numbers are obviously below the robust average 2.9% for 2018, but healthy nonetheless, considering the various factors that were hitting consumer confidence and stocks in Q4 of last year. Last week, we saw FedEx report a disappointing quarter and forward guidance. The company is a good proxy for global economic activity and it specifically said it is experiencing “slowing international macroeconomic conditions and weaker global trade growth trends.” Also, this past week we saw the Fed indicate that it will likely not raise rates again this year and it announced the end of letting its bond book run off – both very dovish moves. The Fed has been data dependent so the statements that it made—effectively forecasting zero rate increases from the prior forecast of two—was a strong statement about its current belief in a lack of inflation pressures and more limited growth.
Equities have sprinted ahead in large part due to the easing of financial conditions seen in improved credit spreads, less strength in the U.S. Dollar, and a Fed that has clearly communicated a more dovish stance relative to its comments in early October of last year. The recent rally may also be a rebound correcting the excessive equity declines from October through December 2018, when the market appeared to be pricing in a high likelihood of a U.S. recession. The Fed’s position has changed a lot since that time, especially from the overly aggressive Fed comments in October of still further rate hikes ahead. The chart below shows financial conditions (in green) rising sharply beginning Oct 3rd of last year when Fed Chairman Powell said that the Fed was a “long way from neutral.” This led to financial conditions tightening, credit spreads widening, and the beginning of an S&P drop that ultimately declined nearly 20%.
Source: Bloomberg, LLC.
The equity market rally in 2019 is very strong relative to the U.S. and global economic backdrop, but it is much less strong in light of the very sharp overreaction that we had in Q4 2018. Looking forward from here, the outlook for the current expansion to keep moving forward is still in place and looking fairly healthy, particularly if the U.S. and China can reach an agreement, which seems increasingly likely. The economy remains near full-employment and inflation is still below the Fed’s threshold of concern, an environment traditionally considered to be “goldilocks” or ideal. And the Fed’s most recent outlook for GDP growth in 2019 and 2020—at 2.1% and 1.9%, respectively—is right in-line with where we’ve been on average for the last ten years. Moreover, the S&P 500 is priced at a very reasonable 16.3 times the 12-month forward earnings forecast—this is below where we were in late September of last year when the market was trading at 16.9 times. And when compared to periods of U.S. history at comparably low inflation rates—at which times the S&P traded at 19.5x on average—the market remains cheap.